By Michael Vodicka
Despite the markets' push to record levels, energy stocks have been locked into a bearish slump for the past two years.
With natural gas plummeting to an all-time low in the summer of 2012 and crude contained by slow economic growth, energy stocks have been big underperformers. That shows up in the sector's 3% gain in the past five years, 12% gain in the past three and just 7% gain in 2013 against the S&P 500's 20%.
But with natural gas trading well above its multi-year low and crude recently breaking above $100, the stage could be set for a rebound.
One of my favorite ways to cash in on the energy trade is with offshore drillers. I'm bullish on the offshore drilling industry because that's where most of the new oil is being found. In the past decade, more than 40% of all newly discovered oil was found in ultra-deep water, bypassing both onshore and near-shore discoveries. Big finds in the Gulf of Mexico and off the coasts of Brazil and Africa will also continue to drive demand for offshore drilling services.
There are plenty of great offshore drillers to choose from, including Transocean (NYSE:RIG), Diamond Offshore Drilling (NYSE:DO) and Noble Energy (NYSE:NBL). But my favorite pick from the group is SeaDrill (NYSE:SDRL), one of the largest offshore drillers in the world with a fleet of 66 drill ships and a market cap of $20 billion. With crude surging above $100, Seadrill is up 20% in the past two months. Take a look:
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But looking forward, Seadrill stands out from its peers because of its unique combination of growth, value and income.
As one of the largest offshore drillers in the world, Seadrill operates in the shallow, mid- and deepwater markets, providing the company with a diversified revenue stream. But the ultra-deepwater market is the fastest growing, and that's where Seadrill is making targeted investments to capitalize on the bullish trend.
On July 15, Seadrill announced it had placed an order for four new ultra-deepwater drilling rigs scheduled for delivery in 2015. Seadrill capitalized on weakness in the Asian shipbuilding market, negotiating a unit cost of less than $600 million. Each new rig is projected to produce $100 million a year in earnings before interest, taxes, depreciation and amortization (EBITDA) and expected to add 10% to total EBITDA by 2016.
Seadrill will also continue to capitalize on rising day rates as it renegotiates existing contracts and enters new ones. On July 11, Seadrill announced it had secured a 30-month $214 million contract for its West Freedom jack-up rig. That equates to a day rate of $234,000, which is a huge premium to its current day rate of $155,000, a great example of the cyclical nature of the drilling industry and the impact that a bullish trend can have on earnings.
Seadrill also boasts a dividend yield of 8.4%, more than three times the current return on the 10-year Treasury. That has led to speculation about the sustainability of Seadrill's dividend. For the time being, higher day rates are driving the company's cash flow to support a high dividend yield. But Seadrill is a leveraged play, with $8.8 billion in long-term debt and $816 million in cash and equivalents, increasing its vulnerability to economic cycles.
With Seadrill investing in future growth and capitalizing on rising day rates, analysts are bullish, projecting earnings growth of 29% in 2013 and 30% in 2014. Seadrill's earnings are expected to grow 22% a year over the next five years, a huge premium to the industry average of 12%.
Risks to Consider: The energy industry is particularly sensitive to global economic growth. Seadrill is also a leveraged play in the offshore drilling industry, making the company more vulnerable to economic cycles.
Energy stocks have been out of favor for the past two years, with many leading names trading near record-low valuations. But with natural gas trading well above its multi-year low and crude breaking above $100 for the first time in two years, this could be a long-term turn in the market. Seadrill is a great way to play that trend. In spite of the company's bullish outlook, Seadrill's forward price-to-earnings ratio of 15 is in line with its peer average of 14 and just a small premium to its 10-year average of 12. When you add its impressive 8.4% dividend yield, Seadrill makes for a compelling combination of growth and income.
Disclosure: I am long SDRL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.