Hedging Against Nuclear Iran Risk

Includes: CVX, HERO, UNG, USO
by: Patent Plays

On Friday President Barack Obama declared that Iran would have the means to produce a nuclear weapon, in less than 12 months. Further, the president declared that the United States would not allow a nuclear Iran. This could mean a 6 to 12 month window for a coordinated United States military campaign to eliminate Iran's ability to wage nuclear war. Iran for its part has declared immediate and swift responses to any military aggression guaranteeing the disruption of the supply and pricing of world oil markets.

The consequences of this scenario are well known to all investors. Finding insulating opportunities that yield stability and growth without a "boomerang effect" when tensions are relieved is a very difficult exercise.

Exchange Traded Funds as a defense.

When oil prices rise the reflex tendencies among experienced traders is to allocate into oil funds. United States Oil (NYSEARCA:USO) is among the favorites. This fund seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate light, sweet crude oil. Another favorite is the United States Natural Gas Fund LP (NYSEARCA:UNG). This is also an exchange-traded security that is designed to track in percentage terms the movements of natural gas prices. This investment reflects the daily changes in percentage terms of the spot price of natural gas. These funds are both excellent short term vehicles to hedge against the short term spike in the price of oil or gas. The dilemma occurs when the price of oil, or gas, eventually reverts back to the pre-spike conditions and investors are left scrambling for a chair when the music stops. This leads us to finding insulated spike resistant growth opportunities in oil and natural gas. One such opportunity is Hercules Offshore, Inc. (NASDAQ:HERO). This once high flying oil and gas driller has been quietly feasting off the dead remains of the industry carnage created by the current administrations unwise prior policy of a drilling moratorium on the Gulf of Mexico. The company limped along managing to stay alive during this crisis wisely adding to its fleet other less fortunate shallow well operators, such as Seahawk Drilling Inc. Today the company has a near monopoly on the shallow drilling market in the Gulf of Mexico. Added to this is the escalation of lease grants by the Obama Administration and the increased desire by larger oil companies to pursue and re-open previously closed GOM opportunities.

Opportunities abound in the Gulf of Mexico

Drilling in the Gulf of Mexico is among the most profitable venues in the world. Companies like Chevron (NYSE:CVX) scour the Gulf for its prized Louisiana light sweet crude. Louisiana Light sweet crude is the most sought after oil in the world and trades at a near $20.00 premium per barrel to West Texas Intermediate crude. Its no coincidence that according to Hercules recent 10-k Chevron is listed among its largest customers. Though Hercules leases other items, such as lift boats, the focus is the jack up rig segment. This segment is the core of Hercules profitability and revenue stream. Day rates are the life blood of income to jack up rigs operators. Just prior to the economic meltdown of 2008 Hercules was getting average day rates of $73,952 on the 24 rigs they leased. Added to that number was a stock price exceeding $38 a share for the calendar year high. Then the meltdown hit and the bottom fell out. In the 2009 10-k we see day rates plunging to $52,549 and the utilization rate of their domestic off shore fleet falling to 58.9%. Investors noticed and the stock price was severely punished, dropping to a 2009 low of $1.16. Then the laws of supply and demand kicked in and Hercules was left with a 2011 day rate average of $48,387. However domestic offshore utilization was up 78.1 %. Hercules answer to resolving the day rate issue was simply to own the supply. They went shopping in February of 2011 and for pennies on the dollar acquired the assets of their chief Gulf rival, Seahawk Drilling. Problem solved. In the 2012 10-k, the company reports 24 leased jack up rigs with an average day rate of $61,764. Just how smart was the Seahawk buy? Hercules purchased 20 jack up rigs at a cost of $105 million. That translates to $11,986 in day rate average spread across the existing 24 off shore jack up rigs. Coincidentally day rate averages for 2012 rose $13,377. Obvious conclusions here seem to reflect that Hercules bought a lot of steel for nothing more than a day rate increase. While the company has not yet reclaimed the day rates of 2008 it appears the increase between 2011 and 2012 has the company well on the way to achieving this. Equally the price of the stock is also on the mend, going from a low of $1.16 in 2009 to $6.94 today. Many factors have contributed to these changes, in my opinion none larger than consolidation of rivals. Looking closely at the 2012 10-k, we see the utilization rate of rigs going from 78.1% in 2011 to 87.4% for 2012. Hercules is quickly reaching maximum utilization of rigs.

Hercules is on the verge of monopolizing the shallow water drilling in the Gulf of Mexico.

Hercules recently disclosed in a "one liner" in their 2012 10-k that they have ownership of 34 out of 40 jack up rigs, that are either operating or cold stacked in the Gulf of Mexico. At that time Hercules controlled 85% of the shallow water drilling in the Gulf of Mexico. Just how significant is this? Imagine the anti trust uproar if drilling in the State of Texas was dominated by just one drilling company. Larger still is the recently reported fact that nearly ½ of all U.S. Oil Rigs (about 23% of the Worlds oil rigs) are drilling in Texas now. Here enters the opportunity. Hercules now has a controlling ownership of most jack up rigs in the Gulf of Mexico. As they reach maximum utilization the day rates will increase. In simple accounting terms 24 operating rigs at a $5,000 day rate increase grosses the company and additional $43.8 million dollars in annual revenue. As the revenue backlog of contracts grows and the lack of competition is felt, it won't be long before Hercules closes the gap between 2008 day rates and today. Since the company traditionally signs long term leases on its rigs the immediate spot price of oil or gas doesn't necessarily cause a spike in its share price.

Hercules Offshore, United States Oil and United States Natural Gas as safe havens from the threat of a pre and post nuclear Iran.

Due to geographical proximity and the obvious demand for more fuel worldwide, one can see the value of Hercules Offshore as a long term growth opportunity and as hedge against price variability in the oil markets. If Iran is indeed sworn to continue its nuclear policy, the United States or possibly Israel, will have no choice but to respond leaving many investors searching for defensive positions. Owning exchange traded funds like Unites States Oil, United States Natural Gas Fund and adding in growth stocks like Hercules Offshore, Inc., that have insulating geographic qualities, provides the perfect hedge against failed Middle East Diplomacy. Hopefully the world will be spared this disaster.

Disclosure: I am long HERO, USO, UNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.