Citigroup Is Bearish on These Offshore Drillers, but What do Hedge Funds Think?

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Shares of Seadrill Ltd (NYSE:SDRL), ENSCO PLC (NYSE:ESV), and Ocean Rig UDW Inc (NASDAQ:ORIG) are trending after the analysts at Citigroup reiterated their ‘Sell’ rating on Seadrill and declared they weren’t very optimistic on other offshore plays. Given many offshore drillers trade substantially below their book value and are extremely volatile, any insight or informed opinion can be vital to determining the future direction of the energy services stocks. Let’s take a closer look at the three companies and examine what top investors think of them as well.

Offshore Oil Drilling BP RIG

Why do we pay attention to hedge fund sentiment? Most investors ignore hedge funds’ moves because as a group their average net returns trailed the market since 2008 by a large margin. Unfortunately, most investors don’t realize that hedge funds are hedged and they also charge an arm and a leg, so they are likely to underperform in a bull market. We ignore their short positions and by imitating hedge funds’ stock picks independently, we don’t have to pay them a dime. Our research has shown that hedge funds’ long stock picks generate strong risk adjusted returns. For instance the 15 most popular small-cap stocks outperformed the S&P 500 Index by an average of 95 basis points per month in our back-tests spanning the 1999-2012 period. We have been tracking the performance of these stocks in real-time since the end of August 2012. After all, things change and we need to verify that back-test results aren’t just a statistical fluke. We weren’t proven wrong. These 15 stocks managed to return more than 102% over the last 34 months and outperformed the S&P 500 Index by 53 percentage points (see more details here).

The analysts at Citigroup are bearish on the industry:

“We see little value in offshore players and reiterate our cautious view on the space. In offshore drilling, our base case sees >20% decline in Deep Water/Ultra Deep Water rig utilisation to >70% by 2017. Importantly, we expect the utilisation to remain <75% to the back end of the decade, with all rig generations affected given the large number of new, uncontacted units. In this environment, we expect day rates to remain driven by cash costs (opex now fallen to c$175k/d on average + c$60k/d for G&A and interest) and reiterate our expectations of c$250k/d day rates in the short term.”

Analysts think the demand won’t increase as much as the market thinks it will, and rig utilization rates and day rates will come in lower than what the market expects. They also think the downturn could last up until the back end of the decade, meaning that companies like Seadrill Ltd (NYSE:SDRL), with substantial debt on their balance sheets, might not be able to postpone the maturities/cover the interest enough to escape serious damage.

We agree, investors should be cautious, but we point out the analysts at Citigroup are assuming relatively low Brent prices to the back end of the decade and low energy prices are anything but certain. As Billionaire Cliff Asness said in a recent interview: “I don’t know where crude prices will go, I just know it will change.” If crude prices recover to a healthy enough point, utilization demand and day-rates will increase and Seadrill, ENSCO PLC (NYSE:ESV), and Ocean Rig UDW Inc (NASDAQ:ORIG) will look a lot better than they do right now. Of course, if they remain low for an extended period of time, the analysts at Citigroup will be right with their bearish view.

In the next page, we will analyze what the smart money thinks of the three offshore drillers.

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