Seadrill: The Best Stock To Profit From Deep Sea Drilling

| About: Seadrill Limited (SDRL)

Domestic oil discoveries like the Bakken may be basking in the investor spotlight today. But waiting patiently backstage is the future of world oil production: deepwater offshore.

Nearly half of all newly discovered oil in the past decade has been in ultra-deep water. Over the next six years, ultra-deep water production is estimated to quintuple. And by 2023, as much as 40% of the world's oil production could come from waters deeper than 4,500 feet.

Indeed, deepwater offshore is quietly seeing tremendous growth. Investors wanting to profit from this should keep a keen eye on one region in particular -- a region that's garnering the most attention from explorers...

It's known as the "Golden Triangle."

When people think of the Golden Triangle, visions of an exotic, underground drug-trade in south Asia often spring to mind. But in the petroleum industry, the deepwater Golden Triangle represents a different region of the world entirely.

It's comprised of three sub-surface basins: the Gulf of Mexico, Brazil, and West Africa. And while these basins have long been known as oil and gas hot spots, only in the past 10-15 years have energy companies started to aggressively tap their deepwater riches.

Last year, this region accounted for 47% of all deepwater discoveries. Today, it's home to over 30% of the world's offshore rigs. By comparison, the prolific North Sea region only has 12% of the global rig count.

In the Gulf of Mexico especially, we're seeing a growing number of deepwater rigs preparing for exploration. Currently, 37 deepwater rigs operated by 14 different companies by are in the Gulf. That number is expected to climb to 60 by 2015 with the new rigs valued at a whopping $16 billion to build -- not exactly chump change. But the opportunity to extract millions of barrels at $100 a barrel makes the payoff too lucrative for major oil companies to ignore. Take Shell and Anadarko, for instance.

In one of its latest projects, Royal Dutch Shell (NYSE:RDS.A) announced it is constructing an offshore facility 200 miles southwest of New Orleans that will produce 50,000 boed from more than 250 million boe of recoverable resources.

Likewise, after a recent upgrade at its Jubilee oilfield operations in Ghana, Anadarko (NYSE:APC) expects to raise its daily oil output by 10,000 barrels to 120,000 bpd by the third quarter of 2013.

And it's not just the Gulf of Mexico and Africa seeing spikes in activity lately. Brazil's offshore development has been on fire as well. It's estimated the country could contain as much as 100 billion barrels of oil equivalent (a huge win for Petrobras (NYSE:PBR), the state-owned producer that's required by law to own a 30% equity in every well that's drilled off Brazil's shores).

Having said that, where should we put our money if we're looking to profit? I see two main ways to play the deepwater drilling game.

One, buy the majors like Shell, Anadarko, or Petrobras. These are the companies that profit directly from the production of any deepwater discovery. But remember, finding a gushing well offshore, much less in ultra-deep waters, is not easy. The costs of developing a deepwater field also have an astronomical price tag -- in the hundreds of millions (if not billions) of dollars. So there is huge financial risk for these companies.

A safer bet may be to invest in the drilling contractors rather than the producers themselves. Barring another major oil spill, rig contractors are going to be very busy for the next few years -- meaning these are going to be the some of the best stocks to own as offshore development in the Golden Triangle continues to grow.

A couple of stocks caught my eye, but one company in particular looks set to prosper in the coming years.

That's Seadrill (NYSE:SDRL).

I see several advantages to Seadrill over its peers.

For one, the company has strong exposure to the Golden Triangle. Of its inventory of 26 drillships and semi-submersibles, 12 of them are currently deployed here. As well, Seadrill has six new ultra-deepwater drillships earmarked for delivery in the Triangle between the second half of 2015 and first half of 2016.

These new drillships are marvels of engineering. They can operate in 12,000 feet of water and drill upwards of 25,000 feet into the earth. They'll cost approximately $600 million each to build and, based on the company's current lease rates, will command anywhere from $447,000 to $627,000 per day. That means the ships have about a five-year payback period (relatively quick for such a large investment).

Seadrill also has the most modern fleet of all offshore drillers and is growing rapidly. When the company was first established in 2005, it had just five rigs available for lease. In 2012, that number had shot to 50. The company also is currently building $8 billion worth of new units. Its construction program totals 9 drillships, 2 harsh environment semi-submersibles, and 11 high specification jack-ups. There are also fixed priced options for two ultra-deepwater units. In total, Seadrill plans to have 75 rigs in operation by 2015. That represents 1,400% growth in its rig inventory in only ten years.

On the money-side of things, the company looks attractive as well. This past quarter, Seadrill generated a record EBITDA of $713 million, up from $604 million the previous quarter. Its operating profit and cash flow from operating activities were also up quarter-over-quarter, hitting $552 million (up from $441 million) and $423 million (up from 318 million), respectively. That's impressive growth by any standard.

Equally impressive is Seadrill's order backlog. The company has contracted orders worth over $19 billion in the coming years: $4.5 billion due next year, $4.0 billion due in 2015, and $3.2 billion due in 2016. The backlog will help the company grow its EBITDA by over 50% in the next two years.

In addition, Seadrill also pays a hefty 8% dividend. Its payout ratio comes in at a unsustainable 149%, but management insists a stable, growing dividend is part of their plan. Whether or not the cashflow kicking in next year is large enough to sustain the dividend is debatable -- but it isn't a major factor in my mind. I like the company for its growth potential. The dividend is just a bonus.

One thing to note is that the company does carry a high debt-load. But considering its large order backlog and the cashflow that new, already contracted out ships will generate (as well as the strength and growth of the deep water drilling industry as a whole), I don't see it as a problem.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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