Offshore drilling is a simple concept, but a very difficult business. With much of the easily accessible on-shore oil and gas reserves already under development, energy companies have increasingly looked offshore to replenish their reserves and fulfill their production needs. Although there is ample oil and gas waiting below the seabed, it is not so easy to access. Operating under the water is a bit like operating in space – it is hostile to man and machine and requires specialized equipment and know-how.

The offshore drilling industry is a multi-billion dollar per year enterprise. While leading players like Transocean (NYSE:RIG), Diamond Offshore (NYSE:DO), Ensco (NYSE:ESV) and Noble (NYSE:NE) represent a significant percentage of the operating rigs, there are dozens of smaller players throughout the world and the market capitalization of the publicly-traded companies in the sector exceeds $50 billion. (Before jumping into this sector, learn how these companies make their money in Oil And Gas Industry Primer.)

History of the BusinessIt took more than 30 years for people to begin looking for oil somewhere other than beneath dry land. The first submerged wells were drilled in a reservoir (Grand Lake, St. Mary's) in Ohio in the 1890s, and the first saltwater wells were drilled shortly thereafter in the Summerland Field of California. The first offshore rigs were basically modified land rigs, and it was not until 1947 that the first well was drilled completely out of sight of land (in the Gulf of Mexico). Since then, there has been ongoing innovation in the field and the industry has expanded significantly. Now there are few areas technologically out of reach for exploration, and offshore exploitation of energy resources is a major factor in the global energy economy.

Key TermsLike every sector, there are a few key terms that investors need to know. The most important terminology covers the type of rigs a company employs, as different rigs have different earnings potential and demand characteristics.

  • JackupJackups are the most common type of offshore drilling rig, and tend to be the most volatile in terms of rates and demand. Jackups have a barge section that floats on the water (and holds the drilling equipment) and multiple legs (typically three, but sometimes more) that extend down to the sea floor. Jackups are typically towed to the targeted drilling site and, upon arrival, the legs are jacked down to the sea floor.
    Once in place, these platforms are typically steady and sturdy, with a drilling platform well above the waves. Because they do physically touch the bottom of the sea floor, they are generally only usable in relatively shallow water – up to around 400 feet of water. Most jackups drill down through holes in the platform, but some (called "cantilevered") drill over the side of the barge. (Drill down into financial statements to tap into the right companies and let returns flow; check out Unearth Profits In Oil Exploration And Production.)
  • SemisubmersibleSemisubmersibles are quite a bit different than jackups. Semisubmersibles float on submerged pontoons and have an operating deck that is well above the surface. Below the surface are anchors and umbilicals that essentially tie the rig in place, though some do have powered systems that can help keep the rig on target. With succeeding generations, the capacity of these rigs has increased, and the most modern generation of semi-submersibles can operate in up to 10,000 feet of water. While jackups can earn high day rates in specific circumstances, semisubmersible rates tend to be three- to five-times higher.
  • DrillshipsLike semi-submersibles, drillships can operate in a wide variety of circumstances, and are often used in locations with very deep water. Like semi-submersibles, drillships typically have an operating limit of 10,000 feet – a limitation that has more to do with extending a drilling operation through that much water as opposed to any limitations of the ship itself.
    Drillships basically look (and operate) like very large boats, with drilling taking place through a hole in the hull (called a moon pool). These ships are completely independent and self-powered. While not as stable semisubmersibles, drillships are mobile and can carry a lot of equipment – making them a good option for drilling exploratory wells. Like semisubmersibles, day rates for drilling ships are often quite a bit higher than those for jackups.

Important MetricsAt the risk of oversimplification, offshore drilling revenue is a function of day rates and utilization rate, with day rates representing the price and utilization representing volume. A day rate is the amount of money that a company receives for a day's drilling activity. Like any price, day rate is a function of both demand for a service and the cost of providing it – rates typically move up quickly when demand spikes, and specialty equipment (used in difficult or harsh conditions) always carries a premium. (How a company accounts for its expenses affects how its net income and cash flow numbers are reported; read Accounting For Differences In Oil And Gas Accounting.)

Utilization refers to the percentage of a company's fleet that was actively engaged and earning money during the time period. Utilization is a function of both supply (how many rigs the industry has available) and demand, (how many the energy companies need or want) and moves in cycles. Offshore drillers are usually price-takers, but it is not uncommon for companies to remove rigs from service (especially older rigs that are more expensive to operate) when prices decline.

Investors should also be aware of a company's philosophy towards contracts and spot rates. While some companies prefer to pursue contracts for all of their rigs (and sometimes these contracts run for several years), others are willing to take their chances and accept whatever the going rate (spot rate) may be. This decision has a lot to do with the risk tolerance of the management team and its ability to accurately forecast future rates. Companies that accept spot pricing during cyclical upswings can out-earn rivals operating on contracts, but the opposite is also true in periods of falling demand. (These options represent one of the most important political commodities; see Fueling Futures In The Energy Market.)

Fleet age is a metric that seems obvious, but is actually a little more complicated. On the obvious side, it is a measure of the average age of the company's fleet. What fleet age can tell an investor, though, is somewhat more complicated. Older equipment is usually less powerful and may require a higher level of ongoing maintenance. Typically, a less powerful rig means that it takes longer to drill a well, so clients will generally not pay as much for an older rig - at least, when there are enough rigs that clients can afford to be choosy.

On the other hand, older fleets have already seen the brunt of their depreciation, and can be cheaper to operate on an accounting basis. Likewise, a company that elects to utilize an older fleet is generally saving money on capital expenditures, and that may mean higher dividends to shareholders or a cleaner balance sheet. As a rough rule of thumb, a younger fleet is more desirable in the beginning of a cycle and through the top of a drilling cycle, but older fleets are more desirable when drilling activity is waning or at cyclical lows.

RisksThe biggest risk in the offshore drilling industry stems from the fact that it is both a service industry and is dependent upon its customers and their budgets, and highly sensitive to commodity prices. If major oil and gas producers foresee lower energy prices, they curtail their drilling budgets. In order to smooth over some of the vagaries of the business, some drilling companies pursue multi-year contracts for their services. Such contracts are a trade-off for the drillers – it gives them a guaranteed book of business, but at the cost of locking in a rate that may or may not be competitive years later. (Not sure where oil prices are headed? This theory provides some insight; see Oil As An Asset: Hotelling's Theory On Price.)

Overcapacity is a common risk in the industry, as well. When day rates move into the high end of the range, companies activate stacked rigs and commission new construction. Historically, overcapacity has been a bigger issue in the jackup market, where construction costs and lead times are shorter and where it is more practical to cold-stack rigs (that is, keep them idled in anticipation of future demand).

Government regulation is an evolving risk for the industry. Since the BP Macondo oil spill of 2010, the U.S. government has asserted the right to issue drilling moratoriums for its offshore areas. Such moratoriums essentially end all activity in the covered area and supersede prior contracts. Governments around the world have varying levels of regulatory oversight and rules. In some areas (particularly the developing world), the requirements are minimal, but there is always the risk of more regulation and more expensive operating requirements.

Natural and man-made disasters are another clear risk to the industry. Hurricanes can damage or destroy equipment, and operators will almost always postpone drilling activities when a storm is expected. Man-made disasters can cover a lot more ground – anything from minor fires onboard the rig to major accidents that result in the loss of the rig. Although serious damage from disasters has been relatively uncommon, it does present a risk.

ValuationDue in part to the cyclical nature of the business, valuing offshore drilling companies is trickier than valuing a typical industrial company. When traditional ratios like price/earnings look low, that is often a sign of peak earnings and a time to avoid the stocks.

Cash flow modeling should work, but the problem with all models is that they are increasingly inaccurate the longer they extend. A savvy investor might be able to accurately forecast market conditions and the resulting profitability and capital expense budget of a company, but it is quite difficult. Alternatively, investors can try to build "average cycle" models that try to forecast an average level of profitability and cash flow over a complete cycle, but these too are tricky.

For better or worse, the ratio of forward enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) is the most commonly-used metric for valuing these stocks. Generally speaking, this sector trades at a range of 7.0-8.0-times EV/EBITDA.

Valuation approaches that attempt to assess underlying asset values can also be useful. Price-to-book value is a simple and familiar formula. Stocks in this sector typically trade in a range of 2.0- to 5.0-times price/book – so when the ratios are in the "twos" that may be a buy signal, while ratios in the "fours" suggest the sector is closer to a peak.

In comparison, asset replacement cost attempts to assess what it would cost to replace a company's current fleet. Unfortunately, this is not a very accessible metric for the individual investor – it is not easy to find current quotations on new-build rigs, and it takes a lot of knowledge to adequately discount the age and capabilities of the fleet.

These approaches are also not necessarily useful in isolation – a company may appear cheap because its EV/replacement value appears low, but upon further investigation, an investor sees that the company has never managed to produce margins on par with others in the industry. Accordingly, investors who seek to use asset-based valuation metrics need to place them in the context of how the company's profitability compares to others, as well. (This simple measure can help investors determine whether a stock is a good deal; check out Value Investing Using The Enterprise Multiple.)

The offshore drilling industry is dynamic, and is always finding new solutions to what were once intractable technological problems. Combine the ongoing global appetite for oil, the reality that major discoveries most likely lie offshore, and the improving technological capabilities of drillers, and this is a sector likely to continue to get Wall Street's attention.

This is a tricky and cyclical sector, and it is not an appropriate place for beginning investors to make their first stock purchases. For more experienced and risk-tolerant investors, though, this overview is a good place to begin, and a quick primer in the industry essentials. Armed with this knowledge, start digging into the individual financials of the companies in the industry, and see whether there are appealing investment prospects waiting to be discovered.