It's said that the best time to invest is when there's blood in the streets, and in recent quarters, few industries have been bloodier than deep-sea drilling. Companies like Transocean (NYSE:RIG), Seadrill (NYSE:SDRL), and Atwood Oceanics (NYSE:ATW) have seen their stocks killed. Is there opportunity to be had? I think the answer is yes.
Let's look at why Transocean and Seadrill, with two of the largest deep-sea drilling fleets, are set to dominate this important industry, and why Atwood Oceanics -- though a smaller and less well-known company -- deserves to be on every deep value investor's radar as well.
The future of deepwater drilling is bright
Despite the recent oil crash, the fact is, oil will remain a vital source of world energy for many decades to come. According to the Energy Information Administration, by 2040, the world's demand for crude is likely to grow by 14 million barrels per day, and $22.5 trillion of new investment by oil producers will be needed to supply growing world demand during this time period.
Deep-sea drilling is expected to be the fastest-growing source of new oil production, with enormous offshore reserves in Brazil, the Gulf of Mexico, and Africa providing a major component of this supply.
In fact, as this chart from energy analyst firm Rystad Energy shows, deep-sea oil production is poised to grow 19 times faster than conventional onshore oil production, which means potentially enormous demand for the most modern and safest deep-sea drilling rigs.
Transocean and Seadrill have existing deep-sea drilling fleets of 38 and 27 rigs, respectively, and are both currently constructing an additional seven UDW or ultra deep-water rigs each, to meet this future demand.
Meanwhile Atwood Oceanics, while possessing a much smaller fleet -- just 13 rigs, including two UDW newbuilds -- represents a more concentrated bet on the future of deep sea drilling. That's because 62% of Atwood's fleet is composed of UDW rigs which command day rates many times larger than other rig types, such as shallow water jack-ups -- which can only operate in a few hundred feet of water.
Short-term challenges are immense
Of course, just because deep-sea drilling has a promising long-term future, doesn't mean investors can or should ignore short-term risks to the industry. This is especially true for larger drillers like Transocean and Seadrill, which both have major short-medium-term risks that investors need to be prepared for.
For example, Transocean is the world's largest offshore driller, but that status comes at a cost, including a large number of very old rigs. In an environment of lower oil prices and weaker demand, less modern rigs, with fewer safety features, not only command much lower day rates, but often can't find work at all.
That's why, in light of the oil crash and a glut of brand-new UDW rigs being delivered over the next few years, Transocean management has been forced to make some very hard choices, including slashing its dividend by 80% to preserve cash and scrapping 19 older UDW rigs so far.
Scrapping so many obsolete rigs -- with more cuts likely in the future -- creates a lot of short-term pain, specifically $4.6 billion in write-offs that have hammered the company's earnings over the past three quarters. Potential investors need to be aware that Transocean still has a large number of older rigs that it might need to scrap in the coming quarters in order to achieve its long-term vision of becoming a pure premium driller.
Atwood Oceanics: a less risky investment
Compared to Seadrill, Atwood Oceanics is a less risky investment in deep-sea drilling for two main reasons. First, Atwood is far less leveraged than Seadrill, with less debt than the average offshore driller, while Seadrill is among the most debt-laden companies in its industry.
Second, Atwood is far less exposed, in the short term, to falling UDW day rates than either Seadrill or Transocean. As a percentage of its fleet, it has far fewer UDW rigs going off contract through the first half of 2016 -- during which time there is little chance that day rates will recover -- than either of its larger competitors.
Takeaway: Deep-sea drilling investors need patience, but could end up richly rewarded
Despite the pain of recent years, deep-sea drilling will be a very important source of future oil production, and Transocean and Seadrill will likely represent two dominant players in the industry. Meanwhile Atwood Oceanics, while smaller and less well known, represents an intriguing more UDW focused investment, especially for long-term deep-value investors willing to patiently wait out the current deep-sea drilling industry downturn.
Adam Galas doesn't own shares in any companies discussed but does lead The Grand Adventure dividend project, which recommends Atwood Oceanics and Seadrill. The Motley Fool recommends Seadrill. The Motley Fool recommends Atwood Oceanics and Seadrill. The Motley Fool owns shares of Atwood Oceanics. Try any of our Foolish newsletter services free for 30 days.