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Transocean--An Opportunity Amid Uncertainty

We like this offshore drilling firm's profit potential and prudent approach.

Stephen Ellis, 07/30/2010

These articles were originally published in June and July 2010 for the Opportunistic Investor newsletter.

We think that opportunities are opening up across the energy industry because of the whole Gulf oil spill fiasco. One of these is Transocean RIG, whose rig BP BP was leasing when the disaster struck. The market is currently terrified of anything connected with BP or the Gulf of Mexico. Because Transocean is smack dab in the middle of the mess, its stock has fallen to $45* from $92 in a rapid fashion. 

There is no question there is a tremendous amount of uncertainty around the company and the industry. Deep-water drilling is heavily restricted in the Gulf of Mexico, and thousands of barrels of oil have leaked into the Gulf. The eventual damages will reach tens of billions of dollars. Despite these risks, we think investors have also unduly punished Transocean. As we will show below, we think the oil spill will affect the company's fundamentals less than what investors are expecting, and the stock represents a compelling investment today.

Impact of the Oil Spill on Transocean
The loss of Deepwater Horizon, though tragic, doesn't have a huge impact on Transocean's financial health. The rig was insured, and the insurance already paid out the claim. In fact, in the short term, the $560 million insurance payout is a good thing for Transocean.

We think there are two main sources of uncertainty for Transocean:

* Potential financial liability from the oil spill

* Structural changes to the deep-water drilling industry, especially if drilling in the Gulf is banned for a long period of time.

Let's tackle these one by one. The regulatory/legal framework governing the spill is the Oil Pollution Act, enacted in 1990 after the Exxon Valdez disaster in 1989. The OPA basically sets up a mechanism where affected people (fishermen, people who own beachfront property, and so on) can receive compensation from a "responsible party," which is designated by the Coast Guard.

BP has already accepted its designation as a "responsible party" for all spills originating under the surface of the water and is already paying out claims. Transocean has also been designated as a responsible party but only for claims arising from the rig itself. Obviously, damages from a gushing oil well is gargantuan compared with possible leakage from the sunken oil rig, so Transocean has not been hit by any claims.

The OPA stipulates that BP must pay out all reasonable claims stemming from the Macondo well disaster once it accepts its designation as the "responsible party," but the firm may recover damages from third parties through further lawsuits. So, if BP determines that Transocean contributed to the disaster, then Transocean may be liable for damages. However, the burden of proof then falls on BP, and that burden is quite high. BP has to prove that Transocean, while following BP's orders, was grossly negligent or incompetent which materially contributed to the spill. When BP sues Transocean, which we think is very likely, the legal battles will probably last for years. This is OK with us because the important thing is to avoid the immediate multi-billion-dollar hit from cleanup costs and civil damages. In fact, the longer the lawsuit drags on, the better for Transocean.

Although the spill's damages will probably eventually reach several tens of billions of dollars, we think BP will bear the brunt of the pain because it had ultimate control of the rig, it had a history of cutting corners and acting irresponsibly, and its reputation in the U.S. is extremely poor at the moment. Nevertheless, Transocean will probably eventually have to pay something after lawsuits start flying. By investing in the stock, we are implicitly making two bets:

* The total amount will be manageable, in the single-digit billions after insurance in a worst-case scenario as opposed to double-digit billions. Transocean has about $1 billion in insurance.

* The hit will be spread out over many years, as opposed to in the next year or two.

From all the information we have today, this seems like a pretty reasonable bet to us.

Another big overhang on the stock are fears that the moratorium on deep-water drilling, currently scheduled to last for six months, will last much longer. Related to this risk is that new regulations, insurance, and other safety precautions will permanently decrease the returns on capital from deep-water drilling, which affects the economics of the entire industry.

Countering the Gulf-specific concerns is the fact that Transocean has already contracted many of its most valuable deep-water rigs through 2011, with many contracts extending beyond that. Overall, the contract backlog stands at $28 billion, which should carry the company through the next two years even if the Gulf remains off limits. Due to Transocean's high asset quality, the rigs that are currently working in the Gulf today can be redeployed to other oil fields.

We have a hard time imagining that the Gulf will remain shut forever. The truth is, deep-water is one of the last places where oil production has the ability to expand. If we want independence from foreign oil, we have to drill in the Gulf. Furthermore, oil drilling supports tens of thousands of jobs in Gulf communities and provides millions of dollars for states and the federal government. In a recession, what state wants to turn down revenues and what politician wants to be seen destroying well-paying jobs? Political pressure is already mounting to end the drilling ban, and that pressure will rise, especially if BP can successfully contain the damage in the next several months. No doubt, regulations will become tighter, but we think the odds of the Gulf being permanently closed to deep-water drilling are very low.

The second part of this equation is harder to handle. How will the drilling industry structurally change as a result of the oil spill? The calculus here is complicated because it involves predicting both U.S. and foreign regulatory changes, which will raise costs. One scenario is that the U.S. could adopt the much tougher U.K.-style regulatory system for the Gulf, which requires the oil and gas company to prove to the regulator that it has identified and dealt with all potential hazards.

