This Oil Stock is Still a Bargain

Tim Begany's picture

Friday, June 17, 2011 - 9:00am

by Tim Begany

Oil and gas drillers have really perked up in the year or so since the Deepwater Horizon oil spill sloshed about 200 million gallons of crude into the Gulf of Mexico. As a group, these stocks have returned nearly 45% in the past 12 months and are up almost 6% year-to-date.

But they haven't all recovered so nicely. In fact, since the spill, shares of an industry behemoth previously known mainly for its big, modern rig fleet and global presence are down more than 30%.

The fact that Switzerland-based Transocean (NYSE: RIG) owned the rig that caused the spill has certainly helped depress the stock. So has a $42 billion lawsuit against the company filed by BP plc (NYSE: BP), which leased and operated the rig. A sizeable first-quarter earnings miss hasn't done the stock of any good, either.

But you know what? All this has positioned the stock for what could be a phenomenal run. In the next three to five years, it may double or better for a couple reasons.

First, at about $62 a share, the stock is available for less than half its actual value of $135.88 a share. To get that number, I multiplied the per-share book value of $67.94 by the historic price-to-book (P/B) ratio of 2. Book value is what Transocean's drilling rigs and other assets would theoretically sell for on a per-share basis if the company were liquidated today. As the historic P/B ratio indicates, investors have typically been willing to pay two times book value for Transocean stock, and I believe they will again as the Gulf spill fades into the past and drilling activity gradually returns to normal levels. Bear in mind this simple calculation doesn't incorporate dividends, which are expected to total $2.45 a share this year and could add a couple dollars or so to my estimate of the stock's value.

 

The $2.45-a-share dividend translates to a yield of 4% based on the stock's current price, which analysts say already factors in most of the concern about how much liability Transocean may incur for its role in the Gulf spill. BP is believed to be largely at fault for the spill as a result of cutting corners on safety, so the $42 billion lawsuit I mentioned may pretty much end up as a failed attempt to pass the blame.

Right now, all Transocean needs to achieve its impressive potential is a catalyst. I think that'll materialize over time in the form of good old-fashioned earnings.

Despite its hardships, the company signed $2.5 billion in new contracts in the first quarter. That brought its contract backlog as of mid-April up to an estimated $24.6 billion -- more than two-and-a-half times 2010 revenue and about two times 2009 revenue. Furthermore, management says market utilization and day rates for all types of rigs should remain steady or improve the rest of this year and throughout 2012 on higher commodity prices and a gradually improving global economy.

This statement may ring false since drilling in the Gulf of Mexico is nowhere near pre-spill levels and isn't expected to be for another year. However, Transocean has the world's largest drilling fleet -- its closest competitor only has half as many rigs -- and operates globally. It should be plenty busy extracting new finds in the Black Sea, for example. There should also be huge rig demand for at least a few years from Petroleo Brasileiro S.A. (NYSE: PBR), the federal oil company of Brazil, which will need to lease deepwater drilling equipment until it finishes the fleet it's building to extract the roughly 80 billion barrels of oil discovered off the shores of Brazil in the past four years.

In the next five years, analysts foresee Transocean's annual earnings growing by more than 22%, compared with 11.5% for the industry as a whole. Transocean is set to outperform because it far outstrips the competition in the number of and expertise with deepwater rigs. This also makes the company less vulnerable to the more volatile shallow-water rig markets. Customers particularly value Transocean's ability to limit downtime, since deepwater drilling costs an average of about $650,000 per day and can run as high as $1 million a day. The average cost to rent drilling equipment from Transocean is an average of about $283,000 daily for all rig types (ultra-deepwater, deepwater, midwater and shallow water).

Action to Take --> At such low prices, Transocean is a strong buy. Yes, there's near-term uncertainty because of the Gulf spill. But, again, most of this has likely been priced in, though it could keep the stock from advancing much in the short-term. However, I like Transocean for the long-term because of its size advantage and deepwater expertise. To me, it's the world's No. 1 play on oil and gas drilling, and the stock should rise considerably with energy prices over time.

P.S. -- I don't know if you're aware of this or not, but a 20-year energy agreement between the United States and Russia is about to expire. The problem is, this deal supplies 10% of America's electricity. When the Russians refuse to renew the agreement, the U.S. will face an entirely new kind of energy crisis. This disruption could send a handful of energy stocks through the roof. Keep reading…

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of RIG in one or more of its “real money” portfolios.