Deepwater Drilling Offers The Chance of Value, Growth and Yield

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When investors get excited about a trend it can be all consuming. Media coverage becomes one dimensional and, as the new surges, the old often gets left behind. There has been seemingly endless coverage of the “shale revolution,” for example. The excitement is understandable. The technique of hydraulic fracturing that has opened up shale fields in North America has actually been around for a while as the first commercial license was issued to Halliburton (HAL) in 1949, but recent technological advances have given commercially viable access to vast quantities of oil and gas that are transforming the US energy market.

It just so happens that this boom has coincided with depression in what, until a few years ago, was seen as the “next big thing” in energy... deep water drilling. Until the potential of shale oil fields became obvious it was oil located deep under the sea that was going to supply our ever growing need for fossil fuel. Then, on April 20th 2010, everything changed. The explosion on the Deepwater Horizon platform was, first and foremost, a human tragedy; 11 workers were killed and 16 more were injured that day. It was also an ecological disaster; despite billions of dollars spent on cleaning and remediation the effects are still evident in the Gulf region.

What it also did, though, was shift the focus of oil production. Drilling in ever deeper water for oil began to look increasingly foolish and, on balance, the ecological risks of fracking began to look less scary. The companies involved in deepwater exploration, drilling and extraction saw their stocks understandably plummet when a moratorium was placed on operations following the disaster, but the recovery one would expect has been slow. As a result, those stocks now look like great long term value.

Transocean (RIG) would be a case in point.

RIGRIG

As you can see the stock fell dramatically at the time of the disaster as Transocean’s involvement became clear, but then, as you would expect, began to recover. The long term hangover in their business of deepwater drilling, however, has dragged RIG back down to hover close to the lows.

This proximity to an obvious stop loss level around $40 makes RIG reasonably attractive from a technical standpoint, but it is the value that is most striking. The company trades at less than 12 times forward earnings, has a Growth to P/E ratio (GPE) of 1.52 based off an 18% earnings growth rate and pays a dividend that equates to a 6.7% yield.

In these days of widespread full valuation, those numbers are striking, but in the world of deepwater drilling they are common. The other pick in the sector, Seadrill (SDRL) is, if anything even cheaper.

SDRLSDRL

They currently trade at an eye-popping 7.2 times earnings and have earnings growth of 22% to give a GPE of 3.06. The dividend has been fast growing and currently represents a yield in excess of 10%. There are, of course, reasons these numbers are so high. The company is considered heavily indebted, even in the capital intensive world of deepwater drilling. Most of their debt, though, is at low interest rates and debt servicing looks extremely manageable. They have a relatively new fleet of rigs, are the second largest in the business, and are continuing to expand.

Of course, none of this value that can be found in both RIG and SDRL will matter a jot if the industry as a whole remains depressed. Rates for their rigs and services have been and remain low, but the longer crude oil holds above $100/Barrel the less likely that is to continue. Pricing of both stocks would seem to be based on the assumption that that situation will never change, but logic dictates that it will.

There will be some who, even with great valuations and an average yield around 8.5% wouldn’t invest in these companies. Those whose reasons for that are based on objections to the ecological disaster of the past or on fears of a similar event in the future I can understand. I believe that the investigation of Horizon, and subsequent regulations and advances, have made a repeat much less likely, but if you disagree and your opinions won’t allow you to invest in deepwater drilling then that is your decision.

If that doesn’t apply to you however, you may wish to consider both stocks as long term holdings. Both look undervalued and are offering a dividend that will cushion any future weakness to some extent. Deepwater drilling will never regain its status as the next big thing, but neither will it go away completely, so buying now while the sector is undervalued makes sense.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Commodities , Business , Investing Ideas

Referenced Stocks: RIG , SDRL , HAL

Martin Tillier


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