These Drilling Stocks Are Buys as the Age of Oil Endures

Offshore oil drillers were about the worst place to be in 2020 as oil prices were falling and demand for crude seemed to be seeping away. Now, the stocks may be the ones to own as investors realize that oil will be needed to make the world go around for decades.

Make no mistake, it was a historic downturn for providers of offshore rigs over the past few years. Oil prices tumbled during the pandemic lockdowns as driving nearly ceased, while the pivot toward renewable energy caused big oil companies to reduce their spending on drilling in hard-to-reach locales. Rigs were taken out of commission as they became too costly to operate profitably, but it wasn’t enough. Many of the offshore drillers eventually filed for bankruptcy in 2021 and 2022, wiping out investors who had bought shares as a value play.

What a difference 12 months makes. The drilling companies, including

Noble

(ticker: NE),

Valaris

(VAL), and

Seadrill

(SDRL), emerged from bankruptcy in strong financial shape and are poised to thrive as major energy companies ramp up their offshore spending.

The stocks are down from early-year highs as oil prices have fallen to under $70 a barrel from the low $80s. The drop in crude, however, isn’t expected to dampen the industry’s ambitious offshore investment plans. Offshore drillers are benefiting as they get higher leasing rates for their rigs, which portend better earnings in the coming years.

Most of the operators have little or no net debt after restructuring their balance sheets in bankruptcy. And while none of the companies pays a dividend, some companies are initiating or expanding buyback programs, and payouts could be reinstated as free cash flow grows sharply in the coming years. With the risks to investors reduced, the stocks look like a buy.

“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.

The offshore industry is a concentrated niche led by Noble,

Transocean

(RIG), Valaris, Seadrill, and

Diamond Offshore Drilling

(DO), and their rigs are increasingly in demand. Global oil production is now running at about 100 million barrels a day, and isn’t likely to change much over the coming decade.

See All the Stocks We’re Bullish—and Bearish—On

Offshore fields are critical to maintaining the pace. While an onshore well that uses hydraulic fracturing, or fracking, can produce 1,000 barrels of oil a day, offshore fields like one off the coast of Guyana in South America can hold billions of barrels of crude, and individual wells can produce 20,000 barrels of oil a day, according to Evercore ISI analyst James West. The annual rate of production declines for offshore wells are typically in the single digits, versus 50% or more for the first year for fracked wells in the U.S.

Despite being hounded by climate activists, European majors like

Shell

and

BP

have pivoted back to oil and pleased their investors after de-emphasizing investments in renewable energy.

“There’s a realization that the oil age will last longer than many prognosticators have suggested,” says West. “The major energy companies recognize they need baseload oil production, and they need offshore for that.”

Just follow the money. Oil-service industry leader

SLB

(SLB), formerly known as Schlumberger, highlighted the offshore opportunity this past week, projecting that major oil companies would commit up to $500 billion in new projects from 2022 through 2025. And for good reason—SLB noted that 85% of offshore fields are profitable even if oil prices drop to $50 a barrel.

There are two main types of rigs: jackups, which operate in shallow water of 500 feet or less, and deepwater rigs, either ships or floating platforms that can operate in 10,000 feet of water, with reservoirs often several miles below the seafloor. The latter command the highest rates, and they are the ones owned and operated by the public offshore drillers.

There are now 100 to 150 deepwater rigs operating in such places as the Gulf of Mexico, the North Sea, and Guyana. Day rates on these rigs bottomed at about $125,000 a day at the height of the Covid crisis in May 2020 and now are approaching $500,000 a day. With the rigs’ operating costs generally below $150,000 a day, current contracts are highly profitable.

Not all of that is flowing through to the drillers just yet. Current earnings are depressed because of older contracts carrying lower leasing rates, but profits are expected to ramp up sharply in 2024 through 2026 as a result of higher rates on more recent contracts.

