A secular bear market is producing deep value in the energy sector.
It’s merely a coincidence, but before I began this article, I read a headline on BusinessInsider titled “The U.S. Is Gushing Oil.” The article’s author, Ed Yardeni, produced an efficient chart that reveals in a glimpse how far U.S. oil production has progressed in the past nine years.
That the United States is a leading energy producer is really common knowledge these days. It’s also common knowledge that value in U.S. energy companies is becoming harder to unearth. This is no surprise: Common knowledge is frequently fully expressed in the share prices of common stock.
For these reasons, I’ve spent more time poking around for value in less popular energy niches. I’m unsure if any niche is less popular than offshore drilling.
To say the offshore drillers have had a rough go of it in recent years is to belabor the obvious: Most of the drillers peaked in 2008, when oil was pushing north to $145/barrel. Since then, it’s been a slow slog south. Many offshore drillers are trading at 50% to 75% discounts from their formerly lofty heights.
The sector suffers from a number of structural problems these days: A surfeit of offshore drilling rigs and weak daily pricing top the list. The problem can’t be any more basic, and it’s one that periodically plagues the sector. Offshore drilling is notoriously cyclical. Good times are invariably followed by bad times, and vice versa.
Despite recent travails, the offshore drilling industry isn’t going away. I expect the major exploration companies – ExxonMobil (NYSE: XOM), Royal Dutch Shell (NYSE: RDS.a), BP PLC (NYSE: BP) – to continue to push into deep-water energy fields. A recent industry report estimates that global offshore drilling spending will likely grow to $134.02 billion by 2019, or at an annual rate 10.6% over the next five years.
In the meantime, many of the large offshore drilling contractors – the firms that supply the ExxonMobils, Shells, and BPs – with the know-how and equipment to exploit offshore opportunities are priced for permanent obsolescence. This fact is revealed not only in multi-year-low share prices, but multi-year-high dividend yields.
I’m attracted to offshore drillers because I know that they are in the trough of the cycle. The following two companies are admittedly deeply mired in the trough, but I believe they offer the best combination of value and income in the sector. I believe they also offer the opportunity for superior long-term total return.
Diamond Offshore Drilling: (NYSE: DO), 9.1% Yield
In 2008, Diamond shares were trading above $140; today they are trading below $39.
Diamond has been hammered relentlessly by analysts over the past 12 months. The analysts invariably (and predictably) focus on the age of Diamond’s fleet, which is one of the oldest among the drillers. The also invariably ignore quality. In the second quarter of 2014, Diamond’s entire fleet experienced only 53 days of unplanned downtime. This is the best quarterly reliability figure they delivered in more than seven years. At the same time, Diamond continues to upgrade its fleet and bring new rigs online.
Diamond also continues to make money, and has beat earnings estimates (albeit lowered estimates) in 15 of the past 17 quarters. Diamond also has highest-rated credit ratings in the sector and one of the best management teams. Diamond is 50% owned by Loews Corp. (NSYE: L), which is controlled by the Tisch family, whose penchant for creating value is legendary.
To be sure, Diamond is in the rough, but I expected its outlook will appear more brilliant within the next year or two.
Transocean LTD (NYSE: RIG), 8.6% Yield
Transocean is trading at an even deeper discount than Diamond Offshore. Transocean’s shares peaked above $140 in 2008 and now trade below $35.
Transocean suffers from a lot uncertainty, which extends beyond the general uncertainty that plagues the sector. Eighty percent of Transocean’s ultra-deepwater rigs (accounting for 50% of its revenue) will be off contract by the end of 2016. At the same time, new contract backlog has been difficult to generate. Price growth, as with most of the sector, has been tepid.
Transocean, like Diamond, is also battle-tested. It’s seen both peaks and troughs. Keep in mind, too, that Transocean’s uncertainty creates opportunity, which is likely one reason famed contrarian investor Carl Icahn owns 5.7% of Transocean’s outstanding shares. Exceptional value opportunities don’t arise at the peak of a cycle; they arise from a trough.
Most analysts, and even the management of most offshore drillers, don’t expect meaningful improvement in pricing and rig-utilization rates until next year, and possibly not until 2016. But the time to buy is not when improvements are realized; it’s when they remain on the horizon.
This isn’t to say that Diamond’s and Transocean’s share prices won’t continue to drift lower; they likely will. Therefore, I recommend dollar-cost averaging into these positions over the next four to six months. You won’t catch the bottom, but you’ll be reasonably assured of keeping your cost basis low and your yield high.
Deepwater Drilling for Dividends
Discover a company that’s drilling into the largest oil reserve in the Western Hemisphere…deep under the Atlantic Ocean. With every barrel of crude oil that it unearths is adds to the massive dividends that it pays its savvy investors. This is the only company that has the high-tech rigs and the sole rights to drill the “Saudi Arabia of the Sea.” And the best thing is…It’s paying out bigger dividend than Exxon and BP. It’s highly profitable and rewards shareholders with unannounced “bonus” dividends. And it pays them out every quarter. That’s on top of its regular, scheduled dividends — meaning shareholders are collecting 8 dividend payments a year, all from this one investment.