Offshore energy activity is growing both absolutely and proportionally to onshore production.
First, the long-term view. As we can see here, energy production (and consumption) is expected to grow steadily through 2040, but conventional production from the traditional basins of the world will steadily decline over that same period. Other areas of production, therefore, will have to compensate, and deepwater oil production is an important part of that.
There are a couple ways to participate in increased offshore energy activity, the most obvious choice being large oil and gas companies with big deepwater exposure, such as a Chevron (NYSE:CVX) or Noble (NYSE:NBL).
That is a fine way to do so, but another intriguing way to participate in this trend is offshore rig lessors. The big oil and gas companies rarely, if ever, actually own the rigs they operate offshore. Most of the time operators will lease rigs and pay a contracted day rate to do so. Exposure to rig day rates is more of a pure-play on offshore activity as opposed to profiting from oil and gas produced offshore as with the oil and gas producers. Offshore rig lessors have the locked-in cash flow thanks to long-term contracts with operators. This oftentimes leads to high, predictable dividends, too. The two best rig lessors, in my opinion, are Seadrill (NYSE:SDRL) and Ensco (NYSE:ESV).
Oftentimes large companies in similar industries will run their respective companies in similar ways and will make similar financial decisions. Not so in the world of offshore leasing. Seadrill is a mostly Norewgian-run company, with a rather European way of looking at dividends. Seadrill currently pays virtually all of its cash flow to shareholders, offering a relatively high 11.25% dividend yield. Ensco, on the other hand, offers a more modest 5.6% yield, but pays only 40% of its earnings per share in dividends. Basically, Seadrill focuses on maximizing cash to shareholders regardless of the business cycle, while Ensco looks for dividend reliability and adheres to the very American business tenet of "under promise, over deliver."
Regarding debt, Seadrill is again the more adventurous of the two. Seadrill's debt sits at $13 billion, in a combination of bonds and swap-protected credit facilities, which comes out to nearly nine times operating cash flow. Ensco's debt, on the other hand, is entirely in bonds, and accounts for under 2.5 times operating cash flow.
But before you dismiss Seadrill as a swashbucking risk-taker, consider the bigger picture. Demand for offshore rigs is increasing steadily. Not only that, since the Macondo accident of 2010, operators are clamoring for and putting a price premium on the newer, safer, state-of-the-art rigs. Seadrill has responded to this demand most aggressively, taking out debt to build the new rigs which the industry demands. As such, Seadrill has the youngest, most deepwater fleet of all the major rig lessors (Ensco is second). This will mean a big competitive advantage in the coming years.
Risk and reward
Personally, I think both companies are good investments at this price, and that the better choice really depends on the needs of the individual investor. Seadrill has the operational edge in a market where up-to-date rigs fetch a day-rate premium. In addition, its very high yield allows investors to quickly build income.
At this price, Seadrill offers the possibility of not only a high yield, but also great capital appreciation if demand for rigs continues to grow. Ensco, for its part, plays a more conservative role: It has less debt and and its dividend has plenty of room for growth over the next few years if the company decides to do so. Ensco is the more 'steady' choice of the two, but may not provide as much upside if rig demand continues to march higher.
Another way to play offshore drilling
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Casey Hoerth has no position in any stocks mentioned. The Motley Fool recommends Chevron and Seadrill. The Motley Fool owns shares of Seadrill. 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.