The 3 Best Offshore Oil Drillers for High-Yield Investors

According to a study by Morgan Stanley and Rystad Energy, by 2035 the world's oil demand will increase by 13%-26%, causing prices to increase to $125/barrel-$150/barrel. 

To meet the massive demand in the face of aging and depleting land-based oil fields, oil companies are having to increase their E&P (exploration and production) budgets enormously. In 2013, total global E&P spending was almost $650 billion. To put that into perspective, according to the CIA world factbook, in 2012 the entire global economy was $85 trillion. This means that $1 of every $130 in the world is spent on finding and producing oil. 

The location of new oil fields is the key to this article and the investment opportunities it presents. Between 2012 and 2030 conventional, land-based oil production is expected to grow at just  a 1% CAGR. In contrast, ultra-deepwater production will grow at a 19% CAGR. 

Recently a series of negative articles and opinions by Wall Street's leading analysts have maximized negativity about the offshore drilling industry: 

• An article in Barron's argues that oil will fall 25% to $75/barrel over the next five years.
• Barclays predicts up to 40% downside for offshore oil drillers due to a glut of new rigs causing plummeting day rates.
• Morgan Stanley and Citigroup predict falling day rates over the next two years will cause a collapse in the stock prices of offshore drillers.

Seadrill has a fleet of 49 rigs (34 UDWs), with another 20 to be delivered by 2016 (11 UDWs). With the most modern UDW fleet in the world (average age 3.2 years), concerns over falling day rates shouldn't apply to Seadrill. Ten out of Seadrill's eleven latest UDW contracts have been for higher day rates, including its highest rate ever ($653,000/day) signed in the fourth quarter of 2013.

With an almost 12% yield that even Barclay's calls "rock solid" and the stock trading at just eight times cash flows (25% below historical average), Seadrill is massively undervalued. In addition, management has recently undertaken a balance sheet strengthening plan to secure the dividend (and grow it gradually during the short-term weakness) while paying down debt.

Combine this with the 20% CAGR EBITDA growth management is projecting through 2016 (due to the fleet growth) and you have the potential for a great investment over the next decade, combining an already sky-high yield with the potential for dividend growth and substantial capital gains. 

Ensco plc  is my second favorite offshore oil driller for two key reasons.

First, it has the second most modern UDW fleet in the world (average age 3.9 years) with six new rigs to be delivered by 2016 (three of them UDW). Unlike Seadrill, which finances its new rigs with cheap debt, Ensco likes to mostly fund new rigs with cash flow -- a major reason why it has the lowest leverage ratio in its industry (27%).

In addition to a fast growing, super-modern UDW fleet, Ensco has the second highest yield in the industry -- 6%. With a payout ratio of 49% and cash flows predicted to grow by 12% annually, this dividend is not just safe but likely to grow in the future.

Noble Energy  is my third favorite offshore driller for three reasons.

First, the yield of 5% is the third highest in the industry, yet represents only a 25% payout ratio. 

Second, cash flow growth after 2015 (due to completion of its new build program) will fund dividend growth. 

Finally, it's spinning off standard rigs into a separate company (Paragon Offshore), leaving Noble a pure premium rig play. This will minimize exposure to short-term day rate weakness and further secure the dividend.

In addition, the Paragon IPO (summer 2014) will likely see Noble sell 20% of Paragon, resulting in further liquidity to pay down debt, secure the dividend, and grow it in the future.

Foolish takeaway
The current concern over offshore oil rig day rates is greatly overblown. The current price weakness is a terrific opportunity for long-term income investors to cash in on one of the strongest megatrends of the next few decades and achieve the trifecta of investing: high yield, fast growing dividends, and superior capital gains.