If there's one sector of the energy industry that's been absolutely painful for investors in recent years, it's offshore drillers. These are the companies that own the drilling platforms and floating vessels capable of operating in deepwater, and no other sector has been slower to recover since oil prices started falling in mid-2014.
Ensco PLC (NYSE:ESV) has been one of the hardest hit. Since oil prices peaked at $115 in June 2014, Ensco's stock price has fallen 92.3%. And while the hindsight view is pretty horrible, successful investing is about identifying companies set for profitable futures.
Is that the case for Ensco? At this stage, I think the answer is yes, with the caveat that the offshore sector still has some consolidation to get through, and spending still remains well below peak levels.
Let's take a closer look at Ensco, and why it's a buy today.
How we got here
When oil prices were still well above $100 back in 2014, offshore drilling stocks were high-flying and expected to continue to perform well. Back then, few investors foresaw the massive oil crash that would send crude oil from over $115 per barrel in mid-2014 to $26.01 in early 2016.
Here's the thing: Offshore drilling stocks are actually even lower now than when oil bottomed in 2016, even though crude is up nearly 150% from the lows. And Ensco has been one of the hardest-hit.
So what gives? In short, spending for offshore oil and gas development has remained historically low, even as global oil demand has generally risen the past two years.
This has been in large part because shale plays like the Permian and Powder River Basin have become some of the lowest-cost sources of new oil in the world; furthermore the oil in these plays can be developed and brought to market incredibly quickly. In ideal circumstances, a producer can go from initial drilling to pumping oil in a matter of months -- or even weeks. Offshore reserves take many years to develop, with some of the biggest projects having taken more than a decade before delivering their first barrel of oil.
That's a long time to develop a resource before getting any payback, and oil markets are uncertain enough from month to month, much less over a period of years.
Moreover, the oil producers which have survived the past half-decade have done so because they've been more conservative with spending. Many of the "drill baby, drill" companies of the $100 oil days simply didn't survive the oil crash, running out of money and getting sold for pennies on the dollar, while a significant amount of consolidation helped save others.
Add it all up, and producers have prioritized quick-turn onshore oil and gas over offshore projects that require bigger up-front capital investments, and take significantly longer to generate cash flows.
Making the case for offshore oil
This story looks like a potential eulogy for offshore oil. However, despite shale having changed producer's priorities, offshore oil and gas are far from dying. To the contrary, the International Energy Agency expects an average of over $150 billion will be spent annually to develop offshore oil and gas between 2017 and 2040.
The reason why offshore oil and gas are expected to remain relevant is simple: Once the resource starts flowing, it's some of the cheapest energy on the planet. Furthermore, offshore sources count for about one-fourth of global output today, and quite frankly it's incredibly unlikely that shale will be able to both soak up new global demand and replace all that offshore oil if development stopped.
Which brings us back to Ensco
When offshore spending dried up in 2015, drillers found themselves with far too many vessels in the water and far too few contracts to support them. Moreover, many of those vessels were old, expensive to operate, and could even work in deepwater and harsh environments.
To paraphrase Warren Buffett, the tide went out, and many offshore drilling companies were worse than naked. They were naked, broke, and unable to head into deeper water.
And while Ensco has taken its share of asset writedowns in recent years to decommission older, non-economical vessels, it has also been one of the biggest beneficiaries of consolidation. In 2017, it acquired Atwood Oceanics, a smaller company with a young, high-spec fleet of floating vessels, and more recently agreed to merge with Rowan Companies (NYSE:RDC), which has a high-quality fleet of jack-up rigs and a strong backlog of work for that fleet.
And they are historically cheap, based on the assets they own today:
My colleague Tyler Crowe is right that book values should be taken with a grain of salt since asset future writedowns could take a bite out of it. However, both Rowan and Ensco have already largely normalized their fleets, and I expect much of what they own -- and how it is carried on the books -- is legitimate.
A combined Ensco and Rowan would have nearly $3 billion in contracted backlog, over $1.6 billion in cash on the books, and less than $250 million in long-term debt due over the next year, giving it a substantial measure of safety to continue riding out the weakness in offshore project investment. And offshore spending is starting to ramp back up, with the expectation that some $300 billion will be spent to develop offshore resources over the next three years.
Yes, there's risk that offshore will continue muddling along and Ensco (even post-merger with Rowan) could struggle. But trading for less than 30% of book value, I think the market is amply pricing that risk in, and investors who buy to hold over the next few years should do incredibly well.