Offshore drilling companies can often be at the whims of the energy market who contract them to drill for oil and gas. But they can also position themselves to take advantage of trends in the offshore drilling market without taking a risk on specific wells.
It's with this in mind that investors need to look at offshore drilling stocks, especially a company like Ensco (NYSE:ESV) which has exposure to many parts of the market. Below I'll outline three reasons investors should be cautious when it comes to Ensco stock.
Deterioration in the offshore drilling market
The offshore drilling market has slown down considerably in 2014, especially for older rigs that don't have state of the art drilling and safety features. Ensco took eight rigs out of service in the second quarter alone and took a $1.5 billion writedown as a result, so the pain is very evident on the income statement.
Older rigs are either being sold, scrapped, or upgraded, something Ensco is spending $570 million doing this year. But it's also spending $2.8 billion between 2014 and 2016 on new drilling rigs that will keep up with competitors in offshore drilling.
It's likely that new rigs will be able to find work even in a slow drilling market but the problem for Ensco will be the older rigs in its fleet. If management has to discount just to win contracts it'll be a drag on earnings, which could have a negative impact on the stock.
Jack-ups can be volatile
Ensco has done extremely well this year in part because of strong demand in the jackup market. But jackup rigs come with far shorter contracts than their ultra-deepwater counterparts, who regularly have contracts extending five years or more.
This makes for a far more volatile market, something the industry has seen first hand over the last five years alone. So, while jackup rigs are currently running at a 99% utilization rate and commanding strong dayrates that narrative can change rapidly, which could send shares lower.
Compounding the problem is nearly 100 new jack-ups being constructed over the next three years and the fact that much of Ensco's jack-up fleet is over 30 years old. These older rigs will lose contracts to newer competitors in time, which could put further pressure on this shallow water market.
Further writedowns are a very real risk
Demand for both ultra-deepwater rigs and shallow water jackups is key to Ensco's success, and if this demand doesn;t increase as new high specification rigs are built the company is in very real danger of having to write off even more rigs. Ensco has a total of 32 rigs that are currently 30 years or older and it's these rigs that competitors are expecting to be taken out of the market as new rigs come online.
Management is trying to refresh its fleet but as it does it could lose even more revenue and earnings due to the loss of older rigs. Above, I highlighted that there are operational risks with owning older rigs but there's also balance sheet risk because if these older rigs lose all value they'll be scrapped and result in further writedown on the balance sheet, which could be a huge drag for Ensco.
Foolish bottom line
A strong jackup market and new ultra-deepwater drilling rigs have kept Ensco profitable so far in 2014. But if rough contracting conditions continue and the industry's new ultra-deepwater and jackup rigs are completed as expected the company's aging fleet could come under pressure.
These concerns are worth watching because despite looking like a safe dividend yield of 5.9% and P/E ratio of 8.1 there's still a lot of risk in a stock like Ensco.
Travis Hoium manages an account that owns shares of Ensco and Seadrill. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.