Transocean Offshore: Contrarian Put Spread Idea

Last week was an absolutely wonderful week to be an options market participant. We hope you've been enjoying the market's manic-depressive mood swings as much as we have - euphoria one day; doom and gloom the next. Market participants need to sometimes turn that sort of noise off and focus on the bigger picture.

So the Fannie Maes (FNM) and Freddie Macs (FRE) of the world are now thought of as insolvent? Interesting. That would have been unthinkable a year ago - we published reports with put spread recommendations on FNM and FRE starting back in February of 2007, and were soundly roasted on the pages where we posted them. We made a bunch of money on those positions though, all the way through 2007. We're looking now at the next 18-month cycle of waves. In that line of thinking, we'd like to be contrarian and position ourselves for a surprise - although with a little forethought and a look at the numbers, can anyone REALLY be surprised about the FNM and FRE debacle?

Today's pick is in the oilfield services sector, and its a company we've traded to the upside before - Transocean Offshore (RIG). We saw good news on the stock last week with the award of a contract of significant size, although the stock reacted downwards. That piqued our curiosity - something doesn't jibe. We think the market could be telegraphing that the price of oil is about to turn - that commodity's run is tired. We're already positioned to benefit from an expansion in the refining spreads with calls on Valero (VLO) and Tesoro (TSO) (see last week's picks) and now we'd like to hedge those picks with a put spread on RIG. Is this a contrarian call? Yes, it is. Once again, we're positioning ourselves in front of a potential wave of change that will be pretty dramatic if it comes. Those are the kind of bold plays that get rewarded in the options markets.

Technical Analysis

The chart above shows RIG shares for the last six months. The stock has risen strongly this year, as rental rates for offshore oil rigs and drilling platforms have been solid.

The Relative Strength Index [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are both slowly deteriorating though, and given last week's record oil prices and RIG's contract win, it's our feeling that these shares, on a technical basis, should have been stronger.

RIG Fundamental Data

• Current Price: $146.33
• Shares Outstanding: 318.8 million
• Market Cap: $46.7 billion
• Forward Price / Earnings (Avg. Est): 8.7x
• PE/G Ratio (5-Year Expected): 0.4x
• Price / Book: 3.4x

Transocean Offshore (RIG) is part of the Philadelphia Exchange's Oil Service Sector Index [OSX] - with a significant weighting of roughly 16% of the Index. We evaluated a put spread on that index while constructing this recommendation, and in our opinion the bid /ask spreads on the options on the OSX index are wider than we are comfortable with at this point. The Implied volatility components of the options of both are comparable, but RIG's price spreads are much more appealing.

Just for the record, the current makeup of the Oil Service Sector Index is as follows:

RIG continues to see growth in its revenues, and they are posting the types of numbers that many companies can only dream about today. Comparing year-over-year quarters, RIG's revenues are expected to rise to a level of $3.0 billion during 2Q08, a gain of over 112% from last year, 2Q07, of $1.4 billion. Analysts are expecting a $12.6 billion dollar revenue year for the full year 2008, a gain of 97% over last year's $6.4 billion. That torrid pace has to slow, though, and for the year ending December 2009, expectations are that revenues climb above $14 billion, which, although good, is "merely " a gain of 12% YOY.

All earnings estimates have been stable, with 2Q08 estimates staying at $3.21 per share, and full year 2008 estimates remaining in the $14.20 range per share. The shares represent reasonabe value from a price / earnings ratio perspective. What may come into play here is the rate of growth slowing. For 2009, the full year earnings expectaions are for $16.70. Again, not too shabby, but the pace of growth is slowing. If there is a pullback in energy prices and additional capacity is built in offshore oil rigs, there could be impact to the rental rates that are currently at all time highs in this space.

RIG's balance has $1.6 billion in cash, or about $4.90 per share. The debt they carry though, amounts to over $16 billion - building those rigs costs a LOT of money. The firm's EBITDA is $4.3 billion on a trailing 12-month basis. Any softness in the space that RIG operates in - or any perceived softness - and the shares could pull back fairly quickly.

Investment Recommendation

We recommend investors buy an August put spread in RIG options. We would buy the August $145 puts for $7.20 and sell the August $130 puts for $2.10, for a net cost of $5.10 to this spread. We would look to sell this spread at a price of $11.20 over the next month, and this 'trigger' can be entered with your broker. Please note that these options have only 33 days to expiration, so we think entering that sales price target with your trading broker is a good idea.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in RIG stock or RIG options.

 

Comments

[davy wavy]

With these kinds of numbers (PE,PEG,etc.) in a fundamentally growing industry, and with the offshore oil discoveries continuing, and with longterm future rig contracts in place, how anyone could hope to turn a significant profit speculating on the downside from Transocean is a far stretch in my opinion. The risk vs return is tough going except for a brief period here or there...pure speculation!!

[frdm45]

Very contrarian indeed. Don't companies like Transocean sign contracts with clients like Petrobras with durations of 2, 3 or even five years? Transocean has announced a flurry of contract signings in the last few months, I would assume they are based on oil being at least over $100 dollars. Wouldn't the flip side of that be that the revenue they are bringing in now is based on where oil was 2 or 3 years ago? Wouldn't that mean that today's P/E doesn't really reflect oil at over $75-$100 or more per barrel? I would guess Transocean factors into their price the profit margins the customers are making on the oil they drill or at least the price is influenced by it? Aren't there also relatively high barriers to entry in the offshore oil services market? I don't really see much of a downside in RIG especially in the medium to long term. Maybe I'm missing something. I know the debt is a bit high but they expect to pay that down quickly in a few years with their amazing amount of cash flow. If I've overlooked some crucial fact please enlighten me.

[frdm45]

..........also, why is this stupid post about SOL here?

[Hutch]

Very nice call.