From IIonline..."Battered offshore drillers could strike it rich
Their stocks are down 60% or more, but profits should gush from companies like Transocean Offshore and Diamond Offshore when oil prices rise.
By Clint Willis
Lately, oil stocks have been pumping out losses for investors. The OSX Index, which follows 15 oil-services companies, has declined roughly 55% from its October 1997 peak. Shares of offshore drillers, which provide rigs and other equipment and services to the industry, have been hit even harder: The Jefferies Offshore Drilling Index has plummeted more than 65% since January 1998.
The continued weakness in both crude oil and natural gas prices is the primary reason for the decline, notes Rod McKenzie, an oil analyst at Jefferies & Co. in Houston. But despite low oil prices, some slick analysts are beginning to smell bargains in the oil patch -- and their favorites include the dirt-cheap offshore drillers.
The stocks' fans argue that regardless of what happens to oil's price in the next six months, its current doldrums could pose a terrific opportunity to buy shares of solid drillers at enormous discounts from their long-term values. And if the price of oil rebounds from its recent depressed levels, the shares could be huge winners no matter what happens to the Internet stock "bubble."
'Greed will again be the driving force'
Analyst Dan Pickering at Simmons & Co. International calculates that the downside risk in the group is roughly 26%, compared to an upside potential of 100% or more. However, he notes that shares of many companies -- including Rowan (RDC) and Noble Drilling (NE) -- already are trading near his downside targets.
"Right now, fear is keeping investors away from the offshore drilling stocks," he says. "But when the fundamentals of the business begin to stabilize, greed will again be the driving force in the sector."
Pickering and other analysts who like the offshore drillers cite these factors:
•The stocks are astonishingly cheap. Shares of offshore drilling companies are down 50% to 75% from their October 1997 highs. The stocks are trading near book value and below market net-asset values -- and less than 50% of the replacement values. The stocks as a group recently traded at an average price-to-earnings ratio of around nine times projected 1999 earnings, which is only 44% of the S&P 500 multiple of 21.6. In the past, offshore drilling multiples have not stayed below 50% of the market average for sustained periods.
•Many drillers have strong balance sheets and cash flow. A number of offshore drillers went bankrupt when oil prices were low during the early 1980s. But Lehman Brothers analyst Paul Chambers notes that a number of offshore drillers have strong free cash flow and low debt, reducing their downside risk. Moreover, their strong balance sheets allow them to make acquisitions and expand their fleets, diversifying into offshore construction and services.
•The energy industry increasingly depends upon offshore production. By 2000, Chambers expects that offshore drilling will account for some 40% of worldwide daily production, up from around 25% in 1990. He calculates that worldwide use of offshore rigs will remain between 85% and 95% of capacity, with prices firming up over the next several years. At the same time, continued consolidation in the offshore drilling industry has reduced the number of competitors and will help support pricing.
The wildcard: oil prices
All of those factors will support offshore drilling companies during the next year or two, regardless of oil prices. But the payoff will be sooner -- and much bigger -- if the price of oil moves higher during 1999.
Oil recently fetched a mere $10.73 a barrel. But analysts cite three factors that could send oil prices up to $20 a barrel or even higher during the coming year.
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Some analysts think that's going to happen. Oil recently fetched a mere $10.73 a barrel, down from around $22 in 1996. But analysts who are bullish on the commodity cite three factors that could send oil prices up to $20 a barrel or even higher during the coming year.
•OPEC and non-OPEC producers' compliance with agreed-upon production cuts was only 79% in November, one reason for oil's weak price. But some analysts, such as Jennifer Hu of Simmons & Co., believe members will exert strong pressure on holdouts Iran, Venezuela and Saudi Arabia at their March meeting, leading to tighter quotas.
•The Middle East remains something of a powder keg, and forecasters expect colder weather worldwide this year, boosting demand for heating oil.
•The U.S. rig count fell 35% in 1998, and overseas rigs have declined from 819 to 689 this year, according to analyst Robert Ford at CIBC Oppenheimer.
Drilling in the toughest environments
Analysts recommend offshore drillers that fit three criteria:
•Their rigs should be well-suited to difficult or hazardous conditions; such companies should be able to charge high day rates (the daily rates companies charge their customers) and book customers well in advance.
•Their finances must be strong enough to ride out any extended slump in the industry and support improvements in their rigs.
•Their stocks should be dirt-cheap.
CIBC Oppenheimer's Allen Brooks likes Diamond Offshore Drilling (DO), a leader in deep-water drilling. Consensus estimates call for Diamond's profits to rise 9% to $2.01 per share this year, despite oil's low price. Meanwhile, chief executive James Tisch is spending more than $100 million a year to improve the company's drilling rigs. He's also drawing on Diamond's strong cash flow to buy back shares of the company's stock, which is down 58% from its 52-week high of $54.
The company purchased 3.5 million of its shares during the third quarter of last year. Brooks figures the firm will buy back more shares during the coming months, and it's not hard to understand why: Shares of Diamond Offshore recently traded at a mere six times the company's 1998 cash flow of $3.96 a share. Brooks figures the stock could rise to $30 within the next 12 months; it's now around $23.
Well-suited for deep-water drilling
Lehman Brothers' Paul Chambers favors Transocean Offshore (RIG), now trading around $26. Transocean provides contract drilling for offshore oil and gas wells. A high percentage of the company's fleet already is under contract, which will make it easier to meet analysts' earnings estimates. Moreover, demand continues to be strong for rigs that are well-suited to deep water and other difficult environments, and Transocean rigs fit that description well: The company has drilled almost 40% of all projects ever done below 3,000 feet.
All of that helps explain how the company has maintained a 98% capacity utilization rate with sharply higher day rates this year. Brooks figures that the company's earnings will rise 17% to $3.40 a share in 1999. Recently, the stock traded 58% below its peak last May, giving it a P/E ratio of 9.40, based on consensus 1999 estimates. Brooks gives Transocean a price target of $48 for 1999.
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Two other drillers worth a look are Rowan and Noble Drilling. Rowan's shares have declined about 70% since last January, to around 9 1/4, and recently traded at a P/E ratio of five on estimated 1999 earnings. Meanwhile, the company's strong balance sheet (debt is just 26% of capitalization) leaves room to invest in new rigs that can operate efficiently in difficult climates. One recently launched rig will add 30 cents a share to this year's profits. "Based on price to net asset value, Rowan is the cheapest out of all the offshore drillers, which makes it a strong buy," says Chambers of Lehman Brothers.
Noble Drilling, down 63% since last January to around 12 1/2, is refurbishing five rigs to operate further offshore; four of them already are under long-term contracts. They'll benefit from strong demand as deep-water drilling grows during the next several years. Debt is a mere 10% of capital, leaving plenty of room to buy back shares, which recently traded at a P/E ratio of 9.4 on estimated 1999 earnings. Brooks notes that the stock recently traded at around 46% of its net asset value; he thinks it could rebound to $22 within 12 to 18 months.
So if your complaint about the market is that it's too expensive, here's your chance to buy top-quality companies in an extremely important sector of the economy at a big, big discount. Of course the only caveat is that they could get even cheaper before turning around. |
