Many energy stocks just can't seem to catch a break these days. For bargain hunters, though, this is a good thing. The world's oil production is shifting from onshore production in geographies such as the Middle East and Russia to deepwater and North America. This production shift is a long-term investment thesis, and one that is being drowned out by short-term fears of modest price drops in oil.
For those willing to dip into oil and gas, there are many reasonably priced names from which to choose. This article is going to look at two that are down significantly and are now attractively priced.
Deepwater drilling is often seen as a risky, marginal method of oil production. Many perceive deepwater as not only prone to headline-catching accidents but also the first operational casualty in the event of lower oil prices. This is due to the industry's capital-intensive nature. While it is true that deepwater is very capital intensive and does require higher oil prices, it has a few things going for it.
First, profits are tied to the higher Brent Crude price, and not West Texas Intermediate, which trades at a substantial discount. Second, deepwater operations will not only remain profitable but also will increase activity as long as oil stays above $100 per barrel. The Saudi oil minister has, on a number of occasions, pledged to regulate capacity in order to keep Brent above $100.
Perhaps the best value in the deepwater space right now is Seadrill (NYSE: SDRL ) , a lessor of offshore drillships which is down by nearly 14% since October. A high-dividend but also high-debt company, Seadrill is, unfortunately, often misunderstood by retail investors.
In a nutshell, Seadrill yields a very nice 9.3% with a trailing price-to-earnings ratio of only 8.1. The company's free cash flow, a key metric in determining a company's ability to pay its dividend, does not cover cash paid out to shareholders. This, coupled with the company's increasing debt load, is enough to scare many retail investors away.
The above chart is perhaps the best explanation of Seadrill's current situation. The demand for deepwater drilling is rising. In response to this demand, Seadrill is spending substantial capital and taking on substantial debt in order to expand its fleet. Of course, it takes a couple of years to order, build, and commission a ship, and so the capital spent on these ships does not automatically translate into profits.
The above chart shows the earnings before interest, taxes, depreciation, and amortization impact of newly built ships added to Seadrill's fleet last quarter. We can expect Seadrill to continue to spend capital and grow its fleet until the end of 2015. But make no mistake, this is a growth story just as much as it is a dividend story. When we consider just how cheap Seadrill is right now, I believe the stock is worth giving a chance.
Value from shale
The Eagle Ford shale in Southern Texas is the second most economically viable shale play in the US. Development in the Eagle Ford only started in 2010, and most experts believe that this shale will produce for at least two decades with existing technology. A major theme in 2014 will be the development of the newer Western portion of this shale.
Rapidly growing Sanchez Energy (NYSE: SN ) , a small-cap producer in the Eagle Ford, is one of the companies leading that charge. Of this small company's $700 million capital budget for 2014, Sanchez will spend $295 million of it in developing the Western portions of this shale. The result should be 37 brand new wells up and running in this premier shale play.
And it gets better, too. Wells in all of Sanchez's areas of operation, with the exception of only the lower-reserve wells in the Western-most acreage, will fetch an internal rate of return of more than 20% were West Texas Intermediate oil to drop to $80. In fact, Sanchez is among the highest-margin producers in the Eagle Ford, bested only by one of its peers.
And surprisingly enough, Sanchez is actually trading at a discount to its peers. Carrizo Oil & Gas and EOG Resources, two other Eagle Ford-focused plays, trade at 2.6 and 3 times book value, respectively. Sanchez, on the other hand, trades at only 1.3 times book. While we don't know exactly how much Sanchez will grow its oil production this year, last year it managed to grow oil production by triple digits, and this year the company is drilling more wells than it did in the last. With rapid oil production growth in a premier shale play and a very reasonable valuation, Sanchez is also worth a shot.
The composition of energy production is shifting to both the shale and deepwater. Many names in these two growing sectors, however, are down on fears of modestly lower oil prices. Now is a good time to take advantage of this, and get into this secular growth at a reasonable price.
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