Why Offshore Drilling Stocks Can Make A Comeback In 2020

Uptick in new project opportunities are expected to reverse years of decline in offshore drilling contractor revenues. With the energy sector emerging from the crude slump and debt-driven overhaul, renewed interest in the offshore drilling space is finally raising hopes for the industry’s recovery.

Crude Plunge Aggravates Offshore Industry Struggles

When oil was in the triple-digit territories of 2014, energy companies had billions of dollars in exploration budgets. The aggressive approach was essentially tied to commodity prices and severely dented balance sheets when prices fall to a 13-year low of around $26 per barrel in 2016. With operating profitability compromised, the worst oil crash in over half a century triggered major restructuring and a change in the companies’ long-term focus. Most producers concentrated on becoming leaner by shunning large, capital intensive projects.

In particular, the price slump forced the top energy companies to cut spending on the costly offshore drilling projects due to lower profit margins. This, in turn, meant less work for the beleaguered drillers. With old contracts rolling off, the companies either got rigs stacked or bore high reactivation costs and accepted much-reduced dayrates. As a result, overall revenues were impacted. Most offshore drilling stocks lost billions in market value during this period.

Sustained Oil Prices Above $60 Per Barrel to Spur Revival

WTI crude, the U.S. benchmark, bounced back above $60 per barrel following the recent agreement on a phase one trade deal between U.S. and China. The development – coming after months of wrangling – is seen to prop up the oil demand outlook on the back of revival in global economic growth. Also boosting oil, the OPEC+ group announced cutting output by as much as 500,000 barrels per day from Jan 1 for three months. This is in addition to the existing production curbs of 1.2 million barrels per day by OPEC, Russia and other non-member oil producers.

Sustained prices over $60 is likely to drive operators to make longer-term plans, as deepwater projects become cost effective if taken up for a long term. Consequently, demand for offshore drilling services should picked up. Sector consolidation, adoption of superior technologies, new operational systems’ optimization of the fleet by strategic sell-offs and acquisition, seeking profitable collaborations, among other strategic strides, will certainly help boost future prospects of the drilling companies. While one does not expect the sunny days of the drilling industry to return immediately, signs of recovery can definitely be seen.

Let’s discuss the most important factors shaping the industry’s turnaround.

Depleting Onshore Reserves: One of the key positive arguments for offshore drillers is the focus on reserve replacement rate. With less oil being discovered on land and a number of upstream operators depleting their reserves fast, capital is moving into offshore projects. In fact, supplies from offshore fields are expected to be the primary contributor in meeting reserve shortfalls in the long run. There is just no alternative.

Radical Cut in Costs: Operators think that the lessons learnt during the bust years will help them undertake sizeable expenditures, while maintaining the target capital structure. With the offshore players greatly reducing costs amid stronger operating efficiencies, most of the projects are likely to generate decent returns even at today's oil prices. The lower breakeven and attractive project economics are leading to more offshore projects being sanctioned.

Considerable Growth in E&P Cash Flows: The good news is most exploration and production companies have plenty of cash to invest. A tight leash on expenditure and conservative spending plans have resulted in cash flow coming in at higher rates, driving offshore spending and drilling activity. Oilfield services major Halliburton (NYSE:HAL) estimates that investments by oil producers in international offshore markets will increase 14% this year and continue in 2020.

Improving Day Rates & Utilization: The offshore spending growth (particularly in markets like Brazil, Guyana and Mozambique) has led to rising day rates and utilization. Both are now comfortably off the bottom in most global operating regions and for majority of the market segments. While nowhere near the boom-year highs, they still remain quite strong and at levels rarely see in recent times.

Drone Strike Over Saudi Oil Infrastructure: The September attack on Saudi Arabia’s oil installations have raised the risk quotient associated with onshore oil production. Following the strike on the state-run Saudi Arabian Oil Company’s (Aramco (SE:2222)) Abqaiq plant – a key crude processing facility – and the Khurais complex, which houses the kingdom’s second-largest oilfield, market watchers have stressed the need to diversify oil supply sources. This would mean more investments in offshore projects, which are considered relatively immune to geopolitical risks.

How to Profit from This Recovery?

With the offshore energy industry looking ready to turn the corner toward growth, we have shortlisted four of them – Noble Corporation plc (NYSE:NE) , Transocean Ltd. (NYSE:RIG) , Saipem SpA SAPMF and Valaris plc (NYSE:VAL) – that might warrant attention going into 2020. Each carrying Zacks Rank #3 (Hold), the companies own some high-quality offshore drilling fleets with presence in major markets. Importantly, their contract backlogs are anchored by a large and diverse group of clients including major, national and independent upstream companies.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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