In today's overheated stock market it's hard to find undervalued companies, and harder still to find such companies in industries poised to benefit from one of the strongest megatrends in the energy sector. Offshore oil drillers offer such opportunities, but potential investors must be aware of both the risks and potential rewards this industry poses.

Industry potential
By 2035 oil demand is predicted to increase by 13%-26%, driving up the cost of oil to $125/barrel-$150/barrel.

With the world's existing land-based fields becoming depleted, oil companies are having to spend increasing amounts of money just to maintain production, much less expand it. In 2013 global E&P (exploration and production) spending totaled about $650 billion (the culmination of 11 years of 15% CAGR growth).

Conventional, land based oil production is projected to increase by just 1% CAGR from 2012-2030, yet ultra-deepwater production is set to soar by 19% CAGR.

This megatrend will drive demand for ultra-deepwater (UDW) rigs and ensure high day rates and profitability. Consider this fact: By 2020 projected demand for UDW rigs will be 455. This is 165 more rigs than currently exist or are scheduled to be built (taking into account likely retirements of older rigs).  

Given that a modern 6th generation UDW (7th generation is just now starting to be offered) costs $600 million and takes three to four years to construct, it's not likely that a glut of such rigs would exist by 2020. However, despite the strong promise of UDW drilling, there are short-term risks that could threaten investors' capital.

Short-term risks
In 2014 and 2015, oil companies are attempting to lower capital expenditure (capex) in order to improve profitability. In addition, a bevy of new UDW rigs are expected to be delivered. The combination of increased supply and decreased demand has caused several Wall Street analysts at Barclays, Citigroup, and Morgan Stanley to become very bearish on the industry for the short term (2014-2015).

In addition, Barron's recently published an article arguing that oil prices are set to decline by 25% over the next five years.

This perfect storm of negative press has fueled a massive decline in the share prices of offshore drillers and created immense long-term buying opportunities. However, investors should be wary, because not all offshore drillers are created equal. Two companies in particular are at the most risk of short-term weakness and due to their aging fleets, have the least long-term growth potential.

Transocean (RIG 2.22%) is the world's largest offshore driller but also has the second oldest rig fleet (its UDWs are 23 years old). Compare this to competitor Seadrill, whose average UDW is only five years old. 

After the disaster with the Deepwater Horizon oil spill, which was a Transocean rig, oil companies only want the latest and safest rigs. That means 6th or 7th generation rigs, exactly the kind Transocean doesn't have and will have to build.

The age of its fleet creates two additional related problems for the company. First, it has 20 UDW rig contracts expiring in 2014. This gives it massive exposure to declining day rates (four rigs are already sitting idle) and is why the company's backlog is already shrinking (down $2.6 billion in 2013).

Diamond Offshore (DO) is in worse shape than Transocean. Its UDW fleet is 33 years old, and its last quarter's utilization rate was just 66% (low demand for obsolete rigs). Earnings declined by 17%, and its average UDW day rate was just $387,000/day. Compare this to Seadrill's $576,000/day and 95% UDW utilization rate and one can see how badly Diamond is doing.

This makes the recently announced 6.5% special dividend perplexing. Given how poorly positioned the company is in terms of the obsolete nature of its rigs and the massive costs to replace its fleet, why pay out such a large dividend?

One explanation may be that the company is majority owned by Loews (the hotel, finance, and energy conglomerate).

Loews is also is the general partner of Boardwalk Pipeline Partners, the MLP whose mismanagement resulted in an 81% distribution cut and catastrophic loss of investor capital. Given the involvement of Loews, Diamond's long-term apparent mismanagement makes more sense.

Bottom line
The offshore oil drilling industry represents one of the best investment opportunities for both income and growth investors over the next several decades. However, both Transocean and Diamond Offshore represent the bottom of the barrel when it comes to quality within the industry. Both companies are weighed down by aging fleets that will need to be replaced with modern, new UDW rigs at great expense.

This will slow future cash flow growth that will limit growth of both the dividend and share price. In the meantime, low utilization and falling day rates due to the uncompetitive nature of their older fleets means that the backlog for both companies is likely to come under pressure. With alternatives such as Seadrill, Ensco, and Noble Energy (each with higher, more secure dividends and better growth prospects) there is simply no reason for either income or growth investors to invest in Transocean or Diamond Offshore.