With offshore drilling stocks taking a beating in 2014 it may be time to reassess whether these stocks are worth buying at a lower value than when the year began. Long-term rig owners should benefit from the fact that over half of the world's new oil reserves are now being found under two miles of ocean, and a temporary slowdown in demand should eventually turn around.
But investors also need to consider the risks as well. Below I'll outline why I think Ensco (ESV +0.00%) is a decent buy, but not the best stock to own in the offshore drilling market.
New drillships like this one are the future of ultra-deepwater drilling. Image source: Seadrill.
The lay of the land
Before we look at Ensco in more detail, it's important to understand how the offshore drilling market is laid out strategically today. As I mentioned, most of the world's new oil reserves are in ultra-deepwater but these reservoirs are also extremely expensive to drill, and oil companies have seen returns on equity fall as drilling gets more expensive, leading to most companies cutting back on new drilling programs this year.
That pullback has been the cause of the weakness seen in offshore drilling. But not all segments of the market are weak. There's essentially a bifurcation of the market with high specification rigs in both shallow and ultra-deepwater being in high demand for challenging drilling sights. On the other end of the spectrum, older rigs are finding less demand and being forced to fight for the scraps with lower dayrates and returns for their owners.
In short, owning a fleet of rigs with modern technology and safety features is at a premium in today's drilling market.
Where Ensco stands versus the competition
The industry's competitive position is best laid out by a presentation recently given by Seadrill (SDRL +0.00%), which shows the number of ultra-deepwater and jack-up units each company owns, their age, and percentage of their fleet the segments account for.
Source: Seadrill.
This chart shows us a few important things. First, Ensco has benefited recently from strong demand in the jack-up market, where it owns the industry's largest fleet but also has a very old fleet. This demand has been great for short-term earnings but it also shows long-term weakness because nearly 100 new, more capable rigs are being built in the next three years and Ensco's rigs may not see as much demand when they're completed.
The other thing to notice is Ensco's floater age, which has actually fallen to nine years after cold-stacking four units last quarter. The company is in better position with its floater fleet than many competitors, and with three more drillships due to be completed next year it's upgrading its fleet quickly.
But this also shows why Seadrill is in a better strategic position than Ensco in ultra-deepwater. Its fleet is younger, meaning higher demand and higher dayrates, and it's a larger percentage of the fleet.
Value and the balance sheet
While Ensco isn't the best positioned company in drilling, it's far lower risk than Seadrill, who has $12.2 billion in long-term debt to $4.7 billion at Ensco. Seadrill also has a loft 11.1% dividend yield to 5.9% for Ensco. That gives Ensco's management even more flexibility with cash flow in the future, something it will need to upgrade the fleet.
From a value perspective, Ensco's shares trade at 8.4 times forward earnings and Seadrill trades for a slightly higher 9.5 multiple. Again, Ensco looks cheaper, but a big driver is recent strength in the jack-up market that might not last long-term.
Why Ensco is good, but not the best
Ensco is in a fairly good position in offshore drilling, and for investors with a low risk tolerance it's probably the safest bet in the space. But long term, I think Seadrill is the better stock, despite the risks presented with its high debt load and commitment to its dividend.
Fleet age and exposure to ultra-deepwater is what matters most right now in offshore drilling, and Ensco is good on that front but Seadrill is simply better.
