A Big Wall Street Upgrade for These Offshore Drillers: Buy or Sell?

On September 26, UBS analysts made waves in the offshore drilling contractor sector, raising their price targets for shares of Transocean LTD (NYSE: RIG), Noble Corporation Ordinary Shares (UK) (NYSE: NE), Diamond Offshore Drilling Inc (NYSE: DO), ENSCO PLC (NYSE: ESV), and Rowan Companies PLC (NYSE: RDC). The market reacted favorably to the news, lifting shares of all five companies -- as well as those of Atwood Oceanics, Inc. (NYSE: ATW), which is soon to be acquired by ENSCO -- between 5% and 10%.

Let's take a closer look at UBS's upgrade and what the near-term and longer-term prospects are for offshore drillers. Even after the big price jump following the upgrade, there's still potentially big upside for investors once offshore drilling demand picks up. But there still remain big risks investors should consider before investing in any offshore drillers.

Why UBS said it upgraded these drillers

After three years and the worst downturn in the segment's history, UBS analyst Angie Sedita thinks offshore drilling is set to improve in coming years. Over the past several quarters, utilization of floating offshore drillships has fallen to near 50%, while jack-up utilization has been near 60%. Sedita's forecast is for utilization to increase to 75% and 79%, respectively, by 2020, closer to historical levels.

Based on this increased utilization, UBS analysts expect EBITDA -- earnings before interest, tax, depreciation, and amortization -- to increase 25% across the segment by 2020, and oil prices to continue recovering and approach $70 per barrel by then.

UBS also expects offshore drillers will be continue working with lenders to extend terms on debt set to expire in the near term. Interestingly enough, All of these drillers are in relatively good shape when it comes to near-term debt expirations. With the exception of Transocean, which has $865 million in current debt -- debt due within 12 months -- and Noble Corporation with $250 million at the end of the most-recent quarter, none of the drillers upgraded by UBS have major debt maturities in the next year:

Even Transocean's $856 million in current debt isn't a major issue; the company has more than $2.4 billion in cash on hand. Similarly, Noble Corporation has over $600 million in cash on hand and $2.4 billion available on its credit facility.

Furthermore, offshore drilling activity has stabilized a little over the past couple of quarters, with more big activity so far this year than in all of 2016. Much of that activity has been extensions of existing contracts, or single-well and short-term work that has kept newer active vessels operating. So, we haven't yet seen an expansion of activity that will start pushing fleet utilization levels back up, but the steady bid activity and recovering oil prices indicate that drilling expansion is just around the corner.

What about the recent run-up?

Since bottoming out in late June, Brent crude futures are up more than 25%, helping drive these offshore drilling stocks prices up as much as 34% over that period. Since mid-August -- offshore drillers didn't start recovering with oil prices -- this group of offshore drilling stocks is up between 23% and 49%. Does that mean the "best money" has already been made?

I don't think so. After all, even after the recent run-up, they're all still well down from before the downturn -- as much as 91% for ENSCO, and Rowan Companies, the "best" performer, is down 69% from its 2013 peak. The group is also still trading for between 20% and 50% of book value per share, a fraction of their historical valuations:

Looking ahead and considering the risks

The first thing to note is that even UBS's projections are for it to take several more years for offshore drilling to really recover, and I think that's reasonable. But I also think that this group of companies are the most likely to outperform the rest of the industry, especially ENSCO once it and Atwood fully combine, and Transocean, with its huge cash pile and recent moves that make it more nimble.

But it is almost certainly going to take at least a year or two -- at best -- for the recovery to really kick in, and potentially longer. The uncertainty in how long it will take is where the risk lives, and that will almost definitely mean offshore drilling stocks will remain some of the most volatile to invest in.

If you're not comfortable riding out the ups-and-downs, this may not be the best place for you to invest. But if you're willing and able to see your stocks potentially gain and lose double-digit value from one day to the next, and sometimes with no apparent reason, you could do very well to buy now and hold for the eventual recovery.

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Jason Hall owns shares of Atwood Oceanics, Diamond Offshore Drilling, Ensco, Noble, and Transocean and has the following options: long January 2019 $15 calls on Transocean. The Motley Fool owns shares of Atwood Oceanics. The Motley Fool has a disclosure policy.