This Stock Is Up 51% This Year … and It’s Just the Beginning

Precision Drilling (TSX: PD)(NYSE: PDS) is up 51% for the year to date. This compares to the S&P/TSX Index’s (^GSPTSE) year-to-date return of 13.5% and a year-to-date return of 19.2% for the S&P/TSX Capped Energy Index (^SPTTEN). The sector is on the upswing and all signs point to it progressing full steam ahead. Here is why investors can expect this outperformance to continue.

Drilling activity gaining momentum

In Precision Drilling’s Canadian operations, drilling activity in the second quarter of 2014 increased 33%, and is at its highest level since 2006. The growth in drilling activity stems largely from the deep basin in northwestern Alberta and northeastern British Columbia. This in turn has driven demand for Tier 1 rigs, which are well suited for drilling in these areas, and which Precision Drilling has focused on in recent years. In fact, it is the company’s goal to become the driller of choice in deep basin gas and liquids.

While Canada saw the greatest increase in drilling activity, levels were strong in all of Precision’s markets. In the United States, drilling activity increased 16% and in the international segment it increased 18%.

Thus, demand for Tier 1 rigs continues to be solid, and since Precision has made the strategic decision to concentrate on these rigs, the company is benefiting from this. These rigs are technologically advanced and can drill the same well in half the time, drill to greater depths, and bore longer horizontals. In fact, Precision is continuing to retire older Tier 3 rigs in favour of the newer and more technologically advanced Tier 1 rigs. The company currently has 237 Tier 1 rigs, compared to only 93 rigs five years ago.

Pricing and margins exhibiting strength

The EBITDA margin increased 17% versus the same quarter last year and came in at 27.3%. On the conference call, management affirmed that this operational leverage, as well as the strong drilling activity, points to a strong 2014 winter. This strength in pricing, along with the increase in activity levels, both contributed to a 25.4% increase in revenue for the quarter.

LNG opportunity playing out

There are a number of current proposals to build liquefied natural gas plants along the coast of British Columbia, with anticipated start-up times from 2015 and beyond. There is a flurry of activity in a number of deep basin plays in northwestern Canada, including the Montney, Duvernay, Horn River, and Liard Basin, all of which are well positioned to be a source of supply for the LNG market. This has increased demand for deep, modern drilling equipment in Canada — that is, Tier 1 Super Series rigs.

Capital budget increased

Due to the strong demand that management is seeing, the company has increased its 2014 capital budget by 12% to $934 million. New rigs will be added at a pace of three per month in 2014 and four per month in 2015, assuming that demand will support this growth as management expects it will.

Alliance with Schlumberger a testament to Precision Drilling

Earlier this month, the company announced that it had entered into an alliance with Schlumberger (NYSE: SLB). With a market capitalization of $146.6 billion, it is the world’s leading oil field services company. The agreement entails Precision continuing to expand its directional drilling services utilizing Schlumberger’s downhole tools and related services, as well as its expertise in different relevant areas. The goal of this agreement is to generate certain advantages for the customer, such as improved drilling performance, efficiency, consistency, and reduced cost of operations.

The bottom line

Precision Drilling is experiencing strengthening momentum that investors should expect to continue. The company has made the right strategic move by focusing on the Tier 1 Super Series rigs, and should continue to reap the rewards for the foreseeable future. Because this is a very volatile sector, the returns that can be made on the way up are extremely high.

When these stocks are on the upswing, they can make a great part of a diversified portfolio and can provide some much-needed torque. While the stock price has already been anticipating this, investors still have time to jump in and benefit from these improving fundamentals, as the upside to these stocks is huge.

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