A Great Play on the Increasing Need for Energy

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Diamond Offshore Drilling (NYSE: DO) is a contract driller of offshore oil and gas wells and currently owns 44 mobile offshore drilling rigs operating all over the world. While Diamond (and others like it) may experience some short-term volatility due to the unpredictability of oil and gas prices and the constantly changing drilling policies of different countries, over the long run Diamond should be a winner. With world energy demand projected to increase fivefold from 10TW*hrs (Terawatt-hours) to 50 TW*hrs by the year 2050, the need for drilling (and the rigs supplied by Diamond) will have nowhere to go but up.

About Diamond Offshore Drilling

Diamond owns 37 floating rigs, which includes 12 ultradeepwater units capable of drilling in depths over 7,800 feet, seven deepwater rigs which drill in depths of 5-6,000 feet, and 18 midwater rigs which drill from 1-4,000 feet. The company also has seven jack-up rigs, which are essentially floating barges with support legs that can be raised or lowered in order to drill in shallow depths of 20 to 350 feet.

Their rigs are located all over the world, and are currently in the Gulf of Mexico, the North Sea, South America, Africa, Australia, and Southeast Asia. Most of the company’s revenue comes from outside of the U.S., with almost half coming from Brazil.

Recently, the company entered into a contract to build a new ultradeepwater rig for BP (NYSE: BP) to use off the coast of Australia. This will greatly expand BP’s Australian operations, where it currently operates three gas fields. The new rig is projected to be completed in late 2015 at a cost of $755 million.  BP has agreed to lease the rig for three years at a rate of $585,000 per day, and it will be capable of drilling in depths in excess of 10,000 feet.

Cheap valuation and attractive fundamentals

At a current valuation of 14.3 times 2013’s projected earnings, Diamond looks to be very attractively valued.  While earnings are actually expected to drop slightly from 2012 to $4.60 per share as a result of increased expenditures related to building new rigs and upgrading existing ones, the company’s earnings are projected to rise tremendously in 2014 and beyond, at which time six of their seven rigs under construction will be delivered. The consensus calls for $7.23 per share in 2014 (meaning that Diamond trades for just 9.1 times next year’s earnings) and $8.04 in 2015.

Beyond 2015, I would expect a significant earnings boost in 2016 due to the completion of the BP rig mentioned above, and I expect an increase in the amount of new rigs, especially those meant for very deep water, over the next several years. Diamond currently pays a low regular dividend as well as a “special” dividend that is actually very consistent, the total of which is $3.50 per share this year, which translates to a 5.3% annual yield, among the best in the market. Also notable is the company’s very strong balance sheet, with almost no net debt (as much cash on hand as debt).

Alternative: Transocean

Transocean (NYSE: RIG) is the largest offshore drilling rig contractor in the world with 82 rigs and another eight under construction. Transocean was the owner of the infamous Deepwater Horizon rig that exploded while contracted to BP. In January, Transocean settled with the DOJ for $1.4 billion in fines, and is still facing several other civil charges. As a result, shares trade at a somewhat depressed valuation and likely will continue to do so until all of the pending suits are behind them.

Shares of Transocean trade for just 10.9 times this year’s expected earnings, which are supposed to rebound nicely going forward on the expected sale of four jackup rigs, which the company anticipates to complete by the end of this year. As a result, the consensus calls for earnings of $6.03 and $6.51 per share in 2014 and 2015, respectively, with estimates as high as $8.10 for the latter.

Summary

Which company is right for your portfolio depends on your particular level of risk tolerance and willingness to wait out legal drama. While Transocean may very well produce the better gains long-term, they could indeed suffer significantly if the pending civil suits go worse than expected. Diamond is a completely reasonably valued way to play this sector, which should grow tremendously over the coming decade and beyond.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of Transocean. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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