The Best Investments for the Expanding Oil-Rig Market

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Over the next five years, it is expected that there will be a strong demand for deepwater and ultra-deepwater (UDW) rigs, as major oil and gas producers increasingly look towards offshore production in water exceeding depths of 5,000 feet. Despite this being a relatively high-risk area of operation, producers hope that the increased danger will be offset by larger and more lucrative hydrocarbon reserves.

Indeed, as of October 2012, there were 197 offshore rigs under construction, or 16.5% of the existing fleet. Of these, 197 new-builds, 43% are jack-up rigs and 39.5% are drillships. Of course, this construction is going to benefit National Oilwell Varco (NYSE: NOV) and Cameron International  (NYSE: CAM), both of which are specialists in their own field.

In particular, Cameron is a specialist manufacturer of high specifications of subsea systems and blow-out preventers. On the other hand, National Oilwell is a specialist in drilling systems. Indeed, one of the best drillers in the sector, Rowan (NYSE: RDC), has four new drill-ships on order. The drilling systems on these ships are manufactured by National Oilwell and the sub-sea systems are produced by Cameron.

Each drill-ship is expected to be leased on day rates of around $600,000, 50% above the rate that is demanded for the company's jack-up rigs. That said, the jack-ups have a drilling limitation of only 35,000 feet in 550 feet of water, while the newer, more expensive drill ships are able to drill to a depth of 40,000 feet in 12,000 feet of water.

Unfortunately, with the standard jack-up market expected to see a 16.5% increase in the number of rigs in operation by 2014, Goldman Sachs expects day rates to become depressed by mid-2014. However, the market for UDW high-spec rigs and drillships is expected to remain strong.

It would seem as if Rowan's move into the higher margin UDW-drillship market will be highly beneficial for the company. Indeed, Rowan's entire current rig fleet is jack-up, so the company is extremely exposed to a large amount of market-specific risk. However, diversification into the drillship market should offset some of the revenue decline that will be seen in the jack-up market from increasing capacity and oversupply in the market.

Rigs are costing more

Rising oil and gas prices are making UDW drilling more attractive.However, the costs of UDW drilling are also rising - good for Cameron and National Oilwell but not good for Rowan and its peers. In addition, oil exploration is being driven into harsher environments, for example the Arctic region. Moreover, there is an issue with technology as older rigs start to become outdated, especially in technologies such as blowout-preventers, drill depth and sub-sea systems. Once again, this is where the services of National Oilwell and Cameron come into demand. In particular, Cameron, which has a large aftermarket division.

Driving work to shipyards

This explosion in rig ordering is driving work to shipyards, which are generally experiencing a slowdown in construction activity as the shipping market remains sluggish. Indeed, the value of subsea drilling hydrocarbon production facilities is expected to grow from around $27 billion in 2011 to $130 billion in 2020.

Cameron is well placed

Investors can look to Cameron to benefit from the drive to higher-spec drilling rigs. Cameron is a well rounded company, manufacturing parts for all stages of the oil and gas industry both on-shore and offshore. Indeed, the company's experience and skills are really in demand and the company's order backlog has expanded 40% year-on-year (as revealed in the most recent Q2 results). Moreover, the company's current backlog is equivalent to a year and a half of revenue, giving Cameron and investors a certain amount of clarity going forward.

In comparison, National Oilwell controls 60% of the drilling-equipment market and generates $21 billion in sales annually; double that of Cameron. However, National Oilwell's stock  is still cheaper than Cameron, trading at a price-to-sales ratio of 1.4 compared to Cameron's ratio of approximately 1.6 and a trailing 12-month P/E ratio of 12.8 compared to Cameron's ratio of 19.4.

Still, despite National Oilwell's size, the company is no more efficient. For example, National Oilwell achieves a return-on-equity of 12.1% and a return on assets of 7.9%, while Cameron achieves a return-on-equity of 12.6% and a return-on-assets of 6.3%.

So, both companies offer their advantages.

What about Rowan?

As I have mentioned above, Rowan is well placed to ride the decline in jack-up day rates over the next few years. And with four new drill-ships generating an additional $2.4 million in revenue per day, which is roughly $218 million per quarter (almost 55% of the company's existing quarterly revenue,) this indicates that Rowan is set for a 50% earnings increase as the ships are delivered through 2016.

Having said all of that, a company that is in an even better position to profit and is currently trading at a lowly valuation is Ocean Rig UDW (NASDAQ: ORIG).

Ocean Rig is a UDW and harsh environment drilling specialist with eight UDW high-spec drill ships and two rigs. Currently, the whole fleet is leased to oil and gas majors, with an average duration lasting until 2015. Ocean Rig has a net-asset-value of $22.30 per share, indicating that the company can currently be bought for less than the value of its assets. On a long-term basis, the company should be due for a re-rating higher as demand for its experience and specialist fleet grows.

Foolish summary

Rising demand for new UDW rigs and drill ships should boost National Oilwell and Cameron over the next few years, while the rising demand for experienced UDW drilling companies will boost Ocean Rig and Rowan.

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Fool contributor Rupert Hargreaves owns shares of National Oilwell Varco. The Motley Fool recommends National Oilwell Varco. The Motley Fool owns shares of National Oilwell Varco. 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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