While drillers scramble to turn North America into a giant tic tac toe grid of horizontal shale wells and to ship liquefied natural gas from Australia to China, strange doldrums have overtaken the market for offshore oil rigs. Strange because for the moment the would-be customers don’t seem especially impressed with the attractive returns available from offshore wells given the currently high crude prices.

The customers are in no hurry, with several of the oil majors delaying offshore development projects in order to generate more cash after expensively failing to grow. This pause has coincided with a glut of newbuilds that entered service over the last two years, inevitably pressuring the rates of older, less advanced rigs.

The end result has been a significant drop in day rates and global fleet utilization levels that has acquired a momentum of its own. The oil majors have nothing to gain and plenty to lose from chartering rigs on fixed, long-term contracts while rates are in decline. Meanwhile, many of the less liquid suppliers with older rigs are deciding that sharply lower rates are better than no business, up to the point where it starts to make sense to scrap their oldest and least  profitable equipment.

Offshore drilling rig and equipment stocks have been locked out of the recent energy while this cyclical downturn plays out. But the market should turn sometime before 2016, when the supply of new rigs will slow dramatically even as development drilling picks up. We want to increase our exposure to this sector while the current news backdrop is weak and valuations undemanding. They certainly could get less demanding still in the near term. But this is an excellent opportunity to pick up strong long-term franchises at a discount.

The latest data point on the offshore space comes from the franchise we’ve been recommending for years with excellent results. Early Wednesday, Aggressive Portfolio mainstay Seadrill (NYSE: SDRL) reported solid but unspectacular results, with consolidated revenue up 13 percent year-over-year and EBITDA up more than 10 percent adjusting for a recent drillship sale to an affiliate.

The company did everything in its power to signal its unshaken faith in the offshore market’s long-term strength, raising the quarterly dividend it had previously indicated would be kept level by two cents to $1 per share and predicting “meaningful improvement” in the current quarter’s EBITDA over the number just reported. Management also noted “increased inquiries by both majors and independent operators following the establishment of a leading edge day rate,” which I take to mean a recent discount offered by a competitor.

Seadrill hasn’t had to do much if any discounting so far, because its newest-in-industry fleet is 96 percent booked for 2014 and 66 percent for 2015. But the clock is ticking, and in the meantime contracting activity in the first quarter was the weakest it has been since the end of 2009, management acknowledged.

It was so weak that one of the company’s newest drillships, the West Tellus — launched just last year — has found no work following the scheduled end of its lucrative short-term engagement in July. It will be parked in the Canaries, probably until next year, while Seadrill searches for a contract in West Africa, Brazil or the Gulf of Mexico.

Those corners of what Seadrill calls the “Golden Triangle” account for the majority of ultra-deepwater discoveries since 2000, according to the company. And ultra-deepwater average production cost of $56 per barrel compares favorably to the $65 for US shale, according to the company.


Source: company presentation

Activity at each point of the triangle is likely to ramp up sometime after next year, but no one knows exactly how much. And in the meantime the rig glut is pressuring rates in the high-margin floater segment.

Seadrill is likely to ride out this storm, especially given its Arctic drilling subsidiary’s investment-and-contracts betrothal to Russia’s Rosneft. While Seadrill’s debt is large, the cost of servicing continues to decline. And if debt markets were to get spooked, perhaps the Russians could lend a hand: Rosneft’s CEO has floated the notion of buying 50 percent of Seadrill.

For oil majors virtually shut out of US shale, there likely is no long-term alternative to developing lower-cost ultra-deepwater prospects, so no reason to believe this won’t happen sooner rather than later as long as crude prices stay firm.

In the meantime, Seadrill’s cash from operations for the quarter was 38 percent above what it will pay out in dividends next month. And while Seadrill still leveraged its balance sheet even more to sustain nearly $1 billion in capital spending, those outlays should diminish in the quarters ahead as Seadrill drags out deliveries of its newbuilds.

Seadrill’s advanced fleet and entrepreneurial culture make it the industry’s best growth bet ahead of the eventual pickup in offshore spending. Buy SDRL up to $50.

