A Safer Bet Than BP — and Still Plenty of Upside

The energy industry has been especially turbulent recently, and investors looking for opportunity in companies afflicted by the offshore rig explosion and subsequent oil spill in the Gulf of Mexico are positioned right in the middle of the hurricane.

I’ve spent some time in the hurricane and have concluded that the share prices of BP plc (NYSE: BP) and Transocean (NYSE: RIG) have fallen to levels that more than discount the downside risk to their operations. [Read: Forget BP: Buy This Instead]

Risk for these stocks stem from cleanup costs, litigation on who is to blame in the calamity and the loss of reputations that will be extremely difficult to rebuild. However, uncertainty is high and no one has a crystal ball on how things will shake out. A safer bet may be to steer clear of these risks and focus on other industry players that are seeing collateral damage from the debacle and are far less likely to see their operations torpedoed by the above risks.

One such opportunity is Diamond Offshore Drilling (NYSE: DO), which along with Transocean, is among the largest offshore drilling firms in the world. Diamond had seven of its 13 semisubmersible rigs operating in the Gulf when the disaster struck, and is losing plenty of revenue due to the subsequent government moratorium halting drilling out of safety concerns for another spill.

This is obviously a near-term setback, as is the negative sentiment that has swept over the industry. Diamond’s share price has fallen roughly -24% since early May and is down almost -60% from when the economy was in full swing and oil prices were reaching all-time highs a couple of years ago.

A frothy oil price is unlikely to be reached again for some time, but economic growth should eventually pick up. The oil leak has been plugged and the Gulf region can begin the painful task of returning to pre-spill condition. BP and related parties will remain entrenched in this process for years to come.

Diamond Offshore, on the other hand, operates in other parts of the globe with a focus on Brazil, Mexico and many parts of Asia. The company can easily shift production and capitalize on the most economical offshore drilling locations. In fact, it may earn additional business as Transocean remains distracted in the Gulf.

For the full year, Diamond should still earn around $7 per share. This includes a good amount of downside from the moratorium and gives the stock a very low forward P/E of less than nine times earnings. The lowest multiple the stock had previously seen in the past 15 years were in 2008 and 1998 — when the average P/E fell to 11.6 and 13.7, respectively. A key driver in this relationship is earnings, which fluctuate along with the price of oil and subsequent demand for offshore oil and gas exploration. Activity remains healthy, as management had a strong $8.2 billion backlog (representing more than two years of revenue) going into the current economic downturn.

Operationally, Diamond Offshore posts industry-leading returns on invested capital and had already been actively redeploying rigs out of the Gulf into more lucrative parts of the world, such as Brazil, Angola and Australia. It has also spent billions upgrading its fleet during the past decade, which helps support utilization of its fleet and the day rates customers pay for its rigs.

Action to Take –> Diamond offshore stands out as a solid choice, as it not directly involved with the Gulf oil spill risks and has only been hit by the short-term drilling ban in the region. Upside exists from an improvement in the currently negative industry sentiment, economic recovery and long-term appeal for offshore drilling as land-based reserves deplete over time.

A return to more normalized double-digit earnings multiples and profit recovery should combine to push the shares up by at least +40% in the next couple of years. Given current industry dynamics, buying the shares is a relatively low risk way to profit from more normalized energy conditions.