Bad Mojo in Offshore Drilling

 | Nov 28, 2012 | 3:00 PM EST
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Deutsche Bank downgraded the entire offshore-drilling sector Wednesday. As usual, the firm is late to the game -- I've been recommending that readers avoid this sector for months. However, this downgrade does present a good opportunity to remind investors why this group is non grata, as well as what could change that.

Look, oil is in a secular bear market. It's been in a bearish trend since the middle of September, when panic about Iran dissipated, and we can even trace it back to the end of Libyan activity in April. Only geopolitical events have managed to rally the oil market, and that fact continues to bolster this bear-market idea -- the fundamentals are just not there.

In the U.S., demand is down and supply is up. We're witnessing a continuing slowdown in Europe and plenty of indications that China is also slowing. Production is increasing in Iraq and Saudi Arabia and Canada from oil sands. The fiscal cliff is coming, and if the U.S. goes over it, on its heels will be a probable 4% drop in gross domestic product. All signs portend a further weakening of oil prices.

Here's where the rubber meets the road in offshore drilling. It is by far the most expensive marginal source of oil. Of course, the cost per barrel is dependent upon the well and its technical challenges, but even the simplest deepwater well will cost about $35 a barrel to produce. Go deep, with necessary horizontal drilling, with remote sensor systems and blow-out preventers, and you can get up to a cost of $60 a barrel.

With oil above $100 per barrel, there's no problem in taking on these costs. But, in light of a seemingly slow-growth environment coming for the next several years, a concentration of assets is set to go to the cheapest sources -- old-fashioned drilling and even newfangled shale drilling techniques.

This is a trend I've been talking about for months, so I am not surprised by the dive in oil-services stocks or the DB downgrade. But an old saw in the fixed-income market makers says, "There are no bad bonds, only bad bond prices." With that in mind, some of my favorite offshore drillers are starting to reach very, very tasty numbers.

Seadrill (SDRL) has been the steadiest, although this name has been pumped by its strong dividend. Cameron (CAM) has been buoyed by mandated blowout-preventer upgrading. Even Weatherford (WFT), leveraged to expensive horizontal techniques and one of my least favored stocks, is getting interesting to me. $9? Hmm -- this one was once the top idea from Morgan Stanley. Are they that bad now? Probably not.

But this sector has bad mojo -- it's all going one way: down. Now's not the time to get cute and buy. But we are getting closer to finding value in this sector. I'll tell you when I'm biting.

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