The Zacks Oil and Gas - Drilling industry has lately been pegged back by the impending end to their legacy high-margin contracts, uncertainties related to slowing upstream capital expenditure growth and inflationary pressures. Although macro challenges are leading to some moderation in activity, we think the space still has fuel left in the tank, especially for the operators that target growth opportunities and operating efficiency initiatives. We advise investors to focus on Valaris Limited VAL, Helmerich & Payne HP and Seadrill Limited SDRL.
Industry Overview
The Zacks Oil and Gas - Drilling industry consists of companies that provide rigs (or specialized vehicles) on a contractual basis to explore and develop oil and gas. These operators offer drilling rigs (both land-based/onshore and offshore), equipment, services and manpower to exploration and production companies worldwide. Drilling for hydrocarbons is costly and technically difficult, and its future primarily depends on contracting activity and the total number of available rigs at a given time rather than the price of oil or gas. Within the industry, it's interesting to note that the volatility associated with offshore drilling companies is much higher than their onshore counterparts, and their share prices are more correlated to the price of oil. Overall, drilling stocks are among the most volatile in the entire equity market.
4 Trends Defining the Oil and Gas - Drilling Industry's Future
Capital Investment Tightness: Despite the improvement in oil prices, for most upstream operators, the focus is still on sustaining the lower spending levels, further trimming breakeven costs and maintaining financial health. Agreed, costs have been slashed and completion activity is looking up, too, but overcapacity and pricing pressure would restrict the positive impact. With customers drilling fewer wells, the demand for oilfield service work has taken a hit. As a supplier of drilling rigs and equipment to the E&P sector, the sentiment toward the industry remains rather uncertain and opaque.
Concerns About Cost Escalation: Most energy companies (including the drilling operators) have been experiencing rising costs in the form of increased expenses related to maintenance and inventory. Despite moderating from record levels, U.S. inflation is still running above the Fed's target. This, together with supply-chain tightness, is not only pushing costs higher but also affecting their capital programs. Apart from being hard to ignore, escalation in expenses is also drowning out the benefits of any commodity price increase. In our view, the inflation-associated headwinds will continue to challenge growth and margin numbers with little chance of a quick resolution. This may lead to a rough road for oil/gas equities engaged in drilling.
Low Reserve Replenishment a Silver Lining: One of the key positive arguments for drillers is the focus on the reserve replacement rate. Over the past few years, the supermajors have struggled to replace all of the oil and gas they churn out, raising concerns about future production. In this context, Chevron’s 10-year reserve replacement ratio of 100% indicates the inability to add proved reserves to the amount of oil and gas produced. This clearly calls for a calibrated approach to meeting reserve shortfalls in the long run. Consequently, a gradual improvement in drilling activity looks likely.
Wind-Down of Legacy, High-Margin Contracts: For most operators, order levels have remained depressed, and day rates are trending just above cash costs despite the strong rebound in commodity prices. This has put increased pressure on their revenue-generating capacity. Further, as the companies’ legacy, high-margin contracts wind down slowly, drillers are faced with the prospect of a drop in backlog (and consequently, revenues), which is likely to accelerate over the next few quarters. This also leaves drillers vulnerable to addressing their massive debt maturities and investment in newbuilds.
Zacks Industry Rank Indicates Bearish Outlook
The Zacks Oil and Gas - Drilling industry is a 12-stock group within the broader Zacks Oil - Energy sector. It currently carries a Zacks Industry Rank #208, which places it in the bottom 17% of around 250 Zacks industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates challenging near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
The industry’s position in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are becoming pessimistic about this group’s earnings growth potential. As a matter of fact, the industry’s earnings estimates for 2024 have gone down 60.9% in the past year.
Despite the dim near-term prospects of the industry, we will present a few stocks that you may want to consider for your portfolio. But it’s worth taking a look at the industry’s shareholder returns and current valuation first.
Industry Underperforms Sector & S&P 500
The Zacks Oil and Gas - Drilling industry has fared worse than the broader Zacks Oil – Energy sector as well as the Zacks S&P 500 composite over the past year.
The industry has gone down 18.3% over this period compared with the broader sector’s decrease of 2.5%. Meanwhile, the S&P 500 has gained 17.1%.
One-Year Price Performance
Industry's Current Valuation
Since oil and gas drilling companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of non-cash expenses.
On the basis of the trailing 12-month enterprise value-to-EBITDA (EV/EBITDA), the industry is currently trading at 16.67X, higher than the S&P 500’s 14.05X. It is also well above the sector’s trailing-12-month EV/EBITDA of 3.63X.
Over the past five years, the industry has traded as high as 24.76X, as low as 7.28X, with a median of 13.14X, as the chart below shows.
Trailing 12-Month Enterprise Value-to-EBITDA (EV/EBITDA) Ratio (Past Five Years)
3 Oil and Gas - Drilling Stocks to Watch
Valaris Limited: Valaris possesses a varied fleet of rigs, including ultra-deepwater drillships, versatile semisubmersibles, and modern shallow-water jackups. With the industry's largest and highest specification fleet covering both floaters and jackups, Valaris maintains a significant presence in key offshore basins, fostering deep customer relationships. The company's robust balance sheet ensures flexibility in capital allocation.
Hamilton-based VALs Value and Growth Score of C and B helps it to round out with a VGM Score of B. The company has a market capitalization of $4.5 billion. Valaris stock, carrying a Zacks Rank #2 (Buy), has lost 15.8% in a year.
You can see the complete list of today’s Zacks #1 Rank stocks here.
Price and Consensus: VAL
Helmerich & Payne: Helmerich & Payne is engaged in the contract drilling of oil and gas wells in the United States & internationally. Its technologically advanced FlexRigs are much in demand. The Zacks Rank #3 (Hold) company has already upgraded most of its drilling fleet with the latest technology. Besides, Helmerich & Payne boasts a strong balance sheet, carrying little long-term debt. With available liquidity surpassing debt levels and no significant near-term maturities, Helmerich & Payne should sail through any difficult operating environment.
Tulsa, OK-based HP’s Value and Growth Score of B each helps it to round out with a VGM Score of A. The company beat the Zacks Consensus Estimate for earnings thrice in the trailing four quarters and missed in the other. The Helmerich & Payne stock has lost 13.3% in a year.
Price and Consensus: HP
Seadrill Limited: Seadrill is a market-leading international driller with strong exposure in key strategic basins like the U.S. Gulf of Mexico, Brazil and Angola. Following the Aquadrill LLC acquisition last year, SDRL has improved its cash flow generation potential significantly. A robust balance sheet, enhanced liquidity and credit profile are the other positives in the Seadill story. The company has transformed its capital structure through accretive transactions and continues to deliver operational excellence.
The Zacks Consensus Estimate for this #3 Ranked offshore driller’s 2023 earnings has been revised 14.8% upward over the past 90 days. SDRL has a trailing four-quarter earnings surprise of roughly 80.9%, on average. Seadrill carries a Zacks Rank #3 (Hold), and its shares have gone down 0.2% in a year.
Price and Consensus: SDRL
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