Offshore Drilling Is the Way To Go

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

Brent crude is priced over the $115 mark again due to Iranian crude import cuts by India and China. Saudi Arabia had promised to ramp up its crude production to meet the shortfall of Iranian crude, but recently cut its production by 700,000 bpd. Moreover, crude demand is expected to grow between 6%-8% annually, and the depleting hydrocarbon resources are putting upward pressure on the commodity.

Oil companies have already begun exploring for new hydrocarbon reserves, and 36 companies including BP (NYSE: BP) and ExxonMobil are actively pursuing the oil E&P opportunities arising in the Barents and Norwegian Seas. This presents a bullish case for deep sea drilling companies, like Transocean (NYSE: RIG), Seadrill (NYSE: SDRL) and Ensco (NYSE: ESV).

Reasons to Buy Ensco

Ensco is the world’s second largest offshore driller, with 70 operational rigs and 6 rigs under development. The company has the world’s most advanced drilling fleet, which not only reduces operational risks, but also saves time and money. Moreover, the company was able to achieve a massive 92% utilization rate of its operational jackups in the recent quarter.

Driven by increased offshore drilling activity, the average day rates of its premium jackups are in excess of $100,000 per day. Its management expects higher average day rates in 2013, especially since its fleet in the Gulf of Mexico and Middle East already have a 100% and 95% utilization rate, respectively. Naturally, leasing its equipment to other drillers creates a parallel stream of income.

Ensco had acquired Pride Equipment, which had been the root of its problems. Its crew lacked experience and was poorly trained, which caused downtime and hampered Ensco’s bottom-line. But the management was tactful to overcome the problems, and the company managed to expand its revenue backlog to $9 billion, with a modest 42% debt/equity ratio.

Reasons To Miss The Peers

But strong catalysts do not necessitate a long position. Taking a look at the financial metrics is important, which are crucial gauges of a company’s financial health. Additionally, we get an insight on a company's operations as compared to the industry.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Forward P/E</p> </td> <td> <p>PEG</p> </td> <td> <p>Yield</p> </td> <td> <p>Payout</p> </td> <td> <p>Debt/Equity</p> </td> <td> <p>Net Profit Margin</p> </td> </tr> <tr> <td> <p>Ensco Plc.</p> </td> <td> <p>9.13x</p> </td> <td> <p>0.46x</p> </td> <td> <p>2.35%</p> </td> <td> <p>29.33%</p> </td> <td> <p>42%</p> </td> <td> <p>28.08%</p> </td> </tr> <tr> <td> <p>Transocean</p> </td> <td> <p>11.7x</p> </td> <td> <p>-NA-</p> </td> <td> <p>0%</p> </td> <td> <p>0%</p> </td> <td> <p>92%</p> </td> <td> <p>-60.62%</p> </td> </tr> <tr> <td> <p>SeaDrill</p> </td> <td> <p>12.15x</p> </td> <td> <p>0.77x</p> </td> <td> <p>8.84%</p> </td> <td> <p>145.3%</p> </td> <td> <p>184%</p> </td> <td> <p>26.98%</p> </td> </tr> </tbody> </table>

From the table above,  we can see that Ensco enjoys the highest net margin. At the current price, its shares appear to be most undervalued with respect to earnings and its growth prospects. Moreover, the high debt/equity ratios of Transocean and Seadrill are somewhat discouraging for investors. Even though Seadrill appears to be undervalued and carries a lucrative yield, I'd advise investors to curb their temptations.

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(3 year operating income, 5 year chart unavailable)

Seadrill has an impractical 145.3% payout ratio. This coupled with the high debt/equity ratio, suggests that dividend payouts could to be unsustainable. To corroborate the statement, its CCE* stands at just $518 million, which is minute for a company with a market cap of nearly $18 billion.

*CCE= Cash and Cash Equivalents

Transocean almost appears attractive at the first glance. Over the last 5 years, its CCE* have risen by nearly 30%, while its liabilities have risen by only 9.5%. But that’s only one side of the story. Its liabilities stand at a towering $20 billion, while its CCE* stand at just a little over $6 billion. Moreover, Transocean’s negative profit margin and mediocre operating income growth takes away all its luster.

Foolish Conclusion

The gradually rising crude prices have renewed the interests of oil E&P companies, and companies like BP are restructuring their business operations to align themselves with their long term goals. BP has been selling its non-core assets, under a plan to raise $38 billion. Moreover 11 of its 15 new projects are high margin oil projects and BP is not alone in the race. I believe that, such E&P activities are only going to increase as oil prices rise.

The strained oil supply coupled with recovering macroeconomic conditions, only present a bullish case for oil prices. I believe that Ensco carries most upside potential due to its strong fundamentals, technologically  advanced fleet and huge drilling experience. Ensco gets a Buy rating, but that doesn’t call for shorts on Seadrill and Transocean.

PiyushArora has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and 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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