Oil prices were dropping and crude demand was waning in 2020. Investors are realizing that oil is needed to power the world for many decades.
It was an historic decline for offshore rig providers over the last few years. The oil prices fell during the pandemic locks as driving almost ceased. Meanwhile, the shift to renewable energy forced big oil companies reduce their drilling expenditures in difficult-to-reach locations. The rigs were removed from service because they became too expensive to run profitably. But it wasn’t sufficient. In 2021 and 2022 many of the offshore drillers filed for bankruptcy, wiping out those investors who bought shares at a bargain price.
It’s amazing how much a year can change. Noble (ticker NE), Valaris(VAL) and Seadrill(SDRL) emerged from bankruptcy with strong financial standing and are now poised to flourish as major energy companies increase their offshore spending.
Oil prices are now under $70 per barrel, down from low $80s. The industry is not expected to be affected by the drop in crude oil prices. The leasing rates of offshore drilling rigs are increasing, which will lead to higher earnings for the industry in future years.
After restructuring their balance sheet in bankruptcy, most operators have very little or no debt. While none of these companies pay a dividend, they are implementing or expanding their buyback programs. Payouts may be reinstated if free cash flow increases sharply over the next few years. Stocks look good to buy now that investors have fewer risks.
“We are in the second year of what we view as a minimum of a five-year…investment growth cycle,” says David Anderson, a Barclays analyst, who views the offshore drillers as the most attractive area of the energy service sector.
Offshore drilling is a niche industry dominated by Noble, Transocean (RIG), Valaris Seadrill and Diamond Offshore Drilling. Their rigs have become increasingly popular. The global oil production rate is currently around 100 million barrels per day. This is not likely to change in the next decade.
Offshore fields will be critical in maintaining the pace. According to Evercore ISI analyst James West, an onshore well using hydraulic fracturing (or fracking) can produce 1,000 barrels per day. However, offshore fields, such as one off the coasts of Guyana and South America, can contain billions of barrels. Individual wells can also produce 20,000 barrels a daily. Offshore wells typically experience a decline in production of only a few percent per year, as opposed to the 50% or higher for fracked U.S. wells.
Despite being hounded by climate activists and BP, Shell have reverted to investing in oil after having de-emphasized investments in renewable energies.
West says that there is a growing realization that the age of oil will last much longer than prognosticators had predicted. “The major oil companies realize they need to produce baseload oil, and offshore is the only way they can do that.”
Follow the money. The oil-service industry leader (SLB), formerly Schlumberger, highlighted offshore opportunities this week. They projected that major oil companies will commit up to 500 billion dollars in new projects between 2022 and 2025. SLB noted that even if oil drops to $50 per barrel, 85% of offshore projects are still profitable.
Deepwater rigs are either floating platforms or ships that can operate up to 10,000 feet deep, often with reservoirs several miles beneath the seafloor. These are owned and operated publicly by offshore drillers and command the highest rates.
In places like the Gulf of Mexico and the North Sea as well as Guyana, there are 100-150 deepwater rigs. The day rates for these rigs were at their lowest point in May 2020, when the Covid crisis was at its height. They are now approaching $500,000 per day. Current contracts are very profitable, as the operating costs of the rigs are generally less than $150,000 per day.
But not all of it is reaching the drillers yet. The current earnings are low because older contracts have lower leasing rates. However, profits will increase dramatically in 2024-2026 due to higher rates on newer contracts.
In addition, the consolidation of companies and the tightening supply have led to a more disciplined pricing system. There is also a virtual absence of new rig construction, which can be as expensive as $1 billion per rig. This should limit the overspending of offshore drillers and keep the most desired rigs scarce. The earnings at Noble are expected to double to $6 per share by 2024, up from $2.45 in this year. They will also go higher in 2025.
Noble has been a favorite among Barclays’ Anderson. He says the company is poised for “enormous contracting opportunities” over the next two-year period, as well as a program of buybacks. Noble signed a contract in May for a 2.5-year period with Petrobras , for a floating oil rig. This was a record for this cycle. Anderson’s price target for Noble is $56, up 50% over Friday’s closing price of $35.62. It’s slightly more costly than other drillers but it is also of higher quality.
Valaris’ stock is lagging behind its peers in 2023, because it leased a number of rigs over the last year at rates that are now below market. This means that Valaris’ re-contracting opportunities will take longer to materialize. Valaris is in a joint venture that has a lucrative rig with Saudi Aramco. The state-controlled Saudi oil company could go public within the next few years. West says that Valaris has a fleet of high-quality deepwater rigs, with some rigs currently being reactivated. West also has a positive view of the Saudi joint venture. He gives Valaris a rating of Outperform and a price target $86. Valaris closed Friday’s trading at $56.56.
Diamond Offshore is the company with the lowest market value and the fewest high-quality assets. However, they do have four of the latest “seventh generation drillships”. Diamond is another Anderson choice, partly because of its size, which could make it an attractive consolidation target. His $20 price target is up 60% over the recent $12.37.
Seadrill has also been consolidating and could be able to benefit from the $1 billion merger with Aquadrill earlier this year. The company described the result as a “best-in-class” fleet with seven drillships of the seventh generation. Seadrill could see its earnings increase in the future as low-priced legacy contracts expire. It is trading at 38 dollars, which is eight times its projected earnings for 2024.
Transocean may be the most risky of all the drillers, but it could also bring the biggest rewards. Transocean is the leader in the industry, owning most of the deepwater drilling rigs that are operational, but also the ones that could be brought back to the market.
The company is heavily indebted with $7 billion of debt against a $4 billion market value. The company is the only major oil rig operator that has avoided bankruptcy. Transocean’s stock, which is currently trading at around $6 or 15 times the projected earnings for 2024, faces a higher level of risk due to its debt. As bondholders become stockholders, the equity price could rise as a result of paying down debt.
Anderson claims that the company’s free cash flow could reach $1 billion annually in 2024-2026. Investors can buy the company’s debt as well, such as 6.8% bonds due 2038 that are currently yielding 11%.
These companies face real risks. The finite lifespan of the rigs could be cut by the energy shift, as well as the linkage between the companies and oil prices that are likely to fluctuate. Oil will remain a major energy source for many decades. One of the best ways to take advantage of this longevity is by investing in a rig industry that’s financially disciplined and consolidated.