While vaccine-related developments and accelerating economic growth have spurred a revival in the energy markets, a number of challenges continue to weigh on the Zacks Oil and Gas – Drilling industry.

That said, a few of the drilling contractors like Helmerich & Payne (HP), Transocean (RIG), Patterson-UTI Energy (PTEN) are Nabors Industries (NBR) are well equipped to deal with the prevailing market headwinds driven by greatly reduced costs amid stronger operating efficiencies.

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 a costly and technically difficult enterprise, whose future is primarily dependent on the contracting activity and the total number of available rigs at a given point of time, rather than the price of oil or gas.

4 Trends Defining the Oil and Gas – Drilling Industry’s Future

E&P Capital Discipline to Weigh on Activity Levels: Last year’s slump in oil prices and the coronavirus-induced demand shock have pushed drilling activity lower by introducing tremendous uncertainty around the exploration and production (E&P) spending outlook. From supermajors ExxonMobil (XOM) and Chevron (CVX) to smaller players like Callon Petroleum (CPE), 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 weak with most of the companies entirely focused on survival. While oil prices have rebounded strongly from the coronavirus-induced depths, most producers will likely continue with their cost-reduction efforts in 2021. With not much chance of a significant E&P capex cut reversal this year, drilling activity is expected to remain weak over the near-to-medium term.

Low Reserve Replacements A Silver Lining for Drilling Demand: Amid the plethora of negative headlines, 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’s 2020 reserve replacement ratio of just 74% 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.

Rollover of Legacy, High-Margin Contracts: For most operators, order levels have remained depressed and day rates are trending just above cash costs. This has put increasing pressure on their revenue-generating capacity. Further, as the companies’ legacy, high-margin contracts wind down slowly, the 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 the drillers vulnerable to address their massive debt maturities and investment on newbuilds.

Project Sanctioning Dependent on Cost Competitiveness: The highly cyclical nature of the industry makes its participants — which generally build big and expensive drilling rigs — heavily dependent on the prevailing business environment. In other words, with the massive upfront costs needed, 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. Of late, be it onshore or offshore, both groups are focusing on improving project economics on the back of lower costs and sophisticated technology. 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 industry is an 8-stock group within the broader Zacks Oil – Energy sector. It currently carries a Zacks Industry Rank #235, which places it in the bottom 6% 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.

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 Outperforms Sector & S&P 500

The Zacks Oil and Gas – Drilling industry has fared better than the broader Zacks Oil – Energy Sector as well as the Zacks S&P 500 composite over the past year.

The industry has surged 136.1% over this period compared with the broader sector’s increase of 32.2%. Meanwhile, the S&P 500 has gained 50.1%.

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 14.58X, lower than the S&P 500’s 18.81X. However, it is well above the sector’s trailing-12-month EV/EBITDA of 5.98X.

Over the past five years, the industry has traded as high as 17.17X, as low as 4.69X, with a median of 10.03X, as the chart below shows.

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

4 Oil and Gas – Drilling Stocks to Keep an Eye On

Nabors Industries: Nabors is one of the largest land-drilling contractors in the world, conducting oil, gas and geothermal land drilling operations. The company is well positioned with a sound mix of high-performance rigs and new rigs working in the key shale plays like Bakken and Permian.

The 2021 Zacks Consensus Estimate for this Hamilton, Bermuda-based company indicates 11.59% earnings per share growth over 2020. Nabors currently carries a Zacks Rank #3 (Hold). The stock has gained 156.3% over the past six months.

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

Price and Consensus: NBR

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 company has already upgraded most of its drilling fleet with the latest technology.

The fiscal 2021 Zacks Consensus Estimate for this Tulsa, OK-based company indicates 47.4% earnings per share growth over fiscal 2020. The provider of land and offshore rigs carries a Zacks Rank #3 and its shares are up 62.7% over the past six months.

Price and Consensus: HP

Patterson-UTI Energy: Patterson-UTI Energy is one of the largest North American land drilling contractors, having a large, high-quality fleet of drilling rigs. The company’s technologically advanced Apex rigs are the key to its success. Patterson-UTI’s proprietary design makes the rigs move faster than conventional rigs, drill quicker and more efficiently.

The 2021 Zacks Consensus Estimate for this Houston, TX-based company indicates 8.29% earnings per share growth over 2020. Patterson-UTI currently carries a Zacks Rank #3. The stock has gained 141.4% over the past six months.

Price and Consensus: PTEN

Transocean: Being the largest provider of offshore contract drilling services, Transocean’s unrivalled backlog of $7.4 billion offers cash flow visibility. As it is, the company’s technologically advanced and versatile drilling fleet differentiates it from competitors and provides it with an edge.

The 2021 Zacks Consensus Estimate for this Switzerland-based rig supplier indicates 30.26% earnings per share growth over 2020. The rig supplier carries a Zacks Rank #3 and its shares have gained 270% over the past six months.

Price and Consensus: RIG

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Exxon Mobil Corporation (XOM) : Free Stock Analysis Report

Transocean Ltd. (RIG) : Free Stock Analysis Report

PattersonUTI Energy, Inc. (PTEN) : Free Stock Analysis Report

Nabors Industries Ltd. (NBR) : Free Stock Analysis Report

Helmerich & Payne, Inc. (HP) : Free Stock Analysis Report

Chevron Corporation (CVX) : Free Stock Analysis Report

Callon Petroleum Company (CPE) : Free Stock Analysis Report

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