Offshore Oil Stocks Are Sinking. Heres What to Buy. – Barron’s

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Offshore oil drilling has been declining for more than five years, but the industry took a sharper turn south in the past few weeks. The companies still standing are now facing more existential questions. Several are carrying debt loads that look unsustainable at current prices.

The shakeout is starting. On Thursday, Diamond Offshore Drilling (ticker: DO) elected not to make an interest payment and said it would work with advisors to evaluate its capital structure. The company isnt in defaultit has a 30-day grace periodbut the market is registering skepticism. Shares are trading at 79 cents, down from $12 a year ago.

More such announcements are likely in the months ahead. Producers are cutting back on drilling to conserve cash now that oil prices are below $30 per barrel. On Friday, West Texas crude futures closed at $18.27, a new 18-year low. Day rates for drilling, which had been rising at the start of the year, are once again tumbling. Several companies that had once been worth several billion dollarslike Noble Corp. (NE), Nabors Industries (NBR) and Transocean (RIG) have now dipped below $1 billion or even $100 million.

Evercore analyst James West says there are two companies that have strong enough balance sheets and operations to weather the storm, though he doesnt think the stocks are buys. Transocean has contracts with major producers Equinor (EQNR) and Royal Dutch Shell (RDS.A) that give it several years of runway. Meanwhile Maersk Drilling (DRLCO) has a balance sheet that gives it similar ballast. But he rates both In-line instead of Outperform, given the prolonged downturn and uncertainty ahead.

On the other side, Valaris (VAL), Pacific Drilling (PACD), and Noble are likely restructuring candidates. Each of those stocks trades under $1 and faces serious challenges ahead.

Noble declined to comment. Pacific Drilling and Valaris didnt respond to a request for comment.

Offshore oil drilling doesnt look like it is going away entirely, of course. Major oil companies like Exxon Mobil (XOM) and Shell have been betting big on offshore projects and have kept them going, even as they cut other spending to deal with the oil price downturn.

If the offshore companies werent so leveraged youd say they were in a better position, West said. Utilization and pricing will drop, but not nearly as bad as a U.S. land fracking company. Offshore spending may be down 10%-15%, but thats not as bad as the 40% expected drop in U.S. land drilling. Oil service giant Schlumberger (SLB) said on its earnings call Friday that it is seeing pockets of resilience in offshore drilling in places like Australia.

The problem is several offshore drillers have too much leverage, and their coming debt maturities and lack of free cash flow mean that the stocks likely wont work well as investments.

West expects multiple companies to restructure and for the industry to consolidate aggressively afterward. Its too early to bet on the winners in this case. Bankruptcies could wipe out the equity of some companies. The industry could fall from 15 sizable players to between three and five. The bigger get bigger and stronger and gain more market share and the weaker get smaller and weaker and get forced out of the market, West said.

He thinks that the major oil service companies are in relatively better shape, making their stocks worth buying at these levels. That includes Schlumberger, which drills on land and in the ocean. Its decision to cut its dividend pleased Wall Street, because the business looks much more sustainable now. And as the shakeout comes closer, Schlumberger is likely to be a winner, along with fellow major service company Baker Hughes (BKR), West predicts. Oil inventory is piling up so fast that it will likely be a year at least before business picks up, so investors will have to be patient. These are fantastic opportunities to get in, but youve got a waiting period before you get paid, he said.

He also rates Halliburton (HAL) at Outperform, but sees it as less attractive than the other two.

Meanwhile, people comfortable investing in risky debt may see more opportunities in offshore drilling companies.

The credit investors are much more interested here than the equity investors, says West. The market caps are so low that if you take any kind of real position you basically own the company or at least get a board seat.

Write to Avi Salzman at avi.salzman@barrons.com

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Offshore Oil Stocks Are Sinking. Heres What to Buy. - Barron's