Even after the push for renewable energy and the natural gas renaissance in recent years, oil is still the lifeblood of the global economy.
Last year, offshore drillers lagged behind the market a bit -- the SPDR S&P Oil & Gas Equipment & Services ETF (NYSE: XES) logged a gain of 23.9% for the year, compared with the S&P 500 Index's 26.4% -- but 2014 is shaping up as a turnaround year for the sector.
The Gulf of Mexico in particular could be a potential "black gold" mine for drillers this year. A report by the U.S. Department of the Interior estimates that there is still around 48 billion barrels of oil that remain undiscovered, but the biggest catalyst could come from our southern neighbor -- Mexico.
Constitutional reform has gripped Mexico's oil industry and broken up a long-running state-held monopoly, Pemex. Private capital should begin to flow into the country later this year, but in the meantime, Pemex has a number of outstanding tenders for drilling contracts that should be filled before the end of the first quarter.
The majority of oil produced by the Mexican giant is found in shallow water, which is perfect for jack-up rigs -- and plays directly into the wheelhouse of Hercules Offshore (Nasdaq: HERO).
Despite a relatively small market capitalization of about $800 million, the oil and gas drilling company has the third-largest jack-up fleet in the world and the largest in the Gulf of Mexico, with around 40 rigs. Its rigs are capable of working in depths ranging from 9 to 400 feet and can drill to depths of 15,000 to 35,000 feet. Nearly 30 of those rigs are located in the Gulf of Mexico with other operations in locations such as Saudi Arabia and Singapore.
International demand for jack-ups has utilization at 95%, and the tight market for jack-up rigs has pushed up Hercules' backlogs to 200 days. This lack of supply gives the company flexibility in marketing and pricing.
The recent downgrade by Global Hunter Securities seems overblown considering that it was derived from its competitor's contract position. Noble Energy (NYSE: NBL) warned of fewer contract opportunities, but a third of Hercules' contracts extend into this year. Currently, NBL looks expensive at 22 times earnings, compared with HERO's price-to-earnings (P/E) ratio of 10.
However, HERO hasn't performed well lately -- down 28% in the past year. In 2012, Hercules lost $0.45 a share, but it expects to end 2013 with earnings of $0.20 a share. The consensus for 2014 has the company's earnings at $0.75 a share -- a gain of 275%. Year-over-year quarterly earnings growth is nearly 150%, and revenue growth is over 40%.
HERO trades at less than its book value of $5.77, representing deep value. In a vote of confidence, one of Hercules' directors recently bought 100,000 shares, signaling strength to investors.
Risks to Consider: Shallow-water wells have seen increased day rates, with Hercules seeing around $95,000 per day in the Gulf of Mexico. Further utilization expenses could hurt profits and future earnings. Insurance expenses in the Gulf remain among the highest in the world after the Deepwater Horizon disaster of 2010, and any future mishaps will only increase premiums.
Actions to Take --> Deutsche Bank assigned a price target of $10 on the stock, representing a potential gain of 104%. The stock is currently trading nearly 20% below book value, representing deep value for investors.