Are You Ready for an Offshore Drilling Buying Opportunity?

It appears Wall Street has become very cautious on offshore drillers. Shares of companies like Ensco (NYSE: ESV  ) , Transocean  (NYSE: RIG  ) , and Noble Corp  (NYSE: NE  ) have dropped between 20% and 30% from their 52-week highs. As much as shareholders have suffered so far, more bad news may be on the way. But further declines might actually present an excellent buying opportunity. Here's why.

Recent results have been good
While shares of offshore drillers have performed poorly, recent results have been pretty good. Ensco, owner of the world's second largest offshore drilling rig fleet, saw its latest quarterly adjusted earnings per share rise 14% year over year. Revenue, meanwhile, grew a nice 16%. Performance was mainly due to higher rig pricing. The amount the company received per rig (average daily rate) spiked 16%. This offset a drop in Ensco's rig utilization, or the number of days rigs were used compared to total available days. Utilization fell to 83% in the quarter from 86% a year earlier.

Noble Corp, an industry peer, reported an even better quarter. Earnings per share jumped 64% from the year-ago period with sales climbing 21%. Average day rate gains, which climbed nearly 22% year over year, boosted results as demand stayed flat. The company's drillship business delivered the most impressive performance. These marine vessels, modified to drill for oil in deepwater areas, posted a 36% increase in day rates and 28% growth in usage during the quarter.

Results from Ensco and Noble show that offering the latest in drilling products can garner higher rates and better results. Transocean, one of the industry's largest participants, operates an older rig fleet and payed the price. Its latest quarterly sales fell almost 9% year over year and adjusted earnings per share plunged nearly 20%. Weak demand for its aging fleet, as only 75% of total operating days were utilized, overwhelmed a slight 3% rise in average day rates.

Transocean may see continued tough times as demand continues to falter. On a recent conference call, company management admitted that clients are delaying drilling programs and increasingly sub-letting rigs.

Demand and supply issues are a concern
A planned drop in fixed asset investments from oil and gas giant ExxonMobil may indicate the entire industry could see weakening demand. ExxonMobil expects capital spending will drop to $39.8 billion this year from a peak of $42.5 billion last year. Future expenditures are expected to fall even further -- to less than $37 billion per year from 2015 to 2017.

While sluggish demand trends might pressure offshore drillers' results, a possible oversupply of rigs could be devastating. Due to a boom in offshore oil exploration after the 2008 financial crisis, drillers have worked to enlarge their fleets. Ensco, in its latest annual SEC filing, noted that ongoing construction programs continue to boost worldwide deepwater rig supplies.

With an estimated 99 deepwater drilling vehicles currently under construction and more than 30 scheduled for delivery in 2014, Ensco believes the new market entrants will depress demand and day rates for older rig models at a minimum. The number of newbuilds, when combined with established rigs whose contracts must be renewed this year, could potentially damage the entire highly lucrative deepwater-drilling market.

Long-term fundamentals remain intact
If weakening demand and an oversupply of rigs should negatively impact the industry, investors may want to consider the drillers on any resulting share-price decline; long-term fundamentals for the industry still appear strong.

The opening of new drilling regions in the U.S. may provide substantial future growth. Governors from Mid-Atlantic and Gulf Coast states have been urging federal officials to finalize rules that would dramatically expand oil and gas exploration opportunities off U.S. coasts. A positive U.S. Department of the Interior environmental impact statement could allow energy companies to begin their search within months.

Oceanic deepwater oil exploration looks to have a bright future as well. While onshore shale oil and gas fields have produced large amounts in total, they are not very prolific on a per-well basis. Shale wells typically produce less than 3,000 barrels of oil per day upon initiation, and their flow rate deteriorates rapidly. On the other hand, a single deep-sea oil find can produce huge amounts for many years. Bonga, Nigeria's blockbuster deepwater oil discovery, is a good example. The find, operated by oil major Royal Dutch Shell, has delivered an average of more than 175,000 of barrels of oil per day since its introduction with the expectation that it will be a major producer for decades to come.

Offshore driller shares look inexpensive
Currently undervalued shares make offshore drillers an even more appealing investment consideration, especially on any further price pullback. On an historical basis the stocks certainly appear cheap. Ensco, trading at around 2.3 times last year's revenue and 5.7 times operating cash flow, seems heavily discounted to its 2006 market valuation. At that time, a good but not peak period for the industry, the driller was valued at around 4 times sales and 7.7 times cash flow.

Noble Corp appears similarly inexpensive. Its current stock market value at near 1.7 times 2013 sales and 4.3 times cash flow is noticeably lower than its 2006 average pricing of 4.6 times revenue and 9.8 times operating cash flow. Transocean shares show the largest divergence, however. They are currently valued at around 1.5 times sales and 6.7 times adjusted cash flow, a pittance to the stock's historical worth of more than 5.8 times sales and 18 times cash flow -- although Transocean is admittedly not the unblemished industry leader it was in the past.

Bottom line
Offshore drillers have fallen noticeably over the last year. Further declines may be possible, even likely, as the industry faces some serious supply and demand issues. But any further drop in their stock prices may be a buying opportunity. The longer-term outlook for companies like Ensco, Noble Corp, and Transocean appears good, and their shares look inexpensive. Investors should watch the sector as it may soon be offering some compelling stock bargains.

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