Deepwater Drillers Offer Deep Value - TheStreet

Deepwater Drillers Offer Deep Value

Industry backlog and dayrate strength suggest healthy long-term demand for these specialized rigs.
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This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

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With easier drilling sources reaching their maturity and tapping out, oil companies are forced to drill much deeper for new supplies. Enter the deepwater drillers. These are the companies that lease rigs to the big oil names that need to drill at the most extreme depths of the ocean, a very specific and expensive task. Fundamentally, the economic landscape of the major deepwater drillers looks solid, and these companies should benefit from the robust, long-term demand for oil.

Oil companies are forward-looking by nature. So while oil prices continue to display high levels of volatility, deepwater exploration companies are not deterred. For decades, worldwide oil consumption has risen by 1% to 2% a year, and this growth will not abate now that emerging economies are consuming more and more of the commodity. China, with four times the population of the U.S., only consumes one-third the volume of oil that the U.S. consumes on a daily basis.

As exploration activities focus on more remote and costly drilling locations, owners of deepwater and ultra-deepwater rigs find themselves in a sweet spot. The rigs are designed to drill at ocean depths of over 4,500 feet (deepwater) and over 7,500 feet (ultra-deepwater). They are prized among the biggest oil companies that realize that the days of drilling shallow oil wells are waning and that vast supplies of the slick stuff are to be found at the nethermost regions beneath the ocean floor.

Oil companies continue to lock in expensive long-term contracts for deepwater drilling rigs, and odds are very slim that they will simply walk away from these multibillion-dollar investments.

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When oil prices were cheaper than they are today, producers were locking in contracts to lease deepwater rigs for as much as $600,000 a day. It takes years to build a deepwater rig, and oil companies are eager to have them to further their exploration activities. New rigs are expected to fetch nearly $1 million a day upon arrival. At costs ranging from $300 million to $400 million, the return on investment (ROI) can be lucrative as typical contracts are for two to four years. Demand is high, and supply is tight. Brazilian oil giant

Petrobras

(PBR) - Get Report

has snapped up the leases of many of the deepest-drilling rigs in anticipation of its newest and potentially massive offshore oil discovery.

Occasionally, industry fundamentals are good enough and valuations attractive enough that they create enticing investments in several sector participants. The volatility in oil prices has affected all businesses relating to oil, and the recent pullback in the deepwater drillers offers ample opportunity.

In the offshore drilling space, two dominant players include

Transocean

(RIG) - Get Report

and

Diamond Offshore Drilling

(DO) - Get Report

.

Transocean has the largest fleet of offshore drilling rigs, and the volatility in oil prices has not hurt the company's overall business. The total contracted backlog stands at $40 billion, and given the high demand for these rigs, these contracts are secure. Transocean produces eye-popping

net margins

approaching 45% and a

return on equity

(ROE) of nearly 40%, while changing hands at a

P/E

of 7.83 and a

forward P/E

of 7.46 (at publication time).

Diamond Offshore operates a fleet of 44 rigs all over the world, and the numbers are equally as impressive -- 35% profit margins, 37% ROE, and a forward P/E of about 9.12. Both companies have seen share prices decline by over 30% in recent months.

A more pure-play opportunity on the ultra-deepwater market is

Ensco

(ESV)

, which owns 12% of the available fleet with seven more rigs on the way. Ensco's core focus is in on water depths exceeding 7,500 feet. It's a much smaller company relative to Transocean and Diamond Offshore, with a market cap of $8.5 billion, but its margins are just as impressive. Ensco has no net debt and generates tons of

free cash flow

.

The ROI of these deepwater rigs is phenomenal. Since 2005, Ensco has taken delivery of four rigs at an average cost of $350 million. In 2005, the average dayrate was around $260,000; last year, the company contracted a rig out for $510,000 a day. Again, these contracts have durations from two to four years. At the low end of the dayrate, the ROI is in the midteens; at the high end, the ROI approaches 21% to 22%. Over time, turning a dollar of investment into $1.20 in returns creates tremendous value that will be reflected in the stock price.

Deepwater drilling rigs are utilized all over the world, and the industry backlog and continued strength in dayrates suggest healthy long-term demand for these specialized rigs.

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This was originally published on

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At the time of publication, Gad had no positions in the stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of the

Gad Partners Fund

, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.

Gad also runs a

value investing blog

inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at

sham@gadcapital.com

.