Ensco Plays It Safe

Rival Ensco (NYSE: ESV) offers a safer way to play the eventual recovery. While its dividend isn’t a double-digit yielder like Seadrill’s, at a current yield of  5.8 percent it’s no slouch and makes up a significantly smaller proportion of Ensco’s earnings.

In fact, Ensco trades at just 7 times its Enterprise Value (market capitalization + debt) to trailing EBITDA,  versus more than 11 times EV/EBITDA for Seadrill. Some of that disparity is justified by Seadrill’s faster growth rate — Ensco’s recent revenue was up only 3 percent year-over-year.

But the relative lack of leverage that keeps Ensco’s yield well below Seadrill could turn into a considerable advantage if the contracting downturn persists beyond next year, or if credit markets should turn less hospitable.

Source: company presentation

Ensco’s fleet is almost as new as Seadrill’s and its operating margin is almost as high. It doesn’t quite have the same short-term insulation from the current downturn: in contrast to the single drillship Seadrill will be shopping this summer, Ensco has already idled three rigs employed a year ago.

But its greater near-term exposure could also become a positive if a rebound in activity catches the market leaning the wrong way. Several analysts have recently downgraded the stock, joining a cautious consensus that could yet prove wrong.

Ensco has a larger presence than Seadrill in the Gulf of Mexico, a likely focus of future spending by the oil majors. ConocoPhillips (NYSE: COP), a longtime contractor of Ensco’s jackup rigs, has recently contracted its first Ensco floater there.

Carl Trowell, 45, named Ensco CEO earlier this month, was recruited from industry exemplar Schlumberger (NYSE: SLB), where he was seen as an up-and-comer. He should have the necessary skills to turn Ensco’s financial flexibility into a competitive advantage, and to relentlessly cut costs before and after the eventual pickup in offshore spending.

Ensco’s large, advanced and geographically diversified fleet trades at roughly its book value, versus more than 2 times book value for Seadrill’s hardware. We like both stocks, but Ensco a bit more right now as a lower-leverage, much cheaper proposition. We’re adding Ensco to the Conservative Portfolio. Buy ESV below $65.

The Jack of All Rigs

National Oilwell Varco (NYSE: NOV) doesn’t build or operate offshore rigs. But it does manufacture the advanced technical equipment installed on land- and sea-based platforms that actually controls the drilling. NOV also supplies a wide range of equipment, parts and services routinely used in land-based drilling operations.

This is a highly lucrative business rich in free cash flow; National Oilwell Varco produced $2.7 billion of operating cash flow in excess of capital spending last year; this year is likely to see an even larger surplus, only some of which will go to pay a dividend increased by 77 percent earlier this month, for a prospective yield of 2.2 percent at the current share price.

Offshore rig equipment sales are still going gangbusters for NOV,  powering the 9 percent revenue growth it reported in the first quarter and accounting for the bulk of the 27 percent increase in an order backlog that now exceeds $16 billion.

This business is expected to cool off in the second half of the year in response to the ongoing offshore market correction. But the recovering sales to North American shale drillers should pick up the slack. Meanwhile, NOV is about to spin off its low-margin procurement logistics business to shareholders, a transaction that should focus investors on the stronger margins and dominant market share NOV commands in  rig equipment.

Starting with the current quarter, National Oil Well Varco will set up new reporting segments highlighting its reliable aftermarket revenue for rig equipment and growing strength in well completions and related services.

In addition to the booming US shale development, with its typically accelerated wear and tear on many of the parts NOV supplies, medium-term catalysts include the spread of shale exploration around the globe, growing demand for floating production platforms and the coming wave of five-year retrofits for the many offshore rigs launched in 2011-12.

For an industry-leading franchise growing nearly 10 percent annually National Oilwell Varco sports a modest valuation of 8 times trailing EBITDA based on its enterprise value. The balance sheet is clean, featuring more cash than debt.

The US accounted for 35 percent of last year’s revenue, with South Korea and Singapore combining for 22 percent because that’s where the shipyards installing NOV’s equipment on offshore rigs are located. The bulk of the company’s cash is held overseas as well, and that’s where NOV plans to look for the modest-scale acquisitions expanding its reach.

This is a top-notch, well-diversified franchise with significant upside potential and shareholder-friendly management, worthy of a spot in our Conservative Portfolio. Buy NOV below $96.