Few stocks have been as battered over the last year as much as offshore drillers such as Transocean (RIG 1.89%), SeaDrill (SDRL), and Diamond Offshore (DO).
With industry conditions continuing to worsen, let's explore three reasons why shares of these companies might crash further in 2015, and why this might prove a great long-term investment opportunity.
Oil prices may fall further and remain low longer than previously thought
Oil prices rallied in February on hopes that a rapid fall-off in U.S. land based oil rig counts -- down 33% compared to last year -- meant that U.S. supply would fall faster than expected and help alleviate the world's supply glut of crude. In fact, according to the International Energy Agency, or IEA, global oil demand is rising at a rate that could eliminate the world's excess supply by the end of 2015.
Source: IEA
However, as if to prove just how unpredictable the world oil markets are, the IEA's most recent world oil market report revealed that U.S. oil production during the fourth quarter was revised upwards by 300,000 barrels per day, and the agency is revising its North American Q1 supply growth estimates as a result.
In addition, the IEA's report pointed out that some of the recent increase in oil demand was a result of traders buying up crude in hopes of selling it at a profit later. With the world's oil storage capacity limited and approaching full capacity, the IEA correctly points out that this kind of demand growth isn't nearly as sustainable as organic demand fueled by global economic growth, which has been slowing as of late, especially in China.
Overall the IEA's February report isn't overly optimistic about oil prices recovering anytime soon. To quote the report: "Behind the facade of stability, the re-balancing triggered by the price collapse has yet to run its course."
Market conditions might not recover until 2017
Image courtesy of SeaDrill
In March of 2014, SeaDrill's CFO Rune Magnus Lundetrae stated in an interview that his company expected the offshore drilling industry to start recovering in 2016. However, Mr. Lundetrae recently revised his statements by stating that SeaDrill doesn't see day rates stabilizing until 2017: "That means you get day rates that at least cover costs including funding." Lundetrae added that he expects day rates to rise to $400,000 per day for the newest UDW rigs by 2017, suggesting rates have potentially further to fall until then, especially for older, less modern rigs.
This bodes poorly for an offshore drilling industry that is facing an increased risk of contract cancellations and renegotiations.
Contract cancellations and renegotiations increasing
Crashing oil prices have increased the number of contract cancellations. Norwegian oil giant Statoil alone canceled five contracts in 2014, including two with Transocean and one with Diamond Offshore. Most recently, Diamond Offshore filed paperwork with the SEC, stating that it's been contacted by several oil companies, which indicates the likely cancellation of six contracts.
If oil prices remain low for the next few quarters, offshore drillers might similarly face additional contract cancellations, or find that oil companies begin demanding the renegotiation of existing contracts at cheaper day rates. Petrobras, for example, recently demanded lower day rates for two of its three-year UDW contracts with Seadrill, a move that forced the offshore driller to remove $1.1 billion from its contract backlog.
Similarly, SeaDrill recently announced that its previous $4.1 billion deal between Russian oil giant Rosneft and SeaDrill subsidiary North Atlantic Drilling, which has already been postponed once, is now unlikely to close at its previously agreed-upon terms.
Takeaway: Worsening market conditions mean offshore driller shares could have further to plunge in 2015, creating long-term buying opportunities
Hopes of a quicker than expected recovery in oil prices and a subsequent recovery in offshore drilling day rates seem to be waning. As a result, it's possible shares of offshore drillers could have further to fall in 2015.
However, given the good long-term prospects of the industry I remain bullish in the long term on offshore drillers as a whole, especially with shares of quality drillers like SeaDrill trading at such undervalued levels. In my opinion, investors with a long time horizon, of five or more years, stand to make substantial capital gains by dollar-cost averaging into these companies at their current share prices. That being said, current and potential investors should be aware of the headwinds facing the industry and the potential for short-term paper losses, and allocate their diversified portfolios accordingly.
