Few stocks have been as battered, bruised, and beaten down over the last year as offshore drillers such as Transocean (NYSE:RIG), Seadrill (NYSE:SDRL), Ensco (NYSE:ESV), Noble Corp (NYSE:NE), and Diamond Offshore Drilling (NYSE:DO).
The oil price crash has resulted in plunging day rates, increased risks of contract cancellations, and even the painful prospect of dividend cuts and suspensions.
However, while all that may be true over the next one to two years, there are three reasons to remain bullish on the industry's long-term (3+ years) prospects. Reasons that could very well allow brave investors who are willing to buy now -- when the market is most fearful -- to lock in incredible income and profit potential.
Long-term trend for oil prices is higher
The current collapse of oil prices is a result of a mere 1.2%, or 1.1 million barrel per day, oversupply of oil. Traders and analysts are speculating that oil prices will remain weak throughout the next year thanks to reports like that of the International Monetary Fund, which recently cut its 2014 and 2015 world economy growth projections by 11% and 5% respectively.
That weaker economic growth has caused the International Energy Agency, or IEA, to cut its 2015 oil demand growth projections by 21%, or 230,000 barrels/day. Most frightening for short-term oil bulls is the agency's estimate that new projects already paid for will result in an additional 1.3 million barrels/day of non-OPEC production coming online next year.
While this may increase the risks of a continued glut of oil suppressing oil prices over the next year or two, in the long term, the growth in demand for crude is likely to require substantially more oil than today.
For example in its 2014 World Energy Outlook report, the IEA estimates that world oil demand will rise from 94 million barrels per day to 104 million barrels/day by 2040. This extra demand will be fueled by a more than doubling of vehicles in the world, primarily in Asia. The projection takes into account the quickly improving fuel economy standards many nations are undertaking, which is why a more than 100% increase in vehicles results in only a 25% increase in oil used for transportation.
While a .4% compounded annual rate of growth in oil demand over the next quarter century may not sound like that great, a catalyst for rising oil prices, keep in mind that most of today's oil production is coming from rapidly depleting traditional oil fields. As the production from these fields declines, new and more expensive sources of oil, such as tar sands, shale oil, and ultra deep-water drilling will be needed to fulfill the world's energy supplies.
The Energy Information Administration, in its 2014 Annual Energy Outlook report, estimates that the average annual cost of Brent oil (the global standard) will increase through 2040, most likely to $145.
Until then the EIA estimates the global annual price of oil won't decline below $90/barrel, with $70/barrel being the lowest prices reach within its models between now and 2040.
While it's entirely possible for a government agency to be way off on such projections, I believe their forecast is reasonable. The combined forces of strong demand growth from Asia, particularly China and India, and declining production from cheaper, conventional sources of oil, will, in my opinion, most likely drive prices toward the higher end of the EIA's projected range, $200/barrel oil within the next quarter century.
Meanwhile, with the recent oil price crash forcing oil companies both big and small to slash investment into new oil production, there is a very good chance the current worldwide oil supply glut will be replaced by scarcity within a few years, driving up the price of crude. As oil prices increase, deep-water offshore drilling would once more become profitable for oil companies, as seen in the below image, which shows Morgan Stanley's projected oil production costs around the world.
This in turn would likely result in much stronger demand for offshore rigs, which could send day rates, cash flows, and earnings for offshore drillers soaring.
Short-term glut of rigs to turn into a long-term shortage
As this image shows, while there may currently be a glut of deep-water rigs, in the long term, the scrapping of older rigs means only 352 floaters will be available for future contracting versus a projected 500 that will be needed in the years ahead. With offshore drillers like Seadrill holding off on new orders given the difficult market conditions, this means offshore drillers will be able to reset their new build plans to maximize the chances that long-term -- 2017 and beyond -- day rates are much stronger than current ones.
The situation is the same with jack-up rigs: Once older rigs are scrapped and retired, only 399 rigs will be available, versus an estimated long-term demand of 470. While it may take a year or two for these older rigs to finally be put to pasture, and that may involve billions of dollars in write downs for companies such as Transocean in the short term, the long-term health of the industry will be greatly improved once this painful process is complete.
Long-term dividend prospects are positive, even for Seadrill
While Seadrill's recent suspension of its dividend was very painful for income investors, it was, ultimately, the right move to maximize the long-term survival and prosperity of the company. Transocean is also likely to cut its dividend next year, a risk current and potential investors need to be aware of and plan for, but again, this will help to ensure a stronger and more financially healthy company in the long term.
However, given the long-term positive trend in both oil demand and ultra deep-water offshore oil production, which is expected to grow 19 times faster than land based production, I am confident that the dividend at Seadrill will be reinstated once market conditions improve. Similarly, while Transocean may have to slash its payout in 2015, I believe by 2020, the dividend will be higher than the current $3/share it pays investors, resulting in a very generous yield on cost for investors who buy at today's undervalued prices.
Bottom line: High-yield offshore drillers currently make excellent long-term income investments
Warren Buffett is famous for saying that the one of the best ways to beat the market is to "be greedy when others are fearful." Well today, the prospects of oil prices continuing to plunge and staying low for several quarters certainly has offshore drilling investors terrified. However, the long-term demand trend for oil is sharply upwards, and that means today's oil price collapse is setting the stage for a potentially strong rally in the future. Combined with the highly positive long-term demand projections for offshore drilling rigs and strong growth in ultra deep-water production, this means that in the long term, day rates, cash flows, and dividends are likely to increase once the current market weakness ends.
While current and potential investors need to be aware of the short-term risks involved and allocate their positions in these companies accordingly, for those brave enough to stand firm during the current pain, now may truly be the best time to invest in these high-yield offshore drillers.