The bankruptcies, consolidation, and tight supply also have produced more pricing discipline. And there is virtually no new construction of rigs, which can cost nearly $1 billion each. That should keep the most desirable rigs in short supply, and limit overspending by the offshore drillers. Earnings at Noble, for instance, are expected to more than double, to nearly $6 a share in 2024 from $2.45 this year, and head even higher in 2025.

Noble is a favorite of Barclays’ Anderson, who says it has an “enormous recontracting opportunity” in the next two years, a clean balance sheet, and a buyback program under way. In May, Noble inked a 2.5-year contract with

Petrobras
,
the Brazilian oil company, for a floating rig at $490,000 a day, a new high for the current cycle. Anderson has a $56 price target on Noble, up more than 50% from Friday’s close of $35.62. At 9.1 times 12-month forward earnings, it’s slightly more expensive than other drillers, but also slightly higher quality.

Company / TickerRecent PriceYTD ChangeMarket Value (bil)2023E EPS2023E P/E2024E P/ENet Debt (mil)
Diamond Offshore Drilling / DO$12.6121.3%$1.3$0.1584.18.7$327
Noble / NE38.151.25.32.4515.56.9335
Seadrill / SDRL38.8919.23.13.2711.98.668
Transocean / RIG6.1735.34.7-$0.63N/A14.76,878
Valaris / VAL57.88-14.44.41.5038.68.4-280*

E=estimate; N/A=not applicable; *Valaris has net cash of $280 million

Sources: Bloomberg; company reports

Valaris stock has lagged behind peers in 2023 because it agreed to lease a group of rigs in the past year or so at what are now below-market rates, which means its re-contracting opportunity will take longer to play out. Valaris has an attractive rig joint venture with Saudi Aramco, the state-controlled Saudi oil giant, that could be taken public in the coming years. “Valaris is well positioned with a high quality deepwater fleet with a handful of rigs being reactivated,” says West. He also likes the Saudi joint venture and has an Outperform rating and $86 price target on Valaris stock, which closed on Friday at $56.56.

Diamond Offshore has the smallest market value of the main offshore drillers, and fewer high-quality assets, but they include four “seventh-generation drillships,” the latest models. Diamond, which trades at nine times projected 2024 earnings, is another Anderson pick, in part because its small size could make it a consolidation target. He has a $20 price target, up more than 60% from a recent $12.37.

Seadrill, meanwhile, has been a consolidator, and could benefit from a $1 billion merger earlier this year with the privately held Aquadrill that resulted in what the company called a “best in class” fleet, with seven seventh-generation drillships. With low-price legacy contracts expiring, Seadrill’s earnings could ramp up in the years ahead. At $38, it trades for eight times projected 2024 earnings.

Transocean is the riskiest of the drillers—but may also have the most reward. It is the industry leader, with the most operational deepwater rigs, while owning the most that have been mothballed and could be returned to market.

The company has considerable debt of $7 billion against a market value of $4 billion. It is the only major rig operator to have avoided bankruptcy. The debt means higher risk for Transocean stock, which trades around $6, or 15 times projected 2024 earnings. But paying it down could push equity prices higher as ownership passes from bondholders to stockholders.

The company could be “one of the greatest deleveraging stories” in energy in the coming years, with potential annual free cash flow of $1 billion in 2024 through 2026, Anderson says. Ultimately, its equity amounts to a turbocharged play on an industry revival, and investors can also buy its debt, like the 6.8% bonds due in 2038, now yielding about 11%.

The risks to these companies are real. They include the finite life of the rigs, which should run another 20 to 25 years or so, but could be cut short by the energy transition, and the companies’ linkage with oil prices, which are likely to be volatile. But it’s dawning on the world that oil will be a key energy source for decades. The consolidated, financially disciplined rig industry could be one of the best ways to play that longevity.

Write to Andrew Bary at [email protected]

Source: https://www.barrons.com/articles/these-drilling-stocks-are-buys-as-the-age-of-oil-endures-9c9d35c4?siteid=yhoof2&yptr=yahoo