In contrast, the U.S. mainly relies on a rules-based approach where regulators, such as the Minerals Management Service, must uncover rule violations. We also have to figure out how these costs affect returns on capital, and how that in turn affects drilling demand and contract terms. Our feeling is that deep-water will remain a lucrative area of investment for oil companies simply because that's one of the last frontiers in oil exploration, and oil companies will always go where the oil is. If that holds true, then increased costs will be passed through to oil companies in the form of higher pricing, and Transocean's long-term profitability remains largely intact.

Some Thoughts on Valuation and Plans
If we are right in that long-term effects to Transocean are manageable, the stock looks cheap today. For example, at $45*, the company is trading for 7 times our 2010 earnings estimate, 8 times our free cash-flow estimate, and 5 times our earnings before interest, taxes, depreciation, and amortization estimate. Free cash flows will cover maturing debt, and earnings should hold up through 2011 even if spot day rates fall dramatically. Future earnings power could be much higher depending on the shape of the global economy and energy prices, especially as Transocean is adding to its fleet of sophisticated rigs.

This would seem like a no-brainer, but our initial position will be fairly modest. The reason is simple--Transocean is still subject to many unknown tail risks that are impossible to value. For example, what if BP improperly constructs the relief well so that it's impossible to plug the current well after the relief well is drilled? What if some negligent act by Transocean came to light and the liabilities balloon? And most dangerous of all, there are probably risks that we haven't contemplated yet. Therefore, though we think the expected value is attractive here, it's definitely possible for investors to face permanent capital impairment.

An Update on the Gulf of Mexico and Transocean
The following was added after the article's initial publication, updating subscribers on subsequent events.

BP has successfully installed a capping stack on top of the well and has sealed off the well. This means that no more oil is leaking into the Gulf, which is the first good news we've had in quite a while. It looks like BP will keep the cap on the well until it can kill the well through a static top kill or through the relief wells.

The implication of this event for Transocean could be quite positive. First, killing the well would halt the flow of oil into the Gulf, which would in turn, let BP focus on the cleaning up the mess. It would also remove a significant amount of uncertainty around BP's final costs, and therefore Transocean's potential liabilities. In our view, the simple act of placing a cap on the potential liabilities for Transocean should remove a key concern that has been weighing down the stock. We don't think Transocean will be responsible for a large portion of BP's well costs, but as we've said before, there is a large element of tail risk here that concerns the market.

Killing Macondo will also give the offshore drilling industry substantial negotiating leverage to end the moratorium early. Interior Secretary Ken Salazar's new moratorium is effectively unchanged from the original moratorium, as he still wants to halt most types of deep-water drilling. Salazar's new rationale for imposing the moratorium include systematic concerns about workplace safety and offshore drilling, the inability of the industry to effectively contain the Macondo spill, the current shortcomings of the industry response plans, and the limited availability of spill-response resources if there should be a second spill. Therefore, if the well is plugged, and the spill resources freed up, we have met two of the major criteria needed for the moratorium to be lifted. Ultimately, if the industry is to get back to work in the Gulf, it needs to convince Salazar that it can drill deep-water wells safely and that it has the capacity and resources to handle any blowouts.

This leads us to our next piece of good news for Transocean. Transocean is taking a prudent approach to dealing with the moratorium and the uncertainty over its Gulf rig contracts. The company's latest fleet status report indicated that it has agreed with BHP Billiton BHP and Royal Dutch Shell RDS.A to accept a suspension day rate for three of its 14 Gulf rigs during the length of the moratorium. All three rigs were previously earning more than $500,000 a day. In contrast, we believe the suspension day rate is likely to be in the $50,000 to $70,000 range. Once the moratorium is lifted, the contract will be extended for the suspension period at the original contracted day rate.

We think the agreements benefit Transocean in two ways. First, by keeping the original contract day rate, the firm does not set a new and lower day-rate benchmark for the rest of its rig fleet. Second, the agreements merely push out Transocean's profits from the rich contracts for a few months, assuming the moratorium ends by November. In effect, Transocean is exchanging a short-term earnings hit in order to keep a lucrative long-term contract. We think this is a much better alternative than accepting a contract termination payment for less than the full value of the contract and then trying to find work during a period of substantial uncertainty in the deep-water market.

Overall, we're feeling cautiously optimistic that future news from the Gulf may be much more positive than negative. The removal of some of the uncertainty that is weighing down Transocean's stock could mean a nice increase in the stock price in the next six months, which would certainly make us happy with our investment.

* Share price as of July 26. Shares were above $47 at the July 29 market close.

Disclosure: OpportunisticInvestor co-editor Michael Tian is long Transocean options. The Opportunistic Investor portfolio is long shares of Transocean.

Stephen Ellis is a stock analyst with Morningstar.

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