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Oil and Gas - Drilling Stock Outlook: Too Many Negative Catalysts

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The uptick in tendering activity and contract fixtures over the past few months notwithstanding, the oil drilling industry is not in a good health. Waiting for that ‘elusive' recovery for about three years, the current oilfield environment remains one of the most difficult ones. With new competitors entering the market and drilling contractors too rattled to make new investment decisions, rig owners have seen a number of their vessels get idled.

While the market is far from being dead, it is no secret that there is a major overhang of drilling rigs ordered when crude prices were trading at $100 a barrel prior to the boom years of 2014, compared with around $65 recently.

Consequently, the drillers are struggling with diving dayrates, lower rig utilization and margin compression. Several quarters of reduced activity and diminishing contract backlog indicates continued pressure on revenues, earnings and cash flows for most of the players.

Industry Lags on Shareholder Returns

Looking at shareholder returns over the past year, it appears that the crude price recovery wasn’t enough for enhancing investors’ confidence in the industry’s growth prospect. Though higher and stable oil prices have led to improving contract visibility and dayrates, industry fundamentals remain challenged. In particular, persistent rig oversupply and renewed geopolitical instability have kept the offshore segment under pressure.

The Zacks Oil and Gas - Drilling Industry, a part of the broader Zacks Oil and Energy Sector, has underperformed both the S&P 500 and its own sector over the past year. While the stocks in this industry have collectively gained 7.7%, the Zacks S&P 500 Composite and Zacks Oil and Energy Sector have rallied 13.6% and 12%, respectively.

One-Year Price Performance

Within the drilling industry, it's interesting to note that volatility associated with the offshore drilling companies are much higher than their onshore counterparts and their share prices are more correlated to the price of oil. Therefore, it's not surprising that most offshore drilling stocks have rallied strongly off their August 2017 lows. But investors should keep in mind that these stocks are prone to quick falls too, unlike the stocks of land drillers.

Drilling Stocks Certainly Not Cheap

Despite the underperformance of the industry over the past year, the valuation looks hardly cheap now. One might get a good sense of this capital-intensive industry’s relative valuation by looking at its enterprise-value-to-EBITDA ratio (EV/EBITDA), which is often used to value oil and gas stocks, given their significant debt levels and high depreciation and amortization expenses.

This ratio essentially measures a driller's current market value relative to what investors are ready to shell out for the next four quarters of estimated EBITDA.

The industry currently has a trailing 12-month EV/EBITDA ratio of 11.19, near the highest level of 12.17 seen over the past year. Even when compared with average level of 7.99 over that period, investors considering jumping in should exercise caution.

The space, however, looks slightly cheaper when compared with the market at large, as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.56 and the median level over the past year is 11.33.

Enterprise Value/EBITDA (TTM)

As the industry’s valuation multiple is closely corelated with crude prices, comparing the group’s EV/EBITDA ratio with that of its border sector may make better sense to many investors. The Zacks Oil and Energy Sector’s trailing 12-month EV/EBITDA ratio of 6.54 and the median level of 6.62 for the same period are way below the Zacks Oil and Gas - Drilling Industry’s respective ratios. Therefore, the space actually looks stretched when compared with the sector’s range in the time period and the investors are unlikely to risk the hefty premium for companies that are considered cyclical and volatile in nature.

Enterprise Value/EBITDA (TTM)

Underperformance May Continue Due to Bleak Earnings Outlook

Expectations of gradual uptick in rig contracting activities from clients worldwide amid higher spot market rates and improved spending should help oil and gas drilling stocks continue generating positive shareholder returns in the near future.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The above ratio analysis already shows that there is hardly any value-oriented path ahead and one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.  

One reliable measure that can help investors understand the industry’s prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences the performance of its stock.

One could get a good sense of a company’s earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year’s reported number, but an effective measure could be the magnitude and direction of the recent change in earnings estimates.

While the consensus earnings estimate for the Zacks Oil and Gas - Drilling industry of -$0.86 per share implies a year-over-year deterioration, the trend in earnings estimate revisions has not been favorable lately either.

Price and Consensus: Zacks Oil and Gas - Drilling Industry

Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings potential.

The consensus EPS estimate for the current fiscal year has been revised 13.2% downward since Mar 31, 2018.

Current Fiscal Year EPS Estimate Revisions

Zacks Industry Rank Indicates Lackluster Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.

The Zacks Oil and Gas - Drilling industry currently carries a Zacks Industry Rank #159, which places it at the bottom 38% of more than 250 Zacks industries. 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.

Our proprietary Heat Map shows that the industry’s rank has been hovering in a relatively narrow range in the lower half over the past five weeks.

In fact, the basis of this bearish outlook could be the steady downward trend in top line that drillers have been showing since the beginning of 2015.

Another important indication of dull future prospect is the deterioration in the group’s free cash flow, which is a key metric for evaluating oil and gas drilling stocks. It’s quite clear that the companies are not generating enough cash to pay off debt along with funding capex and dividend payments.

Bottom Line

With no signs of immediate improvement in market sentiment, 2018 is likely to rank as another challenging year for the drilling market. Even if commodity prices improve, the structural oversupply and pricing pressure will weigh on the sector components’ operating margins.

Moreover, aggravating the issue, there has been an increase in rig supplies, with new builds entering the market. As such, the old rigs are getting scrapped as they no longer remain competitive among the newbuild drillships. With old contracts rolling off, the rigs either have to get stacked or accepted at much-reduced dayrates, thereby impacting overall revenues. Therefore, the only option remaining with the companies are to either stack them, bearing high reactivation costs or just scrap them.  

The space is witnessing intense competition, which further poses risk to their dayrates and utilization levels. While the industry is likely to gain momentum in the coming years on the back of rising crude strength, the drilling contracts should presently focus on strategically adapting to current market scenario successfully. Sector consolidation, adoption of superior technologies, new operational systems optimization of the fleet by strategic sell offs and acquisition, seeking profitable collaborations, among other strategic strides will help the companies perform well in the current market scenario.

Overall, the industry might not be able to tide over the broader challenges in the near term and therefore none of the stocks in our oil and gas drilling universe currently hold a Zacks Rank #1 (Strong Buy). However, below is a stock that has been witnessing positive earnings estimate revisions and carry a Zacks Rank #2 (Buy).

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

Pioneer Energy Services Corp. (PES - Free Report) : The stock of this San Antonio, TX-based driller has gained 115.9% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 22.2% upward over the last 60 days.

Price and Consensus: PES

 

As mentioned throughout, there are a number of reasons to worry about the industry’s performance in the near to medium term. So, it would be prudent to stay away from some weak drilling stocks for now. Stocks carrying an unfavorable Zacks Rank are particularly expected to underperform.

Here are two such stocks:

Advantage Oil & Gas Ltd. (AAV - Free Report) : The stock of this Calgary, Canada-based driller has lost 51.2% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 17.6% downward over the last 60 days.

Price and Consensus: AAV

Parker Drilling Company (PKD - Free Report) : The stock of this Houston, TX-based driller has lost 73.6% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 19.7% downward over the last 60 days.

Price and Consensus: PKD

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