Four Deepwater Oil Riggers With Fantastic Fundamentals

Includes: DO, GSF, NE, RIG
by: Investopedia Advisor

Investopedia Advisor submits: With most of the major land-based oil fields now more or less having been discovered, the hunt for new oil is now focused on the more challenging offshore deepwater regions around the globe. It’s as risky, expensive business that requires special technology and expertise.

That special technology and expertise is in the stock of just a handful of offshore drilling contractors that have built their business around leasing specialized offshore equipment to the majors at short or long-term contract day-rates.

With high oil prices having created something of a stampede by the majors to find those big pay-off deepwater fields, offshore rig demand have skyrocketed. The resulting rig shortage has pushed day lease rates to the highest levels in industry history. Average industry day rates so far this year are up 50% relative to 2005, reaching just over $101,000 a day. In hot exploration areas like offshore West Africa, short-term rates have even reached levels as high as US $195,000 a day.

All this has been good news to companies like Transocean Inc. (NYSE:RIG), Noble Corp (NYSE:NE), Diamond Offshore Drilling Inc. (NYSE:DO) and GlobalSantaFe (NYSE:GSF), who specialize in leasing deepwater rigs. Earnings so far this year have roughly doubled and are forecast to double again next year. Huge contract backlogs on the books stretching into 2008 virtually assure that these earnings gains will materialize.

With all these fundamental industry positives, you’d think investors would be clamoring for the shares of these companies. Not so. While share price gains of between 50-70% were reported in 2005, they have basically traded flat so far this year. Investors have steadily sold off these issues since they hit peak valuations in May. So what’s prompting all the negative sentiment?

While the fundamentals may be fantastic right now, there are signs that industry conditions may have peaked. It’s a case of investors looking beyond the peak to the approaching valley. Here’s what may lie behind these expectations. It’s a basic law of economics that price creates supply. While the supply/demand balance in the global offshore rig business may be tight right now, that may not be the case going forward. Currently, there are approximately 50 new ocean jack-up rigs either under construction or scheduled to be built over the next three years.

Eight of these rigs will come on-stream over the balance of this year with the remainder being brought into service during 2007 and 2008. Assuming that all the rigs currently in service remain active, these new builds should increase the global offshore rig fleet by 13%. That’s bound to push day rates lower.

High utilization levels for the existing fleet are also taking their toll. Maintenance expenditures have been climbing so far this year, in some cases well above analyst’s estimates, prompting a round of downward revisions to earnings forecasts.

The oil price itself is also producing a degree of investor caution on the group. While they are only tangentially affected by oil prices, the drillers’ shares tend to move very much in line with oil prices. Judging by their recent performance, expectations appear to be calling for lower oil prices in the years ahead.

The oil market’s focus continues to be fixated on the supply side of the equation, with things like the Iran nuclear issue with the UN, the shutdown of Alaskan oil production, and the on and off threats of Nigerian production dominating sentiment. The gradual slackening in demand due to decelerating global economic growth is providing a fundamental reason for prices to move lower.

Many analysts concede that the current oil price carries a built in geopolitical risk premium of about US $10-15 per barrel. If the supply issues now dominating the headlines begin to wane, and the crude price risk premium narrows, I suspect the offshore oil drillers shares could move even lower. However, give the inescapable fact that the search for future oil supplies requires significant and growing exploration expenditures in the offshore regions, the outlook for deepwater drilling industry remains very positive.

Investors may want to take advantage of any near-term price weakness in these shares to gain some exposure to this long-term positive trend.

RIG 1-year chart:

NE 1-year chart:

DO 1-year chart:

GSF 1-year chart:

By Eugene Bukoveczky, Contributor - Investopedia Advisor

At the time of release Eugene Bukoveczky did not own any shares in any of the companies mentioned in this article.