If your portfolio doesn't have offshore oil and gas services stocks right now, you can't be blamed. Lower oil and gas prices over the past three years have made for a dismal performance for these energy service stocks. However, there are some signs that market demand is ticking up off its lows. If so, adding shares in Diamond Offshore (NYSE:DO) and Rowan Companies (NYSE:RDC) to your holdings may pay off.
Digging "ultra" deep
Diamond Offshore turned an important corner this past summer, when it posted its best year-over-year revenue growth in three years. Its momentum carried over into the third quarter, too, with sales of $366 million outpacing sales of $349 million last year.
The revenue improvement suggests big oil and gas companies are beginning to warm up to costlier off-shore development again, particularly in the ultra-deepwater market. Utilization rates for Diamond Offshore's ultra-deepwater fleet clocked in at 61% in the quarter, and as a result, operating income for ultra deepwater rigs was $136.2 million, up from $93.2 million in Q3 2016. Operating income for its deepwater, midwater and jack-up fleets were lower year over year, suggesting that the recovery is still only in the early stages.
The drop-off in offshore drilling has been due in part to cheap on-shore shale production that's winning the bulk of shrinking oil exploration and production budgets. Recently, commodity prices have bounced back, and thanks to innovations, the cost of deepwater production is declining. As oil and gas producers begin seeing some wiggle room in their budgets again, it wouldn't be surprising if they look to diversify production by recommitting offshore again.
If so, then Diamond Offshore could see its bottom line bounce back, and that could help propel its shares higher. How high is anyone's guess, but earnings were north of $5 per share, and shares were trading above $60 before the drop-off in crude oil prices in 2014.
Hot for high-spec
A 70-plus-year track record in offshore drilling means Rowan Companies has plenty of insight into the boom-and-bust nature of exploration and production cycles. Its experience allowed it to make moves early on, such as eliminating its dividend to protect its balance sheet. It's also influenced the company's decision to position itself as a leader in high-spec rigs, which historically enjoy higher utilization rates.
While it may still be a bit longer before demand for its high-spec jack-up rigs improves enough to give it pricing power, there's evidence of a jack-up market recovery. Here's what CEO Thomas Peter Burke had to say about the current market during its third-quarter earnings conference call:
We believe firming crude oil prices continued to help the offshore rig market find the bottom and even make some modest improvements in some categories and regions. Interest from our customers to resume exploration drilling seems to be increasing. However, the majority of the visible demand continues to be for shorter-cycle activities and mature basins. While this dynamic is supportive of a gradual recovery in jack-up activity, the deepwater floater market is much more dependent on demand from exploration drilling.
Granted, Rowan -- like Diamond Offshore -- still has concerns that there might not be enough demand to offset deepwater contracts that are rolling off this coming year, but jack-up demand appears to have bottomed out, particularly for high-spec rigs, and eventually, that should translate into better pricing power.
It will be a while before that happens, though. Historically, jack-up utilization has had to reach 85% for prices to head the right direction, and currently, global jack-up utilization is still somewhere near 70%, not including cold-stacked rigs. Rowan's own jack-up utilization rate is 78%, up 6% from Q2, but despite the uptick in utilization, average day rates still decreased slightly in the quarter -- an ongoing reflection of the amount of slack that still remains industrywide.
Nevertheless, I think a good argument can be made that Rowan's shares are in a good position to head higher. Eliminating its dividend saved it about $50 million per year, and a close eye on controlling costs has halved operating costs and helped it build a cash war chest of $1.3 billion, which is enough money to cover all of its debt maturities through 2023.
Rowan also has a unique joint venture with Saudi Aramco called ARO Drilling that makes it intriguing. Saudi Aramco is the biggest jack-up customer in the world, and the Middle East is the biggest market for jack-up rigs. As a result, the relationship offers a degree of earnings visibility, plus opportunities for future growth.
Overall, Rowan's rig fleet is packed with some of the newest and most capable rigs out there, so if oil and gas prices hang in there and offshore demand picks up, it could be the perfect time to add this one to your portfolio.
Todd Campbell has no position in any of the stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.