The Market can remain irrational longer than you can remain solvent. -- Commonly attributed to John Maynard Keynes
Over the past year, Seadrill Ltd (SDRL +0.00%) has joined the rest of its offshore driller brethren in an all-out race to the bottom:
SDRL Total Return Price data by YCharts
This has resulted in a recent spate of massive investor interest, largely driven by a number of investors thinking that these companies are seriously "on sale." While a handful of offshore drillers probably are very good values right now, the Keynes quote should serve as a reminder that the market isn't always driven by rational behavior.
With that in mind, there are at least two reasons that Seadrill -- as well as Ensco Ltd (ESV +0.00%), Diamond Offshore (DO +0.00%), Noble Corp (NE +0.00%), Transocean (RIG 0.32%), and the rest of the offshore drillers -- could see their stocks keep falling, and underperform the market for the next couple of years. Why is this the case?
1. Oil prices falling
Since 2011, oil prices have consistently stayed at or above $100 per barrel, before beginning to decline in late June. Brent Crude (a global standard for oil prices) is now around $91 a 21% decline from the peak this year. The concerning part of this decline is that it is happening in the midst of the biggest geopolitical strife in oil producing regions in years, with war in Syria and Iraq against ISIS, and Russia's oil industry facing sanctions on the back of the country's actions in the Ukrainian conflict.
The growth of oil production in North America is surely partly responsible for some of the price drop, as this has provided some hedge against geopolitical turmoil putting constraints on supply, but one can't ignore good old economic basics at play: supply and demand.
Data source: U.S. Energy Information Administration
Over the past several years, oil demand in the U.S. and in Europe -- historically two of the largest markets for oil products -- has fallen. While Europe's economy remains a mess, improving economic conditions in the U.S. haven't led to a return to prior levels of oil consumption. This is largely a result of fewer miles being driven, but is also a product of more fuel-efficient vehicles on the road. In short, there are less miles and miles per-capita being driven, and the cards doing the driving use less fuel. Frankly, there's nothing to indicate this trend will reverse outside of population growth and a moderate increase as the economy grows stronger.
Furthermore, U.S. production does indeed keep growing, and the source of this growth isn't offshore, but onshore reserves found in shale formations. Many producers have significant investments in these onshore assets, and won't invest in more expensive offshore if oil prices continue to decline.
Before you say, "but oil prices will rebound," remember that $100 oil wasn't really a concern as recently as a decade ago.
2. Investor ignorance
Image source: Steven Straiton
Maybe this sounds like an oversimplification, but it's likely behind a lot of the volatility we've seen over the past year. There has been softness in the offshore drilling market, but it hasn't affected every company the same. However, many investors -- and likely a lot of the daily churning we see in the markets -- aren't buying or selling based on anything specific or material to Seadrill, or any other offshore operator for that matter, but simply stock prices moving and unrelated, general news.
As an example, most investors probably know that oil prices have fallen, and that offshore drilling is expected to be soft over the next few years. Maybe a few even know that operators with older vessels are the most exposed. But how many actually know that Seadrill will enter 2015 with maybe -- maybe -- only three of its 51 in-the-water, under operation vessels not under a long-term contract, versus Diamond Offshore, with nine of its 39 operational-capable vessels not under contract? That's a 94% utilization rate for Seadrill, versus 77% for Diamond Offshore, which is enormous when considering that these vessels generate anywhere from $100,000 to more than a half-million dollars in revenues per day.
Yet over the past year, Seadrill's stock has fallen just as far as Diamond's, despite Seadrill's fleet by far being the most modern in the industry, and the company's track record of getting its vessels under contract being the best in the business.
As is said, it might be an oversimplification, but it's still evidence that the market is lumping the industry together right now, and as long as oil prices stay low, and there's uncertainty around demand for offshore drilling, don't for a minute think that stock prices can't go any lower. But for patient and long-term investors, the interim probably doesn't -- and shouldn't -- matter that much.
Final thoughts: Keep the long-term view
There's plenty of evidence to support that the easiest and most successful way for individuals to invest is long-term, buy and hold. As hard as it sounds, you really should look past the daily market noise, and keep an eye on the business performance. Seadrill's stock is exposed in the short-term, but there are plenty of reasons to like the business for the long term.
As a start, OPEC supplies 40% of global oil, and you can reasonably expect that it will cut back production if prices keep falling. It meets next in November. Furthermore, global demand is rising, and will keep rising as the world's middle class expands over the next two decades. These two factors point toward -- in the long term -- a return to high demand for offshore exploration and production. Looking out five years and longer, those same economic principles of supply and demand, combined with Seadrill's best-in-class fleet and capabilities, point toward a successful investment. Just remember that there is still risk, so keep a diversified portfolio.
