Ensco PLC (ESV +0.00%) and other offshore drilling stocks have heard nothing but bad news in 2014. First, it was a decline in rig demand, then it was fear of oversupply as new rigs come online, and now oil prices have plunged, putting the industry's future profits in doubt.
But it's possible the pain isn't over. There are three big reasons Ensco's stock could have further to fall.
Jackup rigs like this one have helped drive growing offshore profits in 2014, but that may not last long. Source: Seadrill.
A fleet just clinging to life
Ensco's management has recognized that it needs to upgrade an aging fleet of offshore rigs and has done so aggressively in the last few years, but that doesn't negate the fact that it still has a lot of old rigs on the balance sheet that will eventually need to be sold or scrapped. 33 rigs currently listed in the fleet status report were built in 1985 or before -- they're nearing the end of their useful life and will become uncompetitive if the offshore market gets tighter.
We've seen some of that impact so far in 2014, which has included the sale of 18 rigs with another five currently held for sale. Selling rigs has absolutely been the right move, but more sales are needed, and with contract demand slowing and oil prices at a multi-year low, sales may not bring the kind of prices Ensco has enjoyed so far this year.
Dozens of new drillships, like this one from Seadrill, are coming online between now and 2017, and that could reduce rates rig owners get for their older assets. Source: Seadrill.
Long-term, the aging fleet is a huge risk, and demand for older rigs is something investors should watch closely in 2015.
Shallow water demand
What's really helped Ensco's profits this year has been a strong market for jackup rigs. These are shallow water rigs that drillers generally contract for a few months up to a year or two. The short-term nature of these contracts can make the market very volatile year to year.
This year, the jackup market has been very strong, and for Ensco it has helped drive profit growth -- 39.6% of revenue and 43.1% of operating income in the third quarter were from jackups, and both grew faster than floaters in the quarter.
If the offshore drilling market begins to struggle, it's going to show up in the jackup market first. Shallow water drillers will be quick to react to falling oil prices; they can quickly reduce demand, and if they do, profits can abruptly fall off a cliff.
It all comes down to oil
No matter how well Ensco's management adapts to the offshore market, or how well it manages costs, the bottom line for the stock is that oil prices need to recover for Ensco's stock to do well. If oil remains between $75 and $80 per barrel -- or lower -- it'll reduce demand for all drilling rigs, but especially the floaters, which have traditionally come with very high margins. That could be bad news for Ensco, which has a number of aging semisubmersibles and has been expanding its drillship fleet rapidly. Those moves looked great when ultra-deepwater demand was high, but the strategy could backfire if oil prices remain low for the next few years.
What can be maddening about this for investors is that oil prices are entirely out of Ensco's control, but they're the greatest risk for the stock. If you're investing in Ensco, though, it's something you have to pay attention to.
