The Organization of the Petroleum Exporting Countries (OPEC) produces about 40% of the world's oil, and that makes decisions regarding their plans for production important to energy-service companies that rely on exploration and production (E&P) activity to make their money. Earlier today, OPEC decided to extend production cuts put in place one year ago through 2018. It also expanded the cuts to include two member countries that were previously exempt -- Nigeria and Libya, for those keeping score.
Extending production cuts might not sound like good news for energy-service companies at first glance because these companies benefit from production growth, not declines. But that's not necessarily true. Lower OPEC production is designed to increase oil prices, and over time, higher prices lead major oil and gas producers to reinvest more profit back into E&P, not less.
If today's OPEC decision yields the desired result of stable to higher prices for the commodity, activity in non-OPEC areas, including the United States and the North Sea, could benefit. If so, investors will profit from including Diamond Offshore (NYSE:DO) and Rowan Companies (NYSE:RDC) in their portfolios.
A drubbing in offshore oil and gas
Oil and gas drilling stocks have lost 80% or more of their value since 2013 because of falling oil prices due to a glut in global oil supply caused by rising U.S. shale production and a willingness by OPEC to keep its foot on the gas to maintain its market share. The drop-off in global oil prices cut deeply into oil and gas producers' profits, forcing them to reduce E&P activity offshore where it's historically more expensive to build wells. Instead, producers redirected their budgets to U.S. shale projects, which were more profitable because of rapid innovations in pressure pumping and well construction.
This change in focus away from offshore to land-based E&P caused offshore rig utilization to plummet, which, in turn, led to rig companies underbidding each other to keep their rigs busy. Given that backdrop, it's not hard to understand why share prices in companies relying on offshore rig demand, including Diamond Offshore and Rowan Companies, collapsed.
From the ashes...
It's still a tough market for offshore rig companies, especially deepwater players, but there are some encouraging signs that a recovery could be coming. Oil prices have been clawing their way higher since early 2016, and that's encouraging oil and gas companies to kick the tires again on offshore projects. Initially, the interest has been primarily in the jack-up market, where Rowan Companies makes most of its money, but over time, the deepwater market could start to benefit, too, which would be good news for both Diamond Offshore and Rowan Companies.
To be fair, jack-up utilization rates remain below levels where we'd expect to begin seeing any kind of pricing power, but improving rig dayrates could happen quickly once we get industrywide utilization north of 85%. According to Rowan Companies, that's been the tipping point in the past.
Since Diamond Offshore only operates one jack-up rig, it's arguably further behind in recovery than Rowan Companies. However, Diamond Offshore's exposure to the Middle East and Africa is limited, and that suggests that if interest in projects in the North Sea or Gulf of Mexico perks up because those markets fill the supply gap created by OPEC, then it could benefit. Currently, most of its 19-rig fleet is at work in the Gulf of Mexico, or offshore of the United Kingdom.
The situation is a bit different for Rowan Companies. Rowan's fleet is mostly high-spec jack-up rigs, and the Middle East is the biggest market for jack-up rigs, accounting for about one-third of demand. Saudi Arabia alone represents the largest market for these rigs on the planet.
But that's not necessarily a bad thing for Rowan Companies. It's pretty heavily exposed to the market, but unlike competitors, it has a competitive advantage in the form of a joint venture with Saudia Arabia's ARAMCO. The new venture recently began operations, and so far, Rowan Companies has contributed four of its jack-up rigs to it. The plan is for Rowan Companies to contribute more rigs to the venture once contracts expire. The arrangement effectively provides Rowan Companies with an inside track when it comes to Middle East utilization and pricing, somewhat shutting out competitors from what will still remain one of the most important markets for these rigs.
Clarity on demand from the Middle East for Rowan Companies is a good thing, but it's not the only reason why investors ought to consider buying its shares. Rowan Companies also has six jack-ups operating in the North Sea, two jack-ups operating in North America, and three jack-ups operating in Central and South America. If demand for oil remains constant or grows, then contract rates for those rigs could climb meaningfully.
North American oil and gas producers are beginning to look further out in terms of production, and that could mean that they get serious again about off-shore drilling. While U.S. shale activity is likely to remain strong, well-productivity growth is more likely to level off from here than continue accelerating. If so, then a solid argument can be made that offshore production is going to have to pick up if producers are going to meet all of the world's long-term oil and gas needs.
Undeniably, there's still more work to do before an "all-clear" bell for the offshore energy service companies is rung, but we may be witnessing the beginning of a multi-year cycle of improvement for these companies. If so, then adding Diamond Offshore and Rowan Companies shares to energy portfolios could be smart.
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.