Shallow Gulf Waters Get Lonely; Hercules Offshore Holds Hope That It Can Dominate in Aging Energy Field

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June 1, 2011

Hercules Offshore Inc., a contract driller that’s racked up three years of losses and angered shareholders over executive pay, has expanded its commitment to the Gulf of Mexico’s shallow waters at a time when others are packing up and moving on.

In April, Hercules became the biggest rig contractor in the Gulf’s shallow waters when it closed on a deal to acquire the rigs of Seahawk Drilling Inc., a weakened rival.

The company now operates about half of the rigs that are working in the Gulf’s shallow waters. Of Hercules’ 50 shallow-water rigs, 42 are stationed in the Gulf, although many are in storage.

While Hercules is bulking up along the Gulf’s shores, many companies have turned away from those aging fields in search of fresh, more prolific reserves. The population of shallow-water rigs under contract there has fallen to just 39 in May from a peak of 141 in April 2001, according to data tracker

But where some of its rivals see depleted oil and gas reserves, Hercules says it sees opportunity. Drilling in the area has been declining for the past decade, but Hercules is banking on its greater scale to reduce costs and stimulate more customer demand from its clients, such as Chevron Corp.

Even before the Seahawk rig purchase, Hercules said it had reduced operating costs by more than 40% between the third quarter of 2008 and the end of 2010, and trimmed its debt by nearly $300 million over the same period.

“We believe in the Gulf of Mexico long term,” Jim Noe, a senior vice president and the company’s general counsel, said in a recent interview.

Not everyone is bullish about the shallow-water Gulf’s prospects. Loretta Cross, managing partner at Grant Thornton LLP’s corporate advisory and restructuring unit, said she believes drilling activity in the shallow-water Gulf has further to fall.

Hercules concedes that its best growth opportunities lie in international waters, where the fees are higher and the contracts are longer. And more than half of the company’s revenue has come from international operations in the past few years, according to Mr. Noe. But it is holding onto its hopes for the Gulf.

Hercules revenue, which two years ago was more than $1.1 billion, last year shrank to $657.5 million. It ended 2010 with a $134.6 million loss.

The company’s recent results apparently annoyed many shareholders upset over the company’s executive-compensation practices.

On May 16, Hercules disclosed in a regulatory filing that a majority of shareholders voted against the company’s executive compensation plan for 2010, a rare event that has happened at fewer than 2% of more than 1,300 companies this year that have held votes, according to the advisory firm Institutional Shareholder Services.

The non-binding vote came after ISS and Glass Lewis, another advisory firm, criticized Hercules for a gap between pay and performance. Hercules executives received $3.8 million in incentive and retention bonuses last year, more than four times the value of the previous year’s bonuses.

Mr. Noe, the second-most highly paid executive after chief executive John Rynd, said the company would “evaluate and respect the vote that was cast.” But he defended the pay practices and said performance was affected by circumstances the company couldn’t control: the economic recession; the explosion on the Deepwater Horizon rig that prompted a temporary drilling moratorium by the Interior Department; the glut of natural gas that has pushed prices down and hurt demand for the company’s drilling services. Most of what is produced in shallow waters is gas.

Mr. Noe points to the company’s stock price, which is up 80% this year, as evidence that investors generally approve of what the company is doing.

Hercules stock on Tuesday closed at $6.25, down 5 cents, on the Nasdaq stock market. The shares remain far from their loftier heights of $40 a share in 2006, however.

Judson Bailey, a senior analyst at Jefferies & Co., an investment bank that receives revenue from Hercules, flipped his recommendation on Hercules from “hold” to “buy” in early 2011.

“I think management has done a pretty good job of keeping the company upright,” he said. As for Hercules’ enhanced stake in the Gulf, he said, “Is there a market? Yes. How viable? Very uncertain.”

Hercules has moved a few of its eggs out of the Gulf basket. In January it created and became the major shareholder of Discovery Offshore, raising $130 million from 158 investors in Europe, Asia and the U.S. to help finance two new rigs that are being built in Singapore.

The rigs will be capable of drilling at far greater depths and in harsher environments than the rest of Hercules’ fleet.

“Frankly, they’re more likely to work in the Far East, the Middle East, or the North Sea than the Gulf of Mexico,” Mr. Noe said.

-By Daniel Gilbert, Dow Jones & Company, Inc.

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