3 Reasons Offshore Drilling Can Stay Hot

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One of the few consistent bright spots in the economy over the past few years has been energy production. Shale drilling has expanded dramatically in the U.S. over the past seven years, and ultra-deepwater offshore drilling continues to expand around the world.

There are a number of ways for investors to play these two trends but the one that I think provides significant upside with downside risk protection is investing in offshore drilling rig owners. These companies aren't affected by day-to-day swings in the price of oil but they benefit from its long-term move higher and they're providing services to some of the largest new reserves in the world.

Oil isn't going anywhere
The macro trend for oil continues to be strong. Oil continues to trade above $80 per barrel consistently and the long-term trend shows prices remaining near $100 per barrel. This is due to high global demand and some limits to supply (think OPEC).

Long term, this shouldn't change because China, India, Brazil, and even the U.S. are continuing to grow and our energy needs continue to increase. Supply won't easily be added because we've exploited the easy oil fields, something that will drive offshore drilling.

An abundance of offshore oil
Offshore drilling isn't a new concept, but it wasn't until relatively recently that we began drilling in water over a mile deep. This has opened up a whole new world of oil reserves and will serve the ultra-deepwater industry well for years to come.

Brazil is probably the best-known deepwater field, but the amount of reserves in deepwater is expanding elsewhere as well. Angola recently signed contracts with explorers to drill its "pre-salt" oil field that may hold 100 billion barrels of oil. In the same region of the world the Congo and Nigeria also have major deepwater finds.

Last week, the amount of deepwater reserves grew again when Mexico's state-owned oil company Petroleos Mexicanos said it drilled a well that may have 125 million barrels of oil. If the reserves are proven in this field it could double the 13 billion barrels of oil the area thought to exist.

It's been a reinforcing loop for oil drillers. An increase in drilled wells leads to more reserves, which leads to increased production and more wells.

A boom for drillers
The expansion of ultra-deepwater drilling has been a boon for rig owners. Seadrill (NYSE: SDRL  ) has built a foundation on ultra-deepwater and doesn't intend to change course any time soon. Transocean (NYSE: RIG  ) and Noble (NYSE: NE  ) are the other two big names adding to their ultra-deepwater fleets to fill industry demand. Then there's Ocean Rig (Nasdaq: ORIG  ) , the DryShips (Nasdaq: DRYS  ) spinoff, which is the one pure play on ultra-deepwater, although it carries significant risks due to its CEO George Economou.

These companies are commanding $600,000 per day for ultra-deepwater rigs and are signing contracts years in advance. Seadrill has most of its deepwater fleet booked through 2017 and Transocean just signed a 10-year contract for four rigs that won't even be complete for another three years.

The future looks bright in deepwater drilling.

When I'd sell
Ultra-deepwater drilling is hot right now but the bubble has to burst eventually, right?

Investors should keep an eye on the increased supply of ultra-deepwater drilling rigs, which is the biggest risk to current earnings. Not only are Seadrill, Transocean, and Noble expanding their rigs, new entrants are as well. Diamond Offshore (NYSE: DO  ) has four new drillships on order and others in the industry are expanding as fast as they can.

But I don't think there's reason to sell yet. I mentioned before that the offshore market has been a reinforcing loop and I think the trend will continue. More reserves will be found as more supply hits the market, which should mitigate some of the risk.

Until we see dayrates for ultra-deepwater rigs fall below $500,000 I think these companies will do very well.

The best stocks in offshore
I'm still a big fan of Seadrill, even after its run-up over the past year. The stock trades at just 11.3 times forward earnings and pays an 8.6% dividend, which should make value and dividend investors happy.

Noble is also a strong pick as well, although it doesn't pay the same attractive dividend as Seadrill at the moment.

Coming in third for the time being is Transocean, who has struggled with performance recently but might be able to turn things around after selling much of its shallow-water fleet. The company is expanding a large fleet in ultra-deepwater, and if it can execute in the future, then this down and out stock has an opportunity to outperform Seadrill and Noble. I'm just not ready to make that call quite yet.

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Fool contributor Travis Hoium manages an account that owns shares of Seadrill, Ltd. You can follow Travis on Twitter at @FlushDrawFool, see his personal stock holdings, or follow his CAPS picks at TMFFlushDraw. The Motley Fool owns shares of Seadrill, Ltd., and Transocean. Motley Fool newsletter services recommend Seadrill, Ltd. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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10/21/2016 4:01 PM
DO $17.40 Down -0.50 -2.79%
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