Offshore Anxiety: Investing in the Turbulent Drilling Industry

 |  Includes: DO, HAWKQ, HERO, NE, RIG
by: Hedgephone

One of the worst industry performances in the stock market during 2010 was the offshore drilling sector. Drilling stocks were crushed by the Horizon Offshore spill and the resulting ban on new drilling permits in the Gulf of Mexico. Even though the Deepwater Horizon tragedy ruined the whole party for all of these stocks, every single name in the sector was punished and sent to 52 week lows last summer regardless of cash flow and earnings or whether or not they were a “party of interest” in the oil spill or not.

Interestingly, a private Houston based technology startup, Octave Reservoir Technologies, may have an answer to the offshore drilling safety issue with its new Reservoir Alpha software suite that tackles the problem of permanent seismic well monitoring in real time as well as 4D monitoring of well integrity in deep sea wells. Octave’s breakthrough platform relies on seismic geophones that are durable enough to be permanent on new wells drilled in the Gulf. The information collected by these permanent geophones could be vital for monitoring changes in well integrity.

Currently, most wells are monitored using a 50 year old Magnetic Coil technology with no permanent monitoring capability – in short the old technology doesn’t get the job done correctly. The website details their value added service, which in my opinion, the offshore industry vitally needs to operate more safely. So hopefully the great forces of entrepreneurship, capitalism and technological innovation will prevail and the drilling ban (which is stuffing money in the pockets of our rivals and out of the USA) will be lifted and the families and businesses that depend on this industry can get back to work and keeping more of America’s paychecks out of Iran and Iraq.

Until the Gulf of Mexico ban is lifted, however, the stocks evaluated below will continue to face major headwinds and uncertainty going forward and many will likely trade with a downside bias if heavily concentrated in the GOM. Whether the uncertainty and fears are already priced into the stocks and these companies now represent good values at these prices is up to the reader to decide. Oil is bad for the environment and oil spills are horrible disasters, but until we switch to natural gas automobiles or embrace solar, we should be producing as much domestic $91 per barrel oil as possible. Remember that deep sea drilling and Arctic drilling are likely where the growth will be in 2012 and beyond if the Rosneft BP share swap is an indication of where the oil companies are finding the world’s most valuable goop.

(NYSE:RIG): Transocean is the biggest name in the offshore drilling industry and is first up on our list of potential investment ideas for the drilling sector. Transocean has been hammered because of the oil spill and some very savvy investors who bought shares in the $40s after the disaster are now sitting on large gains with the stock at $78 per share. Is more upside possible for RIG? Certainly, RIG is the biggest and most powerful name in offshore drilling and was handed undue blame for the GOM situation – when the late Matt Simmons (RIP and condolences) said the company “deserved a medal” for actions in the Gulf and that the spill was BP’s problem -- investors who agreed with this and stuck with or bought RIG made out like bandits over the past nine months.

I would imagine the weak Dollar and weak Euro will boost oil prices going forward unless Bernanke suddenly gets religion and raises rates or stops QE. Higher oil prices should eventually lead to higher contract day rates in the sector. RIG has the largest percentage of revenue from the deep water business, which is the fastest growing segment in the offshore market (many of the shallow water drills are stacked both in the US and internationally right now). RIG is liable for an unknown amount of the oil spill and is facing many lawsuits surrounding the oil disaster. However, the market was completely wrong in assuming the company would “go bust” because of the spill – it looked all along to me and to others to be the result of old technologies that need more work, and maybe for that reason the offshore ban is at least a good symbol that we can’t let this kind of thing ever happen again. As someone who follows commodities, I think it’s a symbolism we can’t afford as a country right now and that we need an on-the-fly program to make things safer (but that’s mainly just the deficit, debt, and waste objector in me).

Transocean earned around $2.3 billion over the past year (despite the dire calls from the vocal shorts for $0) and generated operating cash flow of approximately $4 billion over the trailing twelve month period. Revenues and earnings dropped off badly this past quarter along with most of the names in the offshore drilling business. With a price to earnings of around 10X, and a price to cash flow ratio of 4X (keep in mind Rig upkeep/maintenance capital expenditures are a very expensive line item for offshore drillers). I think Transocean was less guilty in the oil spill mess than most people do, but that’s mainly because I don’t blame the rig workers for the disaster. I think it was a freak accident, which was obviously ten times worse than a Jerome Kerviel fat finger trade in its resulting destruction. RIG is pretty cheap and if the industry can learn from this and get it right in the future, maybe the company is better off from the experience – capital expenditures will need to be spent on safety measures and arctic deep water drill ships, so don’t expect huge free cash flow growth in 2011; but an upside earnings surprise due to high oil prices or a lowered glut of ships on the market seems highly plausible. There is a glut of rigs on the market as the industry breaks a new Don P bottle every week at various shipyards around the world while at the same time everyone tries to lock in business for last year’s new build drill rigs. In other words, competition from newly built drill ships has likely softened incremental day rate gains that would normally come from higher oil prices for the company ( a good deal for the integrated oils). The older Jack Up fleets in the industry may remain stacked for a long period of time, if not permanently.

