These offshore oil drillers look like bargain stocks as the industry recovers

By Philip van Doorn

Demand for offshore drilling and related services is high, while market values for the companies are low

The energy sector has been the best performer among the 11 sectors of the S&P 500 over the past three years, but investors remain wary of oil and natural-gas producers and the companies that service them.

Right now, the offshore oil and gas drilling industry is continuing to ramp up. This means some drillers and companies that service them are trading low relative to the value of their expected cash flow and to the drilling rigs, service vessels and other equipment they own, according to Charles Lemonides, founder and chief investment officer of ValueWorks.

Lemonides and his team manage a $330 million hedge fund in New York. You can see audited long-term results for the ValueWorks Long-Biased strategy here.

Energy stocks remain cheap

Even before the COVID-19 pandemic caused so much havoc for energy companies - including a moment when the price for front-month West Texas Intermediate crude-oil (CL00) contracts fell below zero since there was a shortage of space to store fuel - the industry had been under pressure for years. After trading above $100 a barrel in June 2014, WTI declined to close out that year at $53.27, according to data provided by FactSet.

The transformation of the world oil and gas industry turned the U.S. into a net exporter of oil, as domestic companies ramped up production. But that set the stage for an oversupply that caused WTI to fall as low as $26.11 in February 2016 - years before the pandemic. And that action caused some players to go bankrupt and led others to sell to competitors in better financial condition. It also caused a broad decline in investment in new domestic and offshore production, which is now being reversed.

So where are we now for energy stocks? Among the 11 sectors of the S&P 500 SPX, there has been a trend for increasing weighted price-to-earnings valuations for most sectors. The energy sector XX:SP500.10 has been the glaring exception:

   Sector or index           Three-year return  10-year return  Forward P/E  Forward P/E one year ago  Forward P/E to 10-year average 
   Energy                               113.4%           41.4%         12.3                      11.7                             80% 
   Information Technology                55.9%          644.7%        29.44                     26.31                            148% 
   Industrials                           28.7%          184.6%         21.7                      18.8                            114% 
   Financials                            27.2%          190.7%         15.6                      13.3                            110% 
   Consumer Staples                      22.5%          150.1%         21.6                      19.5                            110% 
   Utilities                             20.0%          149.8%         17.7                      16.0                            102% 
   Healthcare                            19.5%          194.5%         20.1                      17.7                            122% 
   Materials                             15.6%          127.4%         20.1                      17.6                            120% 
   Communication Services                10.3%          150.3%         18.7                      16.8                             99% 
   Consumer Discretionary                 6.2%          211.3%         24.9                      25.6                             95% 
   Real Estate                            2.7%          115.2%         18.9                      16.3                            100% 
   S&P 500                               29.6%          240.6%         21.4                      18.9                            117% 
                                                                                                                      Source: FactSet 

The table is sorted by three-year total returns through Aug. 23. (Total returns include reinvested dividends.) Forward P/E ratios are prices divided by rolling 12-month earnings-per-share estimates among analysts polled by FactSet, weighted by companies' market capitalization.

The energy sector has been the best-performer among the 11 sectors of the S&P 500 over the past three years and the worst over the past 10 years. The energy sector's current P/E is the lowest of any of the sectors, and its current P/E is only 80% of its 10-year average P/E. So energy is the cheapest sector by two measures.

Lemonides said that even though we are in the midst of a long-term transition away from fossil fuels, he is "investing in energy because you cannot get to zero overnight."

Digging further for value

The numbers above are limited to large-cap stocks in the S&P 500. Some energy companies that had been part of the S&P 500 fell out of the index because their market values had declined so much during the years of weak action for oil stocks. Right now, there are only 22 companies in the S&P 500 energy sector, and you can invest in them as a group with the Energy Select Sector SPDR ETF XLE. Like the index, this ETF is weighted by market cap, which means Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX) make up a combined 40.5% of the exchange-traded fund's portfolio.

During an interview with MarketWatch, Lemonides expressed a preference for offshore oil and gas drillers and one company that provides related offshore services.

Here are the three stocks, with their P/E along with estimated compound annual growth rates (CAGR) for sales and earnings per share through 2026, among analysts polled by FactSet:

   Company           Ticker   Market cap. ($mil)  Forward P/E  Two-year estimated sales-per-share CAGR through 2026  Two-year estimated EPS CAGR through 2026  Share of "buy" ratings  No. of analysts polled 
   Valaris Ltd.       VAL                  4,598          8.2                                                 27.6%                                     82.6%                     94%                      16 
   Noble Corp. PLC     NE                  5,419          8.1                                                  9.1%                                     41.3%                     88%                      16 
   Tidewater Inc.     TDW                  4,652         11.6                                                 29.3%                                     63.9%                    100%                       7 
                                                                                                                                                                                              Source: FactSet 

Although these companies have relatively small market caps, they are widely covered by analysts working for brokerage firms, with overwhelmingly positive sentiment.

Those EPS projections show a high level of confidence in the oil-rig operators and related service providers. Looking at the energy sector XX:SP600.10 of the S&P 600 SmallCap Index SML, the projected two-year sales-per-share CAGR through 2026 is 5.9%, and the projected EPS CAGR is 26.9%. These projected CAGR are 1.0% and 11.0%, respectively, for the large-cap S&P 500 energy sector.

Here are summaries of Lemonides's comments on the three companies:

Valaris VAL operates a fleet of 35 jackup rigs, which have floating hulls and legs that anchor to about 400 feet down for ocean drilling. The company also operates 13 drilling ships that go deeper. "Modern ships cost about a billion [dollars] to build," Lemonides said, adding that the jackups would be valued between $250 million and $500 million each. He estimated it would cost about $20 billion to replicate these fleets with new equipment. Comparing that total with the company's $4.6 billion market cap at a time when demand for its services is rising underlines the value case for this stock. And Lemonides expects the company to hit an annualized cash-flow pace of about $1 billion within the next year and a half.Lemonides described Noble NE as "similar to Valaris." The company operates 14 drill ships and 13 jackup rigs, along with other equipment. He estimates the company will have sales of roughly $3 billion next year, with a "30ish" percentage cash-flow margin. Lemonides believes those numbers and the company's $5.4 billion market cap mark Noble as a value stock.Tidewater TDW operates various supply vessels, tugboats and other craft to service offshore oil drillers, which includes transporting pipes and drilling fluids (known as "mud") to the rigs, while also ferrying staff back from shore. The company also provides services for offshore wind-turbine operators. Analysts polled by FactSet expect Tidewater's 2025 sales to total $1.675 billion, while Lemonides expects the company's free cash flow (remaining cash flow after capital expenditures) to total $600 million. He thinks those number should support a much higher market cap than the current $4.65 billion.

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-Philip van Doorn

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08-26-24 1309ET

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