Rising Stars Buy: Transocean

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This article is part of our Rising Star Portfolios series.

It's no secret that offshore drilling, especially in deep water, is one of oil exploration's last frontiers. Until the recent oil shale revolution, domestic onshore oil production declined for almost 25 years running. The future of oil exploration rests on several-story masses of metal straddling the ocean floor, each a football field wide, drilling 5,000 feet (or more) below the ocean's surface to extract untold quantities of oil.

Transocean (NYSE: RIG  ) , the industry vanguard, practically wrote the book on offshore contract drilling, and it remains the industry leader in size, quality of assets, and technological expertise. But concerns over the economy's still-tentative recovery, additions to the deepwater rig fleet, liability over the Gulf disaster, and accompanying legislation have blotted the shares … or, depending on your perspective, created opportunity.

I think investors' overreaction allows us to buy into the megatrend of deepwater oil exploration at a bargain price. Add prospective industry benefits from the recent Pride-Ensco (NYSE: ESV  ) tie-up, and a possible spin-off, and you've got a value buffet.

I'm purchasing a position in Transocean worth 4% of my first year's capital for my Rising Stars Portfolio.

The business
Transocean makes its living in a delicate science: providing the technological wherewithal and astoundingly complex rigs to extract oil from the ocean's depths. Transocean owns 16 deepwater and 26 ultra-deepwater rigs, with one more on the way, and it derived 50% of 2010 revenue from deepwater activities. Its most technologically advanced rigs lease for $700,000 per day.

Deepwater drilling's also a very good business for Transocean. In this complicated field, technological know-how is crucial -- and Transocean is one of the industry's most experienced operators.

Moreover, because Transocean owns half of the existing worldwide deepwater and ultra-deepwater fleet, and capital barriers to new builds are substantial -- they cost $300 million to $700 million each --Tthe company can influence rates and extract attractive terms through disciplined contract negotiations. While I'd expect this advantage to wane as newly built rigs come to market, the industry dynamic is currently relatively concentrated: five companies own 93% of existing deepwater rigs. Although the industry is cyclical, I'd expect that to reduce cutthroat competition at the high end of the market.

Additionally, there are some heavy demographic influences at play: an emerging market consuming more and more fossil fuels; attractive sector dynamics for deepwater drilling; and an installed infrastructure that's got the world addicted to oil for the near-term. All of that bodes well for Transocean.

The good, the bad, and the opportunity
That said, Transocean's obviously fallen on recent hard times. Questions over legal liability associated with the Macondo disaster, costs from regulation, and a still-dithering economy have left shares hurting ... and created our opportunity.

Let's start with the bad, or seemingly bad:

  • Legal liability and regulation: I think this point is moot. Transocean's contract with BP (NYSE: BP  ) indemnifies the company from environmental liability, save the most egregious of screw-ups. BP and Halliburton (NYSE: HAL  ) seem to bear the brunt of their blame for their flawed well design and willful ignorance of warning signs. Transocean's account of the events supports that argument, as do the government report and even BP's account of the events.

    Last, but certainly not least, BP -- as the well's operator -- bears ultimate legal responsibility. Transocean also has $1 billion worth of insurance, which should soften the potential blow. Something could happen, but at today's prices, I think we're adequately compensated for that risk.

    On the matter of legislation, drillers will bear higher costs. But high demand for rigs means premium drillers like Transocean can more easily pass these costs to their customers.

  • Deepwater deliveries: Deepwater rig counts are expected to increase more than 40% by the end 2013. But the International Energy Agency expects that worldwide liquids production will grow 26% by 2035 (from 2007 levels). Approximately half of these rigs are contracted, and according to Petrobras data, 87% of the oil needed to meet worldwide demand estimates isn't currently developed or discovered. On that basis, I'm confident that oil demand will help soak up excess rig supply. Again, if it's not, I think we're adequately compensated for that risk at today's prices.

And now the good:

  • A possible spinoff: For all the talk of its premium assets, Transocean has a few shallow-water rigs that aren't exactly the cream of the crop. Investors keep speculating that Transocean will either sell those rigs piecemeal, or spin them off into a separate company.

    In its last conference call, management said it's thinking about a spinoff, which I think makes obvious sense. The market seems to be undervaluing Transocean's deepwater assets, perhaps in part because the shallow-water rigs drag them down by association. Selling those rigs or spinning them off might boost shares' value.

  • Pride-Ensco tie-up: Prior to Ensco's acquisition of Pride International, Pride had a bad nreputation for consistently underbidding contracts, pushing down day rates and returns industrywide. Now, Ensco and Transocean hold about half of the current deepwater rig capacity, which should help drive rates higher.

Valuation and risks
I expect that deepwater rig rates will average $465,000 per day, midwater floaters will average about $300,000 per day, and jack-ups will gradually decline below $90,000 (and experience relatively low utilization, as Transocean's fleet is fairly old). On this basis, I expect Transocean's operating margins will average 35%. I peg the shares at about $95 a stub.

The primary risks here are straightforward: New rig deliveries, legislation, and potential fines from the Gulf tragedy. I think today's price pretty adequately accounts for these risks. In addition, remember that drilling decisions ultimately depend on oil prices. A bump isn't particularly worrisome, as oil prices and rig rates should recover. But a nasty double-dip or a widespread Eurozone crisis would be more worrisome, as oil prices might experience a prolonged malaise, which would depress rig rates and discourage drilling activity.

Bottom line
The sum of it's pretty simple: I believe Transocean shares are cheap, and that deepwater drilling will become increasingly important to the world's energy infrastructure. There are many ways Transocean shares can get more expensive. That's why I'm buying now. Join me on my discussion board to talk about it.

Michael Olsen owns shares of Transocean. The Motley Fool owns shares of Transocean and Ensco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 29, 2011, at 4:43 PM, Seering wrote:

    Why would you choose RIG over say ATW, which trades at similar P/E, with higher margins, and has none of the political risk, and has a fleet much younger then RIG. Dont need to spin off the crap, it just doesnt have it.

  • Report this Comment On June 30, 2011, at 11:42 AM, energysystems wrote:

    While I do believe that offshore drilling is the future of oil, I own SDRL. Although currently a much smaller fleet size than RIG, they are expanding very rapidly. Much lower P/E, their fleet is far more modern, they have a higher fleet utilization rate, and they pay a substaintial dividend. The real difference for me, is the fleet age. RIGs deepwater fleets' average age is 21 years(SDRLs' is 5 years). RIGs jackup fleets' average age is 28 years(SDRLs' is 4 years). SDRL is constantly spinning off older assets(rigs), and investing in new ones. They also have a pretty smart guy running the show.

  • Report this Comment On June 30, 2011, at 7:00 PM, polenium wrote:

    If there is any environmental justice, this company will be shut down. We need to put our resources into sustainable energy and a healthy planet and stop funding the Hail Mary passes of a dying industry. We're toast if we don't emissions by 80% in 2020.

    I'd really like it if the Fool stopped looking so much like Goldman Sachs and took a stand on responsible investing.

  • Report this Comment On July 01, 2011, at 11:25 AM, energysystems wrote:

    polenium-Earth is 75% covered in water. It's natural for the progression of oil drilling to go into the water. Renewables would work, if they were as cheap as fossil fuels. With the continued rise of the cost of fossil fuels, renewables will become used more and more. But what should we do, buy electric cars and end up using more coal? Until sustainable energy becomes fiscally sustainable...we'll use what we have.

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