Iraq Oil Shock? 2 Reasons Why Deepwater Is the Place to Be

A crisis in Iraq could lead to a spike in oil prices. If so, deepwater is the best place to be. This article explains why.

Jun 18, 2014 at 9:35AM

Iraq Burning Oil Allvoices Pic

Burning oilfields in Iraq during Gulf War I. Source: Allvoices.com 

With the latest turmoil in Iraq, both global and U.S. oil prices shot up to recent highs. Brent crude, which typically represents global oil prices, now sits at a lofty $113, and West Texas Intermediate is $106 per barrel. At these prices, one would think that all is well in the oil patch. Indeed, most nascent shale plays, deepwater discoveries and new Arctic operations should be very profitable here. 

However, the problems that have been plaguing supply capacity continue. Issues such as infrastructure bottlenecks and export constraints persist in the two sources of fastest-growing capacity; Canada and the U.S. This has caused wide differentials between North American and global oil prices, and those spreads could widen even more as capacity in North America continues to grow. Elsewhere, resource nationalization keeps a majority of the world's prolific oil fields off-limits to international oil companies.

So, while oil prices are indeed high, the biggest beneficiaries to the prospect of persistently high oil prices will be those connected to global oil markets but free from resource nationalization and onshore politics. That's where deepwater oil comes into play.

It is indeed uncertain whether the events in Iraq will lead to persistently high prices. But if prices stay high, deepwater oil is the clear winner in this scenario for two big reasons: First, no matter how turbulent things get in the Middle East, such instability can never make it all the way out to oil rigs which are miles off the shores of places like Brazil, Africa, and the North Sea. Second, all the crude oil pumped from deepwater rigs gets realized at Brent crude prices. In other words, deepwater oil does not get discounted due to infrastructure bottlenecks and export bans, unlike oil from North American shale. In a scenario of persistently high oil prices, deepwater is the place to be. 

Where to start 
The companies most significantly exposed to deepwater are oftentimes not the actual drillers but the lessors of the rigs which are being used. Consider a rig lessor like Ensco (NYSE:ESV). Ensco has a relatively young fleet which is geared to deepwater exploration and production. Of its large-cap offshore peers, Ensco has by far the lowest leverage. A quick look at the company's balance sheet reveals that its debt is a very manageable 2.5 times operating cash flow; a ratio far lower than that of its more indebted peers such as Seadrill (NYSE:SDRL). In addition, Ensco's dividend is only 53% of earnings, which is once again far lower than that of its peers.

For those who would like exposure to a more well-known producer, try Chevron (NYSE:CVX), which has two 'megaprojects' under way in the Gulf of Mexico. Jack and St. Malo, the two massive Gulf drilling projects, will be very profitable undertakings if Brent crude continues to hover over $110 like it is doing today. Like Ensco, Chevron has a solid balance sheet, a well-covered dividend, and a conservative debt load. If the global oil supply situation remains tumultuous, Chevron's offshore expertise will be of great benefit. 

Bottom line
Whether the events in Iraq will turn into a full-blown production crisis remains uncertain. This is not the first time this type of situation has arisen, and it likely won't be the last. Many times, such as during the Arab Spring in Egypt a few years ago, oil prices returned to their usual level. Nevertheless, volatility spikes seem integral to the oil market. Deepwater drillers are far enough away from the turmoil but still benefit from the price spikes that often follow. 

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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.

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