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It is true that offshore drillers and the oil industry, in general, had a tough time last year. For sure as my Seeking Alpha colleagues have noted, Transocean's (NYSE:RIG) backlog had a very challenging time in the past several years. It faced backlog and revenue declines. But at the same time, the backlog decline speed has recently fallen due to the industry recovery. If there is no financial crisis in the near future, Transocean has good chances to start growing since the oil industry is likely to see its golden days very soon. In this article, I will explain why.
The global energy deficit
Quite recently ahead of the heating season many countries discovered their natural gas reserves were empty. This was partly due to the fact they expected green energy sources to satisfy their energy needs. Lots of European countries, Germany in particular, rely heavily on wind energy. But, unfortunately, the weather was not windy enough. So, not enough energy was generated. Moreover, there was also a conflict around North Stream 2. So, not enough natural gas was imported to Europe as a result.
What is more, not all capacity can be quickly brought back online. The 2020 pandemic made many producers substantially reduce their capital spending to extract oil and gas. It is not always easy to bring everything back online. What is more, many American companies also want to improve their balance sheets and pay their stockholders juicy dividends.
As a result, we are facing a real energy supply crunch. You might think that it only applies to natural gas. On the surface, it does seem so. After all, as can be seen from the diagram below, the natural gas prices have almost doubled ahead of the heating season.
The oil price rally was much more moderate. However, not everyone realizes that oil and gas are substitute goods when it comes to heating.
As you can see from the diagram above, there was a dramatic spike in the spot price of natural gas during the 2020-2021 winter. The oil prices also rose. But it is not that obvious if we look at the graph. Instead of using natural gas which was in a very scarce supply, some people have switched to heating oil or diesel fuel to keep their houses warm during the last winter season.
It seems like it will be even more the case this winter season. That is why the demand for oil has further room to run.
The 2021 - 2022 winter
It is very hard to predict weather conditions. Many forecasts are highly inaccurate. However, it is highly likely this winter will be as freezingly cold as last winter. But the difference is that many countries seem to be even more unprepared for extremely cold weather conditions. This is not just Europe that is even willing to burn coal in spite of the very rigid environmental regulations. China is also struggling right now. This simply means that many countries are extremely vulnerable should this winter be colder than usual.
Many meteorologists argue that a La Nina will emerge. This could bring colder weather to the Northern USA and milder weather conditions in the south while making other parts of the world dry out. Meanwhile, the polar vortex that contains icy air above the North Pole is weaker than last year. All that could translate into a frigid cold in Asia, North America, and Europe, thus making this winter season very cold.
You could argue, of course, this fuel shortage is a temporary factor. However, that is not exactly the case. Whilst springtime will eventually come and the weather conditions will get better, the situation we observe now highlights a fundamental problem. First, the oil and gas industry has been highly underinvested. I am not even talking about the year 2020 when the oil and gas production and capital investments in the industry fell to astonishingly low levels. I am talking about the oil investment history from 2003 to 2019.
Source: Dallas Fed
As you can see from the graph above, oil investments have been struggling since 2016. The year 2020 has made matters even worse.
Secondly, green energy sources cannot fully solve the problem. Many large banks and other financial giants have recently reduced their investments in fossil fuels. Instead, they have actively started investing in environmentally clean energy sources. Some of them are more effective than others, of course. But many European countries, Germany and the UK in particular have recently seen how unreliable wind energy is. The same is true of solar batteries. They are excellent when the weather is sunny but they cannot generate enough energy when it is not sunny. Unfortunately, modern technologies still do not allow to accumulate solar energy and use it later.
That is why fossil fuels have really good growth potential. This means offshore drillers will also benefit from the recovery. In my view, developing countries will be even more likely to benefit since many developed countries have lots of environmental restrictions in place to limit oil production. I wrote about this in a lot more detail in my other article. Transocean clearly stands as a beneficiary here.
Transocean's undervaluation
Given the situation, it is not very clear why Transocean's stock is trading that low. After all, Transocean is an offshore oil driller. Its revenue and therefore the stock price relies heavily on the oil prices. Big Oil invests heavily in offshore drilling contracts if it is profitable for them to do so. It is therefore obvious that there is a correlation between the oil prices and the company's stock price.
If we see the recent years, there were times when a barrel of Brent used to cost much lower than it does now, whereas RIG stock traded much higher than it is trading now.
You could argue that it is the backlog problem that matters here. Transocean's backlog is now much lower than it used to be two or three years ago.
Source: Seeking Alpha
It might seem reasonable. However, I also composed a graph for the recent 6 months. After all, there were no significant changes in the company's backlog during the period. At the beginning of July, the company's stock price was above $5, whereas the Brent crude oil spot price was lower than it is now. However, as of the time of writing RIG stock is trading at a price below $4 per share. Even if we take the short-term perspective, the stock clearly deserves to trade higher.
Transocean's latest fleet status report stated the company's backlog declined from $7.4 billion in April to $7.3 billion in July. This was at the slowest pace in recent years. This was a really good result given the company had reported a rapidly declining backlog before. But how about this winter season? And what will happen in the future, given the oil prices will keep rising? In my view, Transocean's stock will skyrocket.
Conclusion
It is highly challenging to predict the future. However, it seems to me that the energy crisis will not last for one season only. It looks like we will face the fossil fuels deficit for a while. That is why the oil and natural gas industry will benefit from capital investments in the near future. Transocean will also clearly be here to gain.
RIG's stock price is unbelievably low, even given the current oil prices. But if we face permanent deficits in the future, Transocean's stockholders will face huge gains.
Of course, everything is possible. In my view, the greatest stumbling block for this prediction is the global economy's health. Many macroeconomists say the Fed and other central banks will most likely begin to tighten the monetary conditions in the near future.
But at this point, I would say Transocean has a bright future.
