3 Specialized Plays on Offshore Drilling

Recent concerns about weakness in the offshore oil-drilling sector have created many opportunities to capitalize on one of the most powerful mega-trends in the energy industry. This article highlights three specialized small-cap drillers that are likely to sail through the short-term weakness and earn investors market-smashing returns.

May 12, 2014 at 8:51AM

Over the past 11 years, oil companies have grown their exploration and production budgets by a 15% compounded annual growth rate to a staggering $650 billion. In 2014 and 2015, oil companies are expected to pull back their deepwater offshore budgets to focus on major oil and gas shale formations in North America.

Meanwhile 17 ultra deepwater (UDW) rigs are scheduled to be delivered between 2015-2016 that have yet to be contracted. This upcoming slowing in demand with increased supply has led many Wall Street analysts to become very bearish on the industry over the short term.

Barclays, Morgan Stanley, Citigroup, and Barron's have all expressed severely negative sentiment on the strength of industry dayrates over the next two years.

However, on a long-term basis, the strength of offshore drilling, specifically UDW drilling, represents one of the best investing opportunities investors are likely to find in this overheated market. This is because UDW oil production is predicted to grow by a 19% CAGR between 2012 and 2030 (compared to 1% CAGR for land-based oil production).

This will require 165 more UDW rigs than exist now or are scheduled to be built. Thus the long-term outlook for the UDW drilling industry is one of rising dayrates, profits, and dividends.

This article is meant to highlight three specialized small-cap drillers that each possess a strong growth catalyst to deliver market-smashing returns to patient, long-term investors.

North Atlantic Drilling (NYSE:NADL) is a subsidiary of Seadrill, which retains 70% ownership in the company. The company operates eight harsh environment rigs (five UDWs and three jack-ups) with one UDW under construction. The investment thesis for this company comes in three parts.

First, the company has a strong $2.6 billion backlog of contracts; it is 99% contracted through 2014 and 73% through 2015. This will minimize the impact of short-term industry weakness in pricing and ensure stable cash flow that secures the dividend, one of the other main reasons for owning this company.

With a 10.8% yield that is covered 2.6 times by earnings before interest, taxes, depreciation, and amortization, North Atlantic's dividend is not only safe (and one of the highest yields in the entire market) but likely to grow in the future.

Which brings me to the final reason to invest in this company -- the growth potential represented by Arctic oil exploration. There are a projected 44 billion to 157 billion barrels of oil in the Arctic (and 299 to 1,547 Tcf of natural gas), and much of it is under the ocean.

As companies such as ExxonMobil and Rosneft explore the Arctic Ocean (joint venture with 36 billion barrels of oil to drill), they will turn to the experts in harsh environments and UDW drilling, experts such as North Atlantic Drilling.

Pacific Drilling (NYSE:PACD) is one of two 100% pure UDW drillers -- Ocean Rig UDW (NASDAQ:ORIG) is the other -- and its fleet of five rigs (with three more under construction) represents the eighth-largest UDW fleet in the world. A major competitive advantage for Pacific Drilling is that, at an average age of just 1.9 years old, it has the most modern fleet in the world.

An exciting investment catalyst for potential investors to consider is management's proposal that Pacific Drilling will begin paying a generous dividend in 2015 ($152 million). Should shareholders approve the plan, the annual dividend of $0.72 per share would yield 6.6%, representing the third-highest yield in the entire industry (behind Seadrill and North Atlantic Drilling).

Management is guiding for 52% CAGR EBITDA growth through 2015 (up to $600 million in 2015), which means the dividend would be very well covered (EBITDA/dividend ratio of 4) and have room to grow quickly in the future.

Combine one of the fastest-growing companies in a fast-growing and promising industry with such a generous dividend and you have the makings of one of the best dividend growth stocks in America.

Ocean Rig UDW is another pure-play UDW company with eight UDW rigs and three more under construction. These three are seventh-generation rigs, the most advanced in the world, and will likely have little trouble securing high-paying contracts.

Ocean Rig's UDW fleet is the sixth largest in the world, and at just 3.1 years old it is the fourth newest. With a strong backlog of $5.6 billion (up from $1.6 billion in 2012), an average fleet dayrate of $526,000, and a 95% utilization rate, Ocean Rig stands toe-to-toe with the best UDW drillers in the industry, most notably, Seadrill.

Foolish takeaway
The recent price collapses in offshore drilling stocks are an overreaction to a brief slowdown in the industry that will mainly affect legacy drillers with large, older, less advanced fleets. The companies listed above all have among the youngest, most technologically advanced fleets in the world and will likely ride out the short-term weakness with ease. For patient, long-term investors, these companies offer not only a chance for strong capital gains but also high and growing dividends as well: the trifecta of investing.

Another way to profit from offshore drilling
Imagine a company that rents a very specific and valuable piece of machinery for $41,000… per hour (that’s almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company’s can’t-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report reveals the company we’re calling OPEC’s Worst Nightmare. Just click HERE to uncover the name of this industry-leading stock… and join Buffett in his quest for a veritable LANDSLIDE of profits!

Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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