The Compelling Investment Case For Deep-Water Drilling

Feb. 7.12 | About: Seadrill Limited (SDRL)

Some of the most profitable oil drilling in recent years has come from deep water drilling. As you might imagine, these deep water drilling operations involve companies sending well-equipped fleets into the ocean. They proceed to drill through the ocean floor to tap some of the richest oil reserves left on the planet. Since oil companies have been exploring land for so many decades, it is becoming increasingly difficult to find oil reservoirs that are worth the effort of extraction. Many energy companies are now looking to natural gas operations, although that commodity remains incredibly cheap, despite its relative usefulness. Perhaps, the last great frontier in crude extraction lie in deep water drilling operations.

Seadrill (NYSE:SDRL), as the name implies, is a company that specializes in deep water drilling. Its business model revolves around contracts with larger integrated oil companies in various regions, offering its modern fleet of drillships and rigs to tap fresh sources of oil. For instance, the two rigs unimaginatively named T15 and T16 are waiting in China's COSTCO Shipyard awaiting deployment next year to extract oil for Chevron (NYSE:CVX). These two rigs are part of a larger series of 11 tender rigs that Seadrill is operating in Southeast Asia, particularly off the coast of Thailand.

In addition to their own fleet, Seadrill has large financial investments in a host of other companies as well. For example, they hold a $452-million stake in the Norwegian drilling company Archer (OTCPK:ARHVF), which added $13 million to net income in Q3 2011 alone. Then there is the $62-million stake in Asia Offshore Drilling (NYSE:AOD), which lost $1 million in the same quarter due to a malfunction. Since problems like machinery malfunctions can happen at any time, investors actually embrace that Seadrill is spreading out the event risk through diversification. Any much smaller deep water drilling company could be crippled through a string of random events that not only prevent drilling operations, but accumulate repair costs rather quickly.

The largest deep water driller, Transocean (NYSE:RIG), is another play on the industry one could look at. The litigation expenses that have plagued the company since the Gulf oil spill of 2010 are responsible for huge declines in the stock's price on top of a string of rig malfunctions, which have hit the company's coffers. In addition, the company has some substantial liabilities totaling about $11.5 billion, which are being reduced at a snail's pace. Nonetheless, the company has been picking itself up and has a bright future in deep water drilling after the Gulf oil fiasco is completely dealt with and the company's long-term debts have been reduced to a more reasonable level.

While the better known investments in the energy sector, like Exxon (NYSE:XOM) or Chevron (CVX), offer strong plays on the energy industry as a whole, there are particular factors to consider. If crude oil remains expensive and demand for refined oil products like gasoline and jet fuel remains sluggish, the refiners will get burned on their financial data, which should in turn adversely affect their respective shares. The big well-known investments in energy tend to be very integrated, which means they do just about everything in the industry, including refining. Since this is the case, appreciation in shares of the big-name oil companies tends to be more sluggish. Ultimately, this means that investors looking to ride a rally in oil would be much better served with raw petroleum producers.

On top of its bright prospects in the deep water drilling industry, Seadrill pays an enormous dividend of 8% which has been continuously increased for years. In addition, the company's status as a petroleum producer (and not a refiner) gives it a big edge over other energy company stocks in an expensive crude oil environment. Investors will not only enjoy the amplified correlation that the shares would experience if crude oil were to move higher, but they'd also enjoy the aforementioned dividend. If you're looking for energy exposure, it's hard to go wrong with a company that generates cash like Seadrill.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.