Offshore Drillers: Finally Safe to Buy, or a Value Trap to Avoid?

Offshore drillersjust can't seem to catch a break. First the industry got hit by a large glut of its most profitable rig type, ultra deep-water drill ships and semi-submersibles, and now the oil crash is causing day rates to fall even further, dragging share prices down to levels not seen since the financial crisis.

RIG ChartRIG data by YCharts

Let's take a look at three leading companies in the space-- Transocean , Seadrill , and Ensco -- and see just how undervalued these companies are, but more importantly let's see if it's finally safe for investors to snap up shares by examining whether these companies' stocks might still have to further to fall.

Offshore drilling shares trading at fire-sale prices ...

Sources: Fastgraphs, Gurufocus

Offshore drillers have been beaten down so low that they truly are selling for a song, whether on a price-to-operating earnings, price-to-cash flow, or price-to-tangible book value basis. However, there is a big difference between a deep value stock, even one of the "dirty value" variety, and a value trap -- a stock that is dirt cheap for good reason.

A value trap is a company whose business is failing and is never likely to recover. Sometimes these are companies with incompetent management, a mountain of debt that the business model can't support, or they are in an industry experiencing secular decline. Sometimes it's even a combination of these factors. Whatever the reason, investors are better off avoiding such stocks.

So are offshore drillers a value trap? I think not, because the future of ultra deep-water oil production is still very bullish. According to the International Energy Agency, or IEA, the world's daily demand for oil over the next 25 years is likely to grow by 14 million barrels per day.As this chart illustrates, ultra deep-water oil production is likely to be a major supplier for this demand.

Then again, a 25-year bullish outlook is cold comfort to investors who have lost so much money recently. So let's look at the next few years to see the two most likely reasons why offshore drillers may continue to struggle.

... but oil prices may still have further to fall ...According to the IEA, even though crude prices have fallen so drastically, "global supply continues to grow at a breakneck pace," up 2.7 million barrels per day over 2014's July production.

While U.S. shale output has started to decline, production growth in Saudi Arabia, Iraq, and Iran has more than made up for it and resulted in a continued global oil glut of about 1.5 million barrels per day.

Source: IEA Oil Market Report.

As this chart shows, oil demand is expected to grow quickly -- by 1.6 million barrels per day in 2015, the fastest rate in five years -- but supply isn't expected to be balanced by demand until the end of 2016.

In the meantime, the lifting of nuclear sanctions against Iran means that further supply growth is likely over the next few quarters, which means crude prices might still have further to drop. Even if they don't, a quick recovery in oil prices isn't necessarily assured. For example, the Energy Information Administration recently cut its average respective 2015 and 2016 oil price forecasts to $54 and $59 per barrel -- hardly the kind of crude prices that are likely to boost demand for offshore drilling rigs.

... and an industry turnaround could still be years awayAccording to analyst firm Rystad Energy, between the second half of 2015 and the end of 2017 54 floaters -- the industry's most profitable rig type -- are scheduled for delivery.

This 12% increase in global supply in 2016 and 2017 is expected to be met with a 10% decrease in demand in 2015, a 7% decrease in 2016, and an 8% increase in 2017. In other words, the global supply glut of floaters is likely to keep getting worse for the next few years, likely resulting in two things:

  • far more floater retirements and the commensurate asset impairments that could badly hurt earnings
  • continued pressure on day rates that will greatly reduce cash flows and make debt servicing more challenging

Takeaway: offshore driller stocks are nowhere near "safe"The long-term outlook for oil prices is bullish, but in the short term, no one can accurately predict how low crude could crash or when it will finally recover. That means that investors in offshore drillers need to be willing to wait potentially until 2017, 2018, or beyond for a recovery in day rates and share prices.

More importantly, always remember that stocks that depend on extremely volatile commodities such as oil are never truly "safe," no matter how undervalued their shares become. That's why it's so important to own a diversified portfolio and not invest too aggressively into any one stock -- even if it seems crazy cheap.

The article Offshore Drillers: Finally Safe to Buy, or a Value Trap to Avoid? originally appeared on

Adam Galasdoesn't own shares in any companies discussed but does leadThe Grand Adventuredividend project, which recommends Seadrill.The Motley Fool recommends Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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