Newsletter Value Investor Insight carried an interview August 25th with Robotti & Co. manager Bob Robotti (pictured left), whose $500 million fund focuses on small and microcap stocks and has generated an average net return of 17.4% per year since its launch in 1983, versus a 10.3% for the Russell 2000, according to Value Investor Insight. Here's the segment of the interview in which Mr Robotti discusses his position in Atwood Oceanics (ATW), which was trading at $41.18 at the time of the interview (chart here):
You’re a long-time investor in the energy business. Where do you stand on the question of whether things are “different this time” with respect to prices?
BR: Our portfolio is currently about 30% in energy, so it’s the biggest industry exposure we have. Having invested in the business as long as I have, the one thing I know about energy prices is that whatever the consensus is about future price movements will be wrong. It always is.
The big increase in energy prices has added a lot more commodity risk to investing in the sector today. It’s harder to be totally agnostic about the prevailing price levels. I do believe the energy market has fundamentally changed and there will be a new long-term, market-clearing price for energy that is higher than it has been. How much higher, I have no idea. The excess supply in the global industry actually started to be used up by the mid-1990s. Because this is a long lead-time, capitalintensive business that has gone through 20 years of underinvestment, it will take many years for responses on the supply and demand side to work their way through the system.
As that happens, what areas of the energy business do you consider most attractive?
BR: In general, I believe the service companies are more attractive than producers in the current environment. Whether oil is $40 per barrel or $70 per barrel, I’d argue it’s not going to have that much impact on demand for services. Many of the big oil companies have declining reserves and will be desperate to add reserves. To do that, they’ve got to spend on finding and developing new production or getting more production out of what they already have. Well-positioned service companies will benefit from that trend for a long time. As I mentioned earlier with Acergy, service companies involved in deep-water exploration should be particularly strong. Exploration success as the number of provinces expands will only breed more activity. At the same time, because of the expense and lead times on the capacity side, there’s much less risk of oversupply than with land-based drilling.
Tell us about another of your favorite oilservice holdings, Atwood Oceanics (ATW).
BR: Atwood is a contractor of large offshore drilling rigs. Four of their rigs are semi-submersibles, which can drill in 3,000 to 5,000 feet of water, for which the leasing rate is now about $400,000 per day. The other rigs they own, which drill in shallower water, go for closer to $200,000 per day. There’s huge operating leverage at current rates: operating costs are $45,000 per day on the semisubmersibles and $30,000 per day on the shallower-water “jack-ups.”
From investing in energy for a long time, you develop an appreciation for smart managements that know how to operate in a cyclical business. They don’t spend money on capacity when everyone else is and they add it on the cheap when no one else wants to.
From 1982 to 1991, Atwood didn’t spend a penny on equipment because they thought the business was going to be oversupplied for years. Then in 1991 they bought an interest in three rigs for $6 million. They spent $10 million to refurbish the equipment and then in 1995 bought the remaining interest for another $16 million. So for $32 million, they owned equipment that had been built in the early 1980s for $240 million. They’re very good capital allocators and understand how to build value.
Isn’t the concern here that many in the industry won’t be so prudent and too much capacity will be added?
BR: Exactly. There are currently around 200 deep-water rigs on the market – semisubmersibles and drill ships – and another 35 are under construction. Most of those rigs are not being built by the traditional industry players, but by speculators who are betting on day rates staying high. Is that too much new capacity? As I said, I’m convinced demand for deepwater drilling is going to explode. So much so that I don’t think the market will be able to meet the demand, even with the new capacity. The world just needs the production from these deep-water provinces.
How does this view play out in your earnings estimates for Atwood?
BR: Their full fleet is contracted out for next year and almost all contracted the following year. Based on contracted rates, the company should earn $5 per share next fiscal year and more like $9 in fiscal 2008. Given that some contracted rates are well below current rates and that they have a new rig coming on in 2008, we think sustainable earnings – at current market conditions – are more like $11-12 per share. Given our view on supply and demand, we believe that’s sustainable for some time.
With the stock recently around $41, the market seems to disagree.
BR: Yes, given that the shares trade at less than 4x what we think the company is going to earn in three years, the sustainability of earnings is clearly where our view differs from the market. The company will have no debt by the middle of next year, so their net earnings will be mostly cash earnings. So within three years, then, not only will they be earning at a very high level, but they will have accumulated $20 or so per share of cash. If that happens, it doesn’t take very sophisticated math to arrive at a share price significantly above where it is today.
What if oil prices go down?
BR: Exploration to find a deep-water field costs $5-7 per barrel. Producing it then costs another $3-5 per barrel. So whether oil is at $75 or $40 won’t make that much difference on demand.