The Case For Transocean

Transocean (RIG) was the most ridiculed addition to our watch list when it traded at more than $90 and our target buy price was a seemingly impossible $50. It closed yesterday at $54. When was it last over $90? You might think it was months ago. Nope, try April 22. In a month, it’s fallen 41% because of worries related to the BP Gulf tragedy.

Oil is not disappearing as a source of energy. It will remain the world’s primary fuel until the last barrel is sold because it is the best politically connected industry on the planet. No matter how awful the headlines get, no matter how much of the planet is spoiled by it, oil will flow because oil corporations pay to keep it flowing. We’re not judging that in this space, though judging it is a worthy pursuit. Here, we’re concerned with how we can profit from oil’s assured future as Earth’s energy.

The congressional testimony I’ve followed in the Gulf tragedy tells me that new regulations are on the way. In the media, the following excerpt from an Associated Press story that ran a week ago, is typical:

“It is long past time to drain the safety and environmental swamp that is MMS [Minerals Management Service],” declared Sen. Ron Wyden, D-Ore. “This agency has been in denial about safety problems for years.”

Sen. John Barrasso, R-Wyo., pointed to an AP investigation that found that rig that exploded was allowed to operate “without safety documentation required by government regulations” and that the government conducted fewer oil rig inspections than it initially claimed and less than its policy requires.

It’s a political calamity that the Obama administration authorized more offshore drilling just weeks before offshore drilling caused what is possibly the worst environmental catastrophe ever. To try to look proactive (even though it’s reactive) and pro-environment (to appeal to those who are willing to overlook yet another broken campaign promise to lessen America’s dependence on oil), the administration is eager to focus the news on everything it’s doing to save the world’s oceans. Safety, safety, safety will rule the day, just as it did following the Exxon Valdez spill in March 1989.

However, such political posturing is relatively meaningless over the long term. Just ask yourself: How much good did those new safety measures publicly announced in 1989 do us in the Gulf? Apropos to our pursuit of profit, how much did they hinder oil industry profits over the past 21 years? The answer to both questions is, not much.

The valuation of oil stocks here is assuming the opposite. It’s assuming that the oil business is going to be dramatically changed by safety regulations on the way. There will be a slowing in activity, but I doubt it’s going hamper long-term industry profit. To understand the impact, let’s consider how much of a slowdown could be on the way.

A key part of the new safety overhaul is blowout preventers, or BOPs. The leak at the bottom of the Gulf of Mexico is a blowout. We want to prevent those, hence an interest in putting BOPs everywhere possible. The best BOPs on the market today, as far as I can find, are good up to around 20,000 psi. The next class likely to be required will need to handle at least 30,000 psi. It’s no small task to develop a BOP that can handle 30,000 psi. It could take 2-3 years, in fact, for the oil industry to deliver one or more models.

During that interim, many of the rigs at work in the ocean today will probably lose their contracts. That will result in an abundance of rigs looking for work, thus day rates are expected to drop significantly. The owners of the rigs will need to outfit them with the new BOPs, and that will also dampen profits in the medium term. These concerns are why rig owners like Transocean are seeing their share prices get clobbered in connection to the Gulf leak.

However, we need to be precise in our worries when they apply to an industry as far-flung as the oil business. Will all rigs be affected equally? Probably not. It seems to me that the types of rigs that will be least affected are the ultra-deepwater types, exactly the kind that Transocean specializes in. Midwater and deepwater rigs are less powerful, and will therefore need extensive remodeling to handle the new BOPs. Ultra-deepwater rigs are the most powerful, and are already pretty close to being able to handle bigger BOPs. That means it will cost less to outfit them for the new regulatory environment.

Also, the contracts for ultra-deepwater equipment run long, so long that they’ll bridge this choppy period in many cases. That will guarantee to Transocean and its ultra-deepwater peers a stream of contractual cash flow more meaningful than political speeches of the moment.

Considering all the factors, I expect aggregate day rates to fall by about one third during the upgrade period, with ultra-deepwater rates falling less. To see what effect that will have on RIG stock, join me in a quick stroll through its history.

Ten years ago, RIG’s annual sales were $1.2 billion. They peaked in 2008 at $12.7 billion. That tremendous eight-year growth of 958% is testament to three factors: (1) the world’s growing demand for oil, (2) the increasingly remote location of oil supplies to satisfy that demand and, (3) RIG’s ability to help oil companies get at remote stores of oil. Which of those three factors do you see changed by current news in the Gulf? I see none. So, the macro thesis for owning RIG remains intact.

Since the 2008 peak, RIG’s sales fell to $11.6 billion last year. We can chalk that up to everything falling in the recession, and oil prices were among the hardest hit numbers. As demand appeared to be on tap again, oil prices and oil company share prices rose right away.

The trend back up in oil industry sales and RIG sales has been unmistakeable, hence our interest in the company. The reduction in day rates that might happen as a result of new regulations will probably just offset growing demand. In other words, sales are likely to plateau for a time, but not likely to fall much. Let’s be a little conservative and assume annual sales of $11 billion.

Currently, RIG’s price-to-sales ratio (PSR) is 1.6. Sales and revenue are the same thing, by the way. When we divide RIG’s stock price by its revenue per share, we get 1.6. You can try this at home once you know that its stock price is $54 and its trailing 12-month revenue per share is $34. Those trailing 12 months happen to have logged overall revenue of $11 billion, the price we’re assuming going forward as well. So, RIG is currently trading at a price that I see as being close to fair value.

How it might be less than fair value, and therefore a bargain, is if sales are better than we think they’ll be and the price investors are willing to pay for sales goes up. The latter is called increasing the multiple, and it’s usually said in reference to a higher PE ratio, but it works the same with PSR. Is there reason to believe investors will pay a higher price for the same revenue in the future? Yes, if they get more optimistic about the oil industry. Glancing toward the Gulf, one can’t help but think they couldn’t get any less optimistic.

We need not rely on conjecture, though, because we know what investors have been willing to pay historically — at least I do and you’re about to know. Over the past five years, RIG’s PSR has averaged 4.7. Are your eyes lighting up yet? If RIG just keeps revenue the same as it is right now, as we speculate it will be able to do even in a tighter regulatory environment, but its PSR grows from 1.6 to 4.7, then its stock price will increase to $160. That’s just $34 in revenue per share multiplied not by 1.6 to get the current price, but by 4.7 to get $159.80.

That right there is reason enough to be interested now, but making the case even stronger is that I consider a flat revenue picture to be the worst-case scenario. If regulations are less strict or companies like Transocean prove faster at implementing new safety procedures, the impact will be less. Given the world’s thirst for oil, I’m guessing that something better than the worst case is what we’ll get.

That’s why I’m itching to buy, and soon. The macro picture looks pretty solid, now we’ll try to get the tactical trade part right. With politicians just warming up and the oil still spewing in the Gulf, we’ll probably be able to buy RIG at prices even cheaper.

Disclosure: No shares of RIG…yet.

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One Comment

  1. Matt
    Posted June 18, 2010 at 2:04 am | Permalink

    I am playing with a stock simulator from I am using the simulator because I am a college student with little to invest with. I wanted to thank you for placing Transocean in my radar. Managing to purchase Transocean at $44.20 and it resting at 49.72, I have made 12.49% in about a week!

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