This year hasn't been kind to the offshore drilling industry. Recently, I wrote an article exploring how Transocean (RIG 0.96%), Seadrill (SDRL +0.00%), Ensco (ESV +0.00%), Noble (NE +0.00%), and Diamond Offshore (DO +0.00%) are massively undervalued and argued that, for long-term investors, this represents an incredible buying opportunity.
The market has continued punishing the industry over continued fears of a short- to medium-term oversupply of new rigs, and of reduced spending by oil companies. To those concerns, the market has recently added fears that oil prices will continue their recent declines because of a slowing of the global economy. Shares of these companies have been in freefall for the past few months as a result.
Brent Crude Oil Spot Price data by YCharts.
Recently, fellow Fool Jason Hall published an article outlining two reasons Seadrill and its peers might continue their decline, however irrational further declines at this point may be. In the spirit of that lesson, let's examine three short- to medium-term risks to the offshore drilling industry to see whether this is the right time to add these companies to your portfolio.
Slowing economic growth and plunging oil prices
On Oct. 7, the IMF cut its global growth forecasts for both 2014 and 2015, citing a doubling of the risk of recession in Europe to 38%, relative to April. The chief concern is a precipitous decline in Europe's strongest and largest economy, Germany, which reported a 0.2% economic contraction last quarter.
The IMF downgraded its expected growth expectations for Germany by 0.5% for the year, thanks in part to concerns over rising energy prices, a result of the West's showdown with Russia. A more serious concern was a 4% decline in Germany's manufacturing sector in August, which was 167% worse than what economists were expecting and came on top of last year's August manufacturing decline of 2.8%.
Another major concern is slowing growth in China, where total bank debt has exploded by 79%, or $11 trillion, since 2008, when the government began attempting to stimulate the economy in the face of the credit crisis to maintain the country's historic 10%-plus growth rate. Recently, the Chinese government has predicted 7.5% economic growth for this year, but many analysts believe the figure may be closer to 5%.
In addition, 52% of U.S. economists are concerned that a Chinese debt crisis may occur within the next few years, which could potentially trigger a global recession and result in long-term oil price declines that, in turn, could decrease demand for offshore drilling even more.
Market correction is long overdue
One of the reasons offshore drilling stocks may continue falling in the short term is simple market fear, which can result in periodic market plunges. History certainly backs this up. Since 1876, the U.S. stock market has experienced no fewer than eight corrections that resulted in a 30%-60% decline and typically lasted 12 to 18 months.
In fact, Yale economics professor Robert Schiller believes the U.S. stock market is historically overvalued right now, with a cyclically adjusted price-to-earnings ratio, or CAPE -- which measures the average P/E of the past 10 years, adjusted for inflation -- of 25.27. Since 1890, its median value has been 15.93, indicating that the market is currently 59% overvalued.
Though past is not necessarily prologue, it's interesting to look at some historical corrections to compare our current overvaluation and potentially see what kind of market declines we might be in for.
| Period | CAPE at Market Peak | Stock Market Decline |
|---|---|---|
| 1929-1932 | 33 | 85% |
| 1937-1938 | 22 | 45.30% |
| 1969-1970 | 21 | 27.60% |
| 1973-1974 | 19 | 42.50% |
| 1987-1988 | 18 | 19.70% |
| 2000-2001 | 42 | 29% |
| 2002-2003 | 30 | 27.50% |
| 2007-2009 | 27.3 | 51% |
| Historical Average | 26.54 | 40.95% |
| Today | 25.27 |
Sources: Multpl.com, "Don't Count on Soft Landing for Stocks" by Shawn Tully, Fortune magazine.
As this table shows, the current CAPE is at or above levels that preceded massive market drops.
| Company | Beta |
|---|---|
| Transocean | 2.45 |
| Seadrill | 1.71 |
| Ensco | 1.83 |
| Diamond Offshore | 1.6 |
| Noble | 2.2 |
| Average | 1.96 |
Source: Yahoo! Finance.
As this table illustrates, offshore oil drillers are, on average, twice as volatile as the S&P 500. Given the highly volatile nature of offshore drilling stocks, a large correction could result in substantial declines from even today's undervalued prices.
Industry downturn may be worse than initially thought
Source: Rigzone.
As this table shows, only 255 of 333 deepwater or ultra-deepwater rigs in the world are currently employed, meaning 24% are looking for contracts. While some of these are older rigs that are likely to be scrapped, this current oversupply, when added to the new rigs coming online within the next year -- 68 to be delivered in 2015 -- represents a major concern for the industry, especially Transocean.
That's because, in 2014 and 2015, Transocean has 73 rigs -- 51% of its fleet -- going off contract. As Seadrill CFO Rune Magnus Lundetrae recently said: "The market is going to be bad this year; it is going to be worse next year. Then it will be stabilizing."
Transocean's own CFO, Esa Ikaheimonen, came to the same conclusion: "You will probably see day rates lower than what I indicated in the [$375,000- to $500,000-per-day] range. ... To me that is the average level where I think the deals will be done."
Given that, just recently, ultra-deepwater contracts were going for as much as $650,000 a day, these day rates represent a 23% to 42% decline in pricing power for offshore drillers. This is especially a concern for legacy drillers such as Transocean and Diamond Offshore, with some of the world's oldest ultra-deepwater fleets. Older, less-advanced rigs are likely to get contracts at rock-bottom rates, if they can find work at all. For example, Noble recently secured a contract for its Danny Adkins rig in the Gulf of Mexico for just $317,000 a day, down 36% from its previous day rate of $498,000, and 21% below analyst projections of $400,000.
Meanwhile, newer rigs from the likes of Seadrill, despite being in higher demand, are certain to face lower day rates as well. This is a major concern for Seadrill investors, given the company's massive debt load, the 19 new rigs the company has being delivered in the next few years (nine of which are coming in 2015 and will have to be paid for), and a very generous dividend. In fact, with the stock's current yield of 17.8%, the market is pricing in a dividend cut for Seadrill despite management's assurances that the dividend is safe through 2016, even should the offshore drilling market not experience a significant recovery.
Bottom line
The combination of a recent market downturn, falling oil prices, and the previous weakness in the offshore oil drilling industry has absolutely crushed the stocks such as Seadrill and Transocean. While I continue to be long-term bullish on the prospects of ultra-deepwater drillers such as Seadrill and view the current share price as a historic buying opportunity, there continue to be risks of further declines that you should be aware of. That's why it's important to remember to own a diversified portfolio and invest only discretionary money that you don't need for the next few years. That way you won't feel any added financial pressure to sell shares of great companies such as Seadrill at the worst possible time, but rather maintain an iron stomach to ride out the current weakness to what may very well prove to be one of the best long-term income-generating opportunities of the next few years.
