The 3 Best Offshore Oil Drillers for High-Yield Investors

Offshore oil drilling is one of the most powerful mega-trends of the next few decades. Due to short-term industry weakness, income investors have a chance to lock in safe, high yields that are likely to grow strongly for many years to come.

May 15, 2014 at 2:53PM

Editor's note: A previous version of this article referenced Noble Energy (an onshore E&P company) rather than Noble Corp (the offshore driller). The Fool regrets the error.

According to a study by Morgan Stanley and Rystad Energy, by 2035 the world's oil demand will increase by 13%-26%, causing prices to increase to $125/barrel-$150/barrel. 

To meet the massive demand in the face of aging and depleting land-based oil fields, oil companies are having to increase their E&P (exploration and production) budgets enormously. In 2013, total global E&P spending was almost $650 billion. To put that into perspective, according to the CIA world factbook, in 2012 the entire global economy was $85 trillion. This means that $1 of every $130 in the world is spent on finding and producing oil. 

The location of new oil fields is the key to this article and the investment opportunities it presents. Between 2012 and 2030 conventional, land-based oil production is expected to grow at just  a 1% CAGR. In contrast, ultra-deepwater production will grow at a 19% CAGR. 

Recently a series of negative articles and opinions by Wall Street's leading analysts have maximized negativity about the offshore drilling industry: 

  • An article in Barron's argues that oil will fall 25% to $75/barrel over the next five years.
  • Barclays predicts up to 40% downside for offshore oil drillers due to a glut of new rigs causing plummeting day rates.
  • Morgan Stanley and Citigroup predict falling day rates over the next two years will cause a collapse in the stock prices of offshore drillers.
This article is meant to show why these negative views of the offshore oil drilling industry are short-sighted and why now is the time for income investors to load up on cheap shares of the best offshore drillers. 
Why the analysts are wrong
In order to satisfy the demand for ultra-deepwater oil production in 2020, the world will need 455 ultra-deepwater (UDW) oil rigs. This is 165 more than exist now or are scheduled to be built. 
Thus the concerns over falling day rates due to a short-term glut of new UDW rigs is misguided because by 2016-2017 global demand will have easily absorbed the new supply. This will keep day rates high for the most advanced rigs. My favorite offshore driller exemplifies this point.

Seadrill (NYSE:SDRL) has a fleet of 49 rigs (34 UDWs), with another 20 to be delivered by 2016 (11 UDWs). With the most modern UDW fleet in the world (average age 3.2 years), concerns over falling day rates shouldn't apply to Seadrill. Ten out of Seadrill's eleven latest UDW contracts have been for higher day rates, including its highest rate ever ($653,000/day) signed in the fourth quarter of 2013.

With an almost 12% yield that even Barclay's calls "rock solid" and the stock trading at just eight times cash flows (25% below historical average), Seadrill is massively undervalued. In addition, management has recently undertaken a balance sheet strengthening plan to secure the dividend (and grow it gradually during the short-term weakness) while paying down debt.

Combine this with the 20% CAGR EBITDA growth management is projecting through 2016 (due to the fleet growth) and you have the potential for a great investment over the next decade, combining an already sky-high yield with the potential for dividend growth and substantial capital gains. 

Ensco plc (NYSE:ESV) is my second favorite offshore oil driller for two key reasons.

First, it has the second most modern UDW fleet in the world (average age 3.9 years) with six new rigs to be delivered by 2016 (three of them UDW). Unlike Seadrill, which finances its new rigs with cheap debt, Ensco likes to mostly fund new rigs with cash flow -- a major reason why it has the lowest leverage ratio in its industry (27%).

In addition to a fast growing, super-modern UDW fleet, Ensco has the second highest yield in the industry -- 6%. With a payout ratio of 49% and cash flows predicted to grow by 12% annually, this dividend is not just safe but likely to grow in the future.

Noble Corp (NYSE:NE) is my third favorite offshore driller for three reasons.

First, the yield of 5% is the third highest in the industry, yet represents only a 25% payout ratio. 

Second, cash flow growth after 2015 (due to completion of its new build program) will fund dividend growth. 

Finally, it's spinning off standard rigs into a separate company (Paragon Offshore), leaving Noble a pure premium rig play. This will minimize exposure to short-term day rate weakness and further secure the dividend.

In addition, the Paragon IPO (summer 2014) will likely see Noble sell 20% of Paragon, resulting in further liquidity to pay down debt, secure the dividend, and grow it in the future.

Foolish takeaway
The current concern over offshore oil rig day rates is greatly overblown. The current price weakness is a terrific opportunity for long-term income investors to cash in on one of the strongest megatrends of the next few decades and achieve the trifecta of investing: high yield, fast growing dividends, and superior capital gains.

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Adam Galas owns shares of Seadrill. The Motley Fool recommends 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.

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