Oil drillers such as Transocean (NYSE:RIG), Ensco (OTC:VAL), and Seadrill (NYSE:SDRL) face an uncertain future. On one hand, increased demand for oil, particularly in the emerging markets, represents an industrywide tailwind. Furthermore, oil is getting harder to find, evidenced by an increasing share of oil discoveries occurring in ultra-deep water and other harsh environments. With all this in mind, it seems the oil drilling sector has the wind at its back.
On the other hand, soaring oil production in the United States leaves open the possibility of lower oil prices. The market seems unsure of the fate of oil drillers, which likely explains why many industry participants hold relatively cheap valuations. However, Foolish investors with an eye on the long term have a great opportunity in front of them. Oil driller stocks have a lot to offer while the market struggles with the uncertainty.
Will a glut of over-supply hurt long-term oil prices?
As has been widely reported, the United States is in the midst of an oil boom. Production is soaring, which may result in damaging effects on the major offshore drillers. While it's absolutely true that the United States is producing oil at levels not seen in decades, this may serve to undercut oil prices.
The U.S. may soon hold four regions that produce a million barrels of oil per day. The Gulf of Mexico remains a major source of production, and even more promising plays in the United States are the Permian, Bakken, and Eagle Ford onshore formations.
Soaring oil production in the United States means the market may soon be flooded with supply. If a glut of global supply hits the market and sends down oil prices, it seems likely that drillers would have a hard time generating favorable day rates.
Market pessimism is overblown
Despite widespread fears of declining oil prices over the long-term, there's plenty of growth left to be had. That's because an increasing concentration of oil discoveries are located in extremely harsh environments, such as ultra-deep water. According to Transocean, there were more than 140 significant oil discoveries in 2012 at depths greater than 5,000 feet. By comparison, there were only about 20 onshore discoveries, and only roughly 120 discoveries at depths of 5,000 feet or fewer.
Oil is getting harder to find, and that places a pronounced need for complex solutions on the world's oil drillers. Thankfully, the industry has gotten ahead of the trend. In particular, Seadrill and Ensco have restructured their business toward ultra-deep water rigs. These two companies hold the youngest fleets of ultra-deep water rigs, which drill for oil at depths greater than 7,500 feet. Seadrill's average ultra-deep water rig is just 3.1 years old, while Ensco's is just 3.6 years old. Transocean will also be heavily involved in this area: it holds the largest ultra-deep water fleet, at 29 rigs.
In addition, oil drillers stand to benefit from their investments in high-specification jackups, which are also designed to meet the challenges presented by harsh environments. In fact, Ensco operates more jackups than Transocean and Seadrill combined.
Low hurdles to clear
One reason for investors to be relatively optimistic about drillers' upcoming earnings is that expectations aren't very high. Valuations remain compressed across the industry, so it's not like investors are demanding much.
Transocean and Ensco trade for just 9 times trailing earnings. Seadrill is even cheaper, as it exchanges hands for just 8 times trailing earnings. This compares to a trailing earnings multiple for the broader market in the high teens. And, investors can take comfort in strong dividend yields across the oil drilling sector as added protection.
As a result, even if oil driller earnings disappoint over the near term, the long-term fundamentals of the industry remain extremely sound.
Who's in charge of supplying these rigs with equipment?