(NYSE:NE): Noble Corporation is one of the strongest businesses in offshore drilling and boasts one of very best safety records in the industry. Noble made a big push for deep water drilling with its purchase of Frontier for $2.16 billion dollars, which also gives them an arctic deep sea drillship (look at BP Rosneft for an idea of where the real black gold is – the North Pole). After revealing that 95% of Frontier’s backlog is with Shell Oil (NYSE:RDS.A) and together with Frontier, Noble has a $13 billion dollar backlog up from 7 billion before the acquisition, the future of this company looks exceptionally bright.

With this immense backlog of business, Noble is positioned to move into the number two spot in the market behind RIG. Noble’s 1.3X tangible book value multiple is appealing, given their historical return on equity of 20% and their large 42% operating margin. Noble has always thrived with its belief that safety and innovation is job number one, and management seems exceptionally seasoned after a decade of market beating growth (Noble was a $1 stock in 1995 – IE these guys know how to make big phreaking money). The timing of the Frontier buy deserves another hat tip to management as the media more or less predicted that the industry would completely shut down and go bankrupt and this hyperbole/panic/T.V. ratings game created a buying opportunity for the company, which complimented its already large book of Shell business. NE is my personal favorite in the space.

(NASDAQ:HAWK): Seahawk Drilling is certainly not as safe as Treasury Bond (btw, that phrase is losing its steam as well), but it could make you some serious money if the drilling ban gets lifted and Seahawk can turn free cash flow into earnings going forward. Trading at a .22X multiple of book value, Seahawk falls into that “ridiculously cheap, pretty good company” category for an investor’s portfolio. Even Peter Lynch had his fair share of asset plays and cyclical stocks that he bought when they had no earnings and sold when they had low PE ratios and everyone liked them. HAWK is a $380 million shareholder equity company that recently lost $75 million or so over the past year, which was likely due to its heavy concentration in the Gulf of Mexico. Investors have given HAWK the shaft, as the company is only valued at $85 million and change. If you think the ban will be lifted or that smaller players will continue to be bought out, HAWK could be a winning investment idea at 22% of tangible book value. recently covered the investment idea in more depth – I’m a cautious but optimistic buyer of the equity here. Where else can you buy $380MM for $86MM? In my view this company could be put in play at any time as surely the assets are undervalued even as spare parts. I need to do more research on their Jack up fleet before taking a sizeable position in the stock, however. This one is risky, but I don’t expect to see large sudden write downs as much as a gradual cash burn situation if the ban goes on a while longer.

(NASDAQ:HERO): Hercules Offshore has recently looked Medusa right in the face and investors have been turned to stone. The thing is, Hercules is free cash flow positive and trades at a ridiculous valuation -- .38X tangible book value and 3.6X TTM Free Cash Flow. I recently bought this stock as I think they can whether the safety storm and will be back in the gulf as early as this summer. America needs domestic oil and gas production to compete in the global economy. It’s only a matter of time until the offshore ban ends, and a new technology (such as Octave – fixes many safety issues that must be addressed for drilling to continue offshore.

(NYSE:DO): Diamond Offshore trades at 10 times 2010 TTM earnings and 5.7X EV/EBITDA making the stock attractive on valuation. Diamond boasts a 27% return on equity and a 30% net margin which is slightly better than Noble. Sales fell 12% last quarter versus the same quarter in 2009, showing that DO is not as affected by the Gulf ban as some of their competition. Diamond is 50% owned by Lowe’s Corporation (NYSE:LOW), which means that the float is relatively small compared with the market cap which can lead to volatility in the share price. DO is pretty cheap and is a stock to watch in 2011. Diamond looks cheap on earnings and L seems cheap on assets -- Lowe’s is big in property and casualty insurance and owns 18 hotels as well as their stake in DO. In the future an arbitrage opportunity may exist between these two stocks, but at this point they both look like decent turnaround candidates and relatively good values at current prices.

The headwinds persist, but the world needs oil and these stocks should benefit if oil prices continue to rise and the glut of drilling rigs becomes less of a factor. The worries are real and the stocks are not without risk, but hopefully new technology will save the day for the sector in 2011.

Disclosure: I am long NE, RIG, HAWK, HERO.