Transocean: An Opportunity in Falling Oil

Crude oil's price has fallen from over $145 in July to under $115 in August and there is every indication it will fall further, at least in the short-term, as expectations of global economic growth and the associated thirst for energy are both trimmed. As irrational as was the rapid surge to nearly $150 oil, current sentiment could easily take oil to $100 or lower, despite the predicted continued growth in long-term demand. Mr. Market, as is often the case, is hardly rational or efficient in the short-term -- his wild exuberance in driving the price of black gold sky-high has now been replaced with depression, which even potential threats to supply cannot turn bullish.

This sudden fire sale of all things related to oil has created some opportunities, as various energy stocks have been brought to below fair value. Though this applies to quite a few companies, one that I like and will use as an example is Transocean (RIG). Based in Houston, Texas, Transocean is the world's largest offshore drilling contractor. As of earlier this month, it owns and operates 137 mobile offshore drilling units, to include 39 high specification floaters (which include ultra-deepwater, deepwater, and harsh-environment semisubmersibles and drillships); it also has 10 ultra-deepwater newbuilds with ex-shipyard deliveries beginning in 2009.

Analysts' consensus growth prediction for Transocean is 22% annually over the next five years. Last Friday, RIG closed at $126.24, for a trailing twelve month P/E of 7.91. Earnings per share are expected to reach $14.43 this year (Dec 08) and $16.50 next year (though some estimates range as high as $15.31 and $18.36, respectively), resulting in a 2009 forward P/E of 7.65. Price to cash flow is also a very low 6.86. At these P/E and P/CF ratios, well below the industry average, one is buying this growth very cheaply. Prospects are good, too, with the revenue backlog growing to almost $41 billion and a new contract with Petrobras. On top of that, Transocean's profit margin, annualized from the most recent quarter, is a very respectable 44%.

The world will not quit growing its need for energy, nor the resultant demand for offshore drilling platforms, in the foreseeable future. At the moment, the market seems to be pricing Transocean for both of those events. Even if the price of oil continues to fall precipitously, deepwater drilling, by one estimate, is economical down to $60-$65. As for rigs flooding the market, Transocean estimates that 70% of new construction is already contracted.

Currently, as energy prices continue to correct -- I suspect that they will continue to do so for a while --  Transocean's share price will likely continue to experience weakness, as Mr. Market marks down everything associated with oil. Therefore, there is no need to rush into this trade -- watch the markets and, when oil regains its footing (don't know when that will be!), it will be a good time to either get into the trade or to add onto existing positions. Transocean will certainly not be the only opportunity in the oil services sector -- a little digging can bring up several more, Noble Corp. (NE) being just one example.

Disclosure:  I am long Transocean calls, though I think it is still a little too early to jump in with significant funds.

Comments

[Emerald:]

Momentum traders (most of Wall Street) are moving out of energy and seeking a new home. The reality of a marginal oil surplus will return with a vengence in another six to twelve months and drillers will florish.

2008 Aug 18 11:27 AM

[Brian Pursley:]

None of which has any impact on Transocean. On the conference call Lee Cooperman asked Bob Long about the commodity price and Bob said and I quote "on the price of oil that will justify deepwater, it’s difficult to say based on some input from a few operators that we hear consistently. My guess would be -- and it’s obviously a total guess -- is that $35 a barrel range is probably up now to the $60 or $65 a barrel range, maybe higher in certain areas." So oil can drop to $60 and Transocean will still be the best and cheapest company in the world.

2008 Aug 18 12:15 PM

[whidbey:]

why get into something where demand is unknown and unknowable, and supply is so varied in respect to refining capacity that no one predict what will be produced, not to mention sold. What is this compulsion to play in the traffic just to see if you can avoid being hit. You are nuts, of course you hold calls.

2008 Aug 18 05:15 PM

[Pipo:]

Read a bullish call on oil by Jim Rogers in:

jimrogers-investments....

If he is right about oil, oil stocks will soar.

2008 Aug 18 07:03 PM

[Camden:]

Brian, I agree with you, but if oil drops to $65 the dayrates RIG can get will be at half of their recent contract prices. The PE will drop to under 6 and the stock will be under $100. Fortunately for RIG holders oil is not likely to drop anywhere near that far. World growth may be slowing but there will still be substantial growth – for at least a couple years, if not decades.

2008 Aug 18 07:51 PM

[Oilwillpull...:]

Didn't RIG add $6B to the backlog in this lastest quarter?

2008 Aug 18 08:22 PM

[freefall51:]

Pipo,

thanks for that link to Jim Rogers. What a smart dude that is.

It is not easy to be an oil bull these days. But I strongly believe that investment decisions with a volume of $ 1 B like for a deep water rig must be based on strongest fundamentals and cannot be based on the vagaries of momentum traders. That would be completely ridiculous. Jim Rogers makes a compelling bull case.

2008 Aug 18 10:50 PM

[BudaBob:]

Rig's backlog suggests it is in fine shape for the next 5 years.

2008 Aug 19 09:46 AM

[Jim Kingsdale:]

Are RIG contracts at fixed rates or do some of them, if not all, call for lower rates if oil prices fall?

2008 Aug 19 09:52 AM

[freefall51:]

Jim,

You raise an interesting question that is not obviously not easy to answer for an outsider. My thinking goes like this (solely based on my background with long term supply contracts in the industrial gas industry):

RIG issues as list of their contracts for their 130 something rigs. Some of them are short term like 1 year, others are 3 - 5 years, the new rigs often with an option to extend for another 5 years to be exercised by the client. The contracted service rates should be escalated with some inflationary indices or alternatively go up or down with oil. I estimate that 15 - 20% of the service contracts are up for renewal every year. On average the profits that we see today have been contracted 2-3 years ago. For those contracts you should reasonably assume that the breakpoints where the rates are negatively impacted have been defined according to the oil prices 2 -3 years ago. I would not expect a big impact for the current service contracts if oil drops below $100 or even $80/ bbl. I snapped up somewhere (unfortunately I cant remember the source) that the latest contracts with PBR had a breakpoint of $ 100/ bbl. I remember that I thought that is conservative, when oil was above $ 130 at that time. Now the latest contracts are going to be effective in 2 years. What will the oil price be then?

2008 Aug 19 11:21 PM

[Omaha_farm_boy:]

Interesting. Boone Pickens was here in Nebr. today -- pimping his project, of course. BUT ... look / Google for an article in the NYTimes on Peak oil. No politics even -- and yeah, it WAS the NYT! Just Google this phrase "oil production has begun falling at all of the major western oil companies" ... to find the sources.

BUT it makes the point that the "Big Seven" traded oils (XOM, COP, TOT, CVX, etc) control only 13% -- the rest is held by the "Nationals" like PeMex.

MY point is that even the Nationals are gonna need help -- RIG is making deals with PetroBras NOW ... and I'll wager they will with PeMex too. OFB

2008 Aug 21 12:29 AM