The Best Play On The Slow Deepwater Rebound

The decline in oil prices has had a dramatic effect on many investors' portfolios, but one sub-sector stands out as being particularly awful; offshore drilling. For those who have not regularly invested in the sector, the story here is an unpleasant one. Over the last few years, as relatively high oil prices spurred investment across the entire energy sector, offshore drilling expanded like everything else.

One area of offshore that saw a particularly large infusion of corporate cash was ultra-deep water (UDW) drilling. UDW companies like Ensco PLC (ESV), Seadrill (SDRL), Transocean (RIG), Diamond Offshore (DO), and Noble Corp (NE). all put substantial investments into bringing new offshore drilling rigs to market. (Note: Noble is a separate company from Noble Energy (NBL). The two have a common corporate legacy, but are separate entities today). As a result, by the middle of 2014, there was an emerging glut of UDW rigs and day rates on these rigs started to collapse.

The oil price collapse last fall exacerbated the supply issues in the industry. By December, many offshore drillers were talking about stacking existing rigs. Stacking involves storing rigs to reduce costs of operation. Stacking can be cold or warm, with each process having different costs and benefits but in both cases, the step is an extreme one for a company to take. The process of stacking is costly, not easy to reverse, and often leads to subsequent rig scrapping.

Stocks across the UDW space have collapsed in value. Transocean, Ensco, and Seadrill are all down roughly 60% or more over the last year. Many companies in the space have short interest ratios of 10% or more of their float, and several have cut dividends. Morningstar and other analysts have cut estimates across the sector, and sentiment across all of the stocks in the space cannot get much worse. No one wants to buy these companies. And that is exactly why sage investors should be looking at the sector very carefully right now.

The downturn in the Deep Water space will not last forever. Already most of the major players in the sector are quickly stacking rigs, deferring the delivery of previously ordered rigs, and cutting costs anywhere they can. All of this is setting the stage for an eventual rebound in the sector. That rebound could start as early as 2016. Influential energy research firm Douglas-Westwood projected that capex in deep water exploration will jump 69% between 2015 and 2019.

The best opportunity in the deep water space right now is Noble Corp, trading under the ticker NE. Compared with many peers, Noble has better financial flexibility and its contract coverage is stronger. The firm has a debt-to-capitalization ratio of roughly 40%, and has nearly 80% of its available rig operating days contracted for 2015 with 60% of days contracted for 2016. The strength in these metrics is reflected in the shallower decline of NE's stock price vs. many peers over the last year.

Even with the currently atrocious market, Noble is still earning a profit. The company will likely earn roughly $2 per share this year and a $1 next year as sector activity troughs (excluding possible non-cash charges to asset values). The company is well positioned for most of the potential industry disasters on the horizon like Petrobras' evolving business outlook. Q1 Operating Cash Flow, excluding capex, looks to be roughly $1.35 per share which implies that Noble can continue to support a reasonable dividend despite the downturn (current yield is roughly 10%). Modeling revenues and expenses based on continuing current trends, NE will likely earn around $1.3 billion in 2016 as the market bottoms. Every other major deep water driller will likely find themselves in more trouble than Noble if the market continues to deteriorate.

Overall, Noble is better positioned to survive the downturn than any other deep water firm. As the market starts to turn, Noble should see considerable upside. NE spun-off most of its low spec rigs in a company called Paragon Offshore last year. PGN has seen a truly awful share price decline as investors seem unsure about demand for its rigs in the future. Nonetheless, the remaining Noble Corp. assets have significant upside potential in even a modest market recovery. As the market starts to recover, Noble should see cash flow of roughly $4-$5 per share eventually. The company's higher specification fleet, limited debt, and efficient operations could make it either an excellent acquisition target or an effective acquirer of distressed firms as the sector bottoms. (An ESV/NE combination would be particularly interesting for investors, were it to happen).

Putting all of this together, and applying a multiple of 15X cash flows, supports a valuation of $75 per share after the market eventually recovers. Right now Noble is not worth $75 a share. And it will take time for the market to correct itself. But even if the market continues to languish, and competitors start going bankrupt (e.g. Hercules Offshore (HERO) earlier this year), Noble would probably be the last major company left standing. Thus the stock is essentially de-risked at these levels. A significant stock price recovery may take a couple of years, but for deep value investors with a medium term outlook, Noble is a rare breed in an expensive market; a cheap stock with significant room for eventual earnings upside.