For value hunters and contrarian investors alike, the offshore drilling sector is now one of the market’s most attractive sectors. However, the big question that needs to be answered is, when should you buy in?

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Offshore drilling stocks tradings at a significant discount

Indeed, with companies like Rowan Companies PLC ( RDC), Transocean LTD ( RIG - Get Report), Noble Energy, Inc. ( NBL - Get Report) and ENSCO PLC ( ESV - Get Report) all trading at a significant discount to book value, the margin of safety available is attractive, although there’s reason to suggest that valuations could fall even further from current levels.

For example, consensus suggest that Transocean LTD ( RIG - Get Report) could encounter serious problems over the next 12 to 24 months as it struggles to find customers. While the company does have options available to it, regarding rig dropdowns into its MLP, there’s still concern about the number of units the company has rolling off contract next year. In the North Sea alone Transocean has four units rolling off contract next year, while the company’s units in the Gulf of Mexico are also struggling to find work for when they roll off current contracts. This could force the company to either cold stack or scrap several older units.

This is where the biggest risk lies to value investors who are looking to buy based on a deep discount to book value. Indeed, industry leader, Seadrill Ltd ( SDRL) warned earlier this year that due to the age of many of its competitors rigs, they will be due for a sizable and costly shipyard refit before the end of the decade. The average cost of these refits will be in the region of approximately $100 million per unit. Consequently, with day rates falling across the board some drillers may find it easier to scrap older units, rather than hike capex for a low return on investment.

ENSCO PLC ( ESV - Get Report) fired the starting gun on these writedowns and scrapings earlier when it announced that it would taking impairment charges as some of its units, “had carrying values that exceeded non-discounted future cash flow projections.” In total, Ensco took impairment charges totaling $4.27 per share during the second quarter cutting book value from $55.3, to $49.4. There’s no certainty that Ensco’s peers will take similar writedowns, nevertheless, a 10.7% reduction in book value per share is something value investors should be aware of.

Complexity remains in the offshore drilling sector

Additionally, the offshore drilling sector remains a complex place to invest. Unless you know the intricacies of the market, which company owns which type of drilling units, what each unit does and the long-term demand of specific units, it’s very hard to place your bets on a prospective winner. The drillers with the older, less capable fleets are like to be the most susceptible to write downs and falling earnings, Ensco, Paragon Offshore PLC ( PGN) and Diamond Offshore Drilling Inc ( DO) all have older-than-average fleets. On the other side of the equation, Seadrill has one of the industry’s most modern and capable fleets and Rowan is currently taking delivery of four new high-spec drillships that will add a significant boost to the company’s bottom line over the next 12 months.

So, there is value to be found in the offshore drilling sector, but you’ve just got to know where to look.

The author has a position in Rowan Companies. No position in any other companies

The post Be Careful When Hunting For Value In Offshore Drilling appeared first on ValueWalk.

-By Rupert H