Reality Setting in for Offshore Drilling

Source: Seadrill.

Reality is biting offshore drilling stocks, and recent earnings reports from Seadrill , Transocean , Ensco , and Diamond Offshore may be the last bright spots we see for a long time. Revenue and profits are holding up well in the short term, but you can tell in earnings releases and conference calls that the mood in the industry has soured, and they're wondering when a turnaround will come.

Reality is, it may be a while.

Setting up for a long slowdown In the three months since offshore drillers have reported earnings, a lot has changed. In Q3, there was a sense of optimism that oil prices would rise fairly quickly and that drilling contracts were just around the corner. In Q4, the tone was different, and backlog that once seemed rock-solid has come into question (I'm looking at you, Seadrill). Maybe more importantly for investors, dividends that were once rock-solid were now sinking like rocks instead.

Driving the downturn in oil prices and drilling in general is OPEC, which is tired of shale producers taking market share over the past decade and is essentially creating a price war. It's trying to squeeze out high-cost producers, and shale is most often pointed to as the first to go. But the reality is that ultra-deepwater offshore drilling also falls in that same boat. OPEC's war may be pointed at shale, but offshore drilling is a casualty of the resulting oversupply of oil in today's market.

The problem for offshore drillers is that for OPEC to be successful in taking back market share in the oil business, it's going to have to wage a long and costly battle against these marginal oil sources. I recently highlighted that despite drilling rigs dropping rapidly, the U.S. is still expected to increase production in 2015, and it could be well over a year before production actually starts to drop. That means contracts may not be coming back in 2015, and we could see oversupply of offshore drilling rigs get worse before it gets better.

Where the pain is being felt first One reaction from oil drillers will be to cold stack rigs, something we're already starting to see. During its fourth-quarter earnings report, Ensco said 36 floaters and 14 jackups from the worlds fleet of rigs have been cold stacked since the start of Q4, including a few of its own.

Source: Ensco.

Cold stacking will result in write-downs and lost revenue for those with older rigs, and it's something Ensco, Transocean, and Diamond Offshore will all likely deal with in 2015. The good news is that when drilling contracts return, there will be less competition available.

Upside potential is bigFor companies who can survive low oil prices and subsequent stacking of rigs, the upside is tremendous. Oil drilling stocks are down 35%-70% in the past year, and P/E ratios have dropped heavily as well. Even a return to previous stock prices means upside of 50% or more.

ESV P/E Ratio (TTM) data by YCharts.

Of course, to reach that potential, companies will have to survive first. Given the stacking taking place, I think the best bet is with companies who own the newest fleets. That puts Seadrill at the top of the list, although net debt of $11.8 billion has to be a concern.

The concern I have for Ensco, Diamond Offshore, and Transocean is the large number of rigs they own that are over 20 years old, and in some cases, as old as 40 years. These will be the first rigs to be cold stacked, and as we saw in Q4, the impact on earnings can be billions of dollars.

There's a lot of potential for offshore drilling stocks, but it could be a long time before that potential is realized because of OPEC's war on shale oil producers. If you have the patience, I think it's an industry worth betting on, but I wouldn't expect tremendous upside for at least a year or two, and it may take longer for the market to stabilize.

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Travis Hoium owns shares of Ensco and 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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