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Oil & Gas Drilling Industry Outlook Not Appealing to Investors

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The Zacks Oil and Gas - Drilling industry consists of companies that provide rigs 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.

Let’s take a look at the industry’s three major themes:

•    The slump in oil prices and coronavirus-induced demand shock has pushed drilling activity lower by introducing tremendous uncertainty around the exploration and production (E&P) spending outlook. From supermajor ExxonMobil (XOM - Free Report) to smaller players like Oasis Petroleum (OAS - Free Report) , all have made drastic cuts to their capital expenditures in an attempt to preserve cash and stay afloat. Obviously, this translates into lesser work for the companies that make it possible for upstream players to drill for oil and gas. In a nutshell, the oil and gas drilling fundamentals remain extremely bearish with most of the companies entirely focused on survival. With no real chance of E&P capex cut reversal this year, drilling activity is expected to remain weak over the near-to-medium term.   

•    However, one of the key positive arguments for drillers is the focus on 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 and Royal Dutch Shell’s 2019 oil reserve replacement ratio of just 44% and 76%, respectively, indicates the inability to add proved reserves to the amount of oil and gas produced. This clearly calls for a calibrated approach in meeting reserve shortfalls in the long run. Consequently, a gradual improvement in drilling activity looks likely.    

•    The highly cyclical nature of the industry makes its participants — who generally build big and expensive drilling rigs — heavily dependent on the prevailing business environment. In other words, it’s extremely difficult for any driller to perform well during a commodity downturn. However, the ability to come up with technologically superior products with higher efficiency can help companies gain a competitive edge in the market. 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. But investors should keep in mind that these stocks are prone to quick falls, unlike the stocks of land drillers.

Zacks Industry Rank Indicates Bearish Outlook

The Zacks Oil and Gas - Drilling is an 11-stock group within the broader Zacks Oil - Energy sector. The industry currently carries a Zacks Industry Rank #198, which places it in the bottom 22% of more than 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 negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are pessimistic on this group’s earnings growth potential. As a proof of this, the industry’s earnings estimate for 2020 has decreased 167.2% in the past year. Meanwhile, the same for 2021 have slumped 592.3% over the trailing 12-month period.

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 lagged the broader Zacks Oil - Energy Sector as well as the Zacks S&P 500 composite over the past year.

The industry has declined 45.7% over this period compared with the broader sector’s decrease of 29.8%. Meanwhile, the S&P 500 has gained 16.7%.

One-Year Price Performance

Industry’s Current Valuation 

Since oil and gas 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 10.53X, lower than the S&P 500’s 12.66X. However, it is significantly above the sector’s trailing-12-month EV/EBITDA of 4.73X.

Over the past five years, the industry has traded as high as 15.30X, as low as 4X, with a median of 9.13X.

Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio





 

Bottom Line

The near-term market softness on account of the latest oil price rout presents one of the most significant challenges to drilling contractors. That said, a few of them are well equipped to deal with the prevailing market headwinds.

Sector consolidation, adoption of superior technologies, new operational systems’ optimization of the fleet by strategic sell-offs and acquisition, profitable collaborations, among other strategic strides, will certainly help boost future prospects of the drilling companies.

For the offshore players, greatly reduced costs amid stronger operating efficiencies are likely to generate decent returns for most of the projects even at today's oil prices. As a matter of fact, the lower breakeven and attractive project economics are leading to more offshore projects being sanctioned.

Considering the abovementioned factors and the industry’s current dynamics, we are presenting four stocks with a Zacks Rank #3 (Hold) that investors may currently retain in their portfolio.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Precision Drilling Corporation (PDS - Free Report) : This company — Canada’s largest drilling rig contractor — boasts a solid earnings surprise history having surpassed estimates by 83.33% in each of the last four quarters, on average.
 

Price and Consensus: PDS

Transocean Ltd. (RIG - Free Report) : Transocean is the world’s largest offshore drilling contractor and leading provider of drilling management services. The company has an expected earnings growth rate of 39.31% for this year.

Price and Consensus: RIG
 

 

Nabors Industries Ltd. (NBR - Free Report) : Nabors Industries is one of the largest land-drilling contractors in the world, conducting oil, gas, and geothermal land drilling operations. The company has expected earnings growth of 14.39% for 2020.

 

Price and Consensus: NBR


 

Helmerich & Payne, Inc. (HP - Free Report) : Helmerich & Payne is engaged in the contract drilling of oil and gas wells in the United States and internationally. The company beat the Zacks Consensus Estimate in three of the last four quarters and missed in the other, delivering an earnings surprise of 20.79%, on average.

Price and Consensus: HP

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