The times, they are a-changing ... at least regarding investor sentiment toward the oil-service sector. After bounding ahead by 53% in 2005, the Philadelphia Oil Service Sector Index has run out of steam this year. It has advanced a mere 11% against the 15% gain recorded by the NYSE Composite Index and has even failed to match the 12% advance of the S&P 500.
Now, I know that oil prices have come down nearly 25% from their highs, but crude still trades north of $60/barrel -- OPEC's new floor -- and it's not as if the major oils have slashed their exploration and production budgets. In fact, according to a recent survey by Lehman Brothers, oil companies are expected to have increased exploration and production spending by 30% in 2006 and plan to raise expenditures by a further 9% in 2007.
That's why I believe that investors might want to take another look at the oil-services sector in general, and at the offshore drillers in particular. Simply put, increased exploration and production spending drive demand for rigs -- especially the specialty rigs used for offshore drilling -- and growing demand allows offshore-drilling companies to realize higher dayrates and, hence, greater profits. Two of my favorite plays among the offshore drillers are deepwater-drilling leader Transocean (NYSE: RIG ) and shallow-water/liftboat operator Hercules Offshore (Nasdaq: HERO ) , because of their leadership positions in their respective markets and attractive valuations.
Let's drill into their prospects, shall we?
Transocean is the largest deepwater driller in the world. Its fleet of roughly 82 mobile platforms includes 33 "high-specification" floaters, 28 of which can drill in ultra-deepwater areas ranging from 4,500 to 10,000 feet. The rest of the company's fleet consists of 20 floaters capable of drilling between 1,000 and 4,000 feet and approximately 25 jack-up rigs used in shallow-water operations -- none of them in the volatile Gulf of Mexico (GOM) market.
Transocean is a pretty simple investment story: An increasing number of the world's newest oil fields are being discovered in offshore locations, especially in deepwater areas where only a few companies are capable of operating. A prime example is the recently discovered field in the GOM -- which Chevron (NYSE: CVX ) estimates to hold between 3 billion and 15 billion barrels of oil and natural-gas equivalents -- that was found at a depth of 5.3 miles below sea level. Drilling at that type of depth will require rigs and expertise that only a few companies possess, and Transocean is one of them. (Diamond Offshore (NYSE: DO ) is another.)
The intensity of demand for offshore drilling services, especially the deepwater variety, was illustrated by Transocean's third-quarter report that its rig utilization rate across its fleet was 87%, up from 81% in the prior year's period, while dayrates averaged $146,900, an increase of 14% from last year's quarter. The company also reported a record contract backlog of $20.2 billion (as of Oct. 31) and said that it had completed roughly $2 billion worth of its authorized $4 billion share-repurchase program.
Given the heightened visibility to earnings because of the backlog, the likelihood of further increases in dayrates, and the company's obvious confidence in the outlook for drilling services (that size of buyback is a nice indicator), I believe that investors might want to take a look at the premier player in the deepwater niche & especially since shares of Transocean trade at a mere 11 times fiscal 2007 estimates.
Now, let's move along for a quick look at mighty Hercules.
Hercules is an offshore driller with nine jack-ups that recorded an impressive utilization rate of 99.3% and an average increase in dayrates of 71% in the most recent quarter. But the main reason I like it is that it's the leading player in the consolidating liftboat market.
Liftboats, in a nutshell, are essentially mobile self-elevating work platforms used in performing numerous offshore services to rigs, such as maintenance, inspection, and repairs.
Hercules Offshore is the leading player in the GOM market. It operates roughly 42 liftboats there and has captured a 40% share of the market. Its largest competitor, Superior Energy (NYSE: SPN ) , holds roughly a 25% market share. In the most recent quarter ended Sept. 30, Hercules reported that dayrates for its liftboat operations average $12,641, a 133% increase over last year's quarter.
In addition to its leadership position in the GOM, Hercules is also bulking up in the international arena. The company just completed a deal to acquire Halliburton's (NYSE: HAL ) West African liftboat business for roughly $50 million, a move that will add 13 liftboats to the four it already has in operation in that area. According to various analyst estimates, this accretive acquisition is expected to add anywhere from $0.15 to $0.30 to Hercules' earnings in 2007. This deal is further proof of Hercules' ability to buy non-core assets from other companies at a discount, fix them up, and redeploy them. According to Credit Suisse First Boston, nine of the company's previous acquisitions were completed at an average price of just 29% of replacement costs.
Given the company's leadership in the consolidating liftboat market, the proven ability of management to execute on its accretive acquisition strategy, and the fact that shares trade at less than seven times fiscal 2007 estimates (and this is before the Halliburton acquisition is factored in), I'd urge value-conscious energy investors to drill into the prospects of Hercules Offshore.
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Fool contributor Will Frankenhoff is enjoying his time writing for the Fool more than playing golf, reading The Financial Times, or rooting for the New York Giants. He welcomes your feedback at email@example.com. He does not own shares in any of the companies mentioned above. The Fool has a disclosure policy.