Over the past few years, two improved drilling techniques have helped expand the amount of recoverable oil and natural gas around the world. Improvements in fracking technology have opened up otherwise uneconomic drilling locations all over North America, and ultra-deepwater drilling is expanding drilling in oceans worldwide.
But one of these is a better investment for a variety of reasons.
The nature of oil drilling
Companies drill for oil or natural gas for one reason -- profits. But drilling on land and drilling offshore provide two different return-on-value calculations and time horizons.
An onshore driller can turn on and off new drilling with the price of oil or natural gas. Look at the correlation of price to the number of inland rigs in operation to show the difference. A few months of down prices, and the number of rigs working inland drops. That's because it takes a matter of weeks to drill an inland well, not a long time horizon for drillers.
US Inland Rotary Rigs data by YCharts.
This has a boom-and-bust effect on companies such as Baker Hughes (BHI +0.00%) and Haliburton (HAL +4.14%), which provide equipment to drillers. If prices are high, then business is good, but if prices fall, business drops off in a heartbeat. Bentek Energy says that Eagle Ford shale well drilling averages about 19 days for each well, so a month's notice may be all that's needed.
In shallow water offshore, a similar boom and bust can take place, because contracts are measured in months, not normally in years. But ultra-deepwater drilling has changed that dynamic. Ultra-deepwater wells take months to drill, and oil companies are locking up rigs with extremely long-term contracts. Last year, Transocean (RIG +0.58%) signed 10-year contracts with Royal Dutch Shell for four newly built rigs that won't even be complete until at least 2015. The contract pays Transocean as much as $520,000 per day, an incredible rate given the long duration of the contract. Competitor SeaDrill (SDRL +0.00%) has half of its floater fleet contracted into 2017.
Just to put the difference in perspective, can you imagine an onshore rig contract that reached until 2025? The onshore market is simply too volatile to make that long-term bet. That's why offshore drilling service companies, particularly those with ultra-deepwater exposure, are the best bet.
How to play the trend
With long-term contracts at high dayrates the norm in ultra-deepwater, there are a few ways to play the trend.
Rig owners are a play on offshore drilling and depending on the company can be a leveraged way to play ultra-deepwater drilling. SeaDrill has one of the largest ultra-deepwater fleets and is adding more rigs this year. Transocean sold a large portion of its shallow-water rigs to focus on ultra-deepwater and is finally putting the Macondo spill behind it. Noble is another company that is focusing on ultra-deepwater by adding new rigs to its fleet at a rapid rate. SeaDrill, my top pick in the space, also pays a hefty 8.5% dividend yield.
Oceaneering International (OII 0.52%) is a service provider to offshore drillers, providing the equipment and technology that make these wells possible. Subsea 7 is another contractor providing engineering services from the seabed to the surface.
You can also bet on specific drillers like InterOil, which has assets off Papua New Guinea, or Cobalt International Energy, which is drilling for oil off the coast of Angola. The challenge with these investments is their volatile nature given the unknowns of these new fields. I'd rather cash in by owning companies contracting with drillers to lock in more certain gains.
Offshore is the way forward
I've mentioned that SeaDrill is my top pick, and one of our analysts has taken a deep dive into the stock to provide investors with both the positive and the negative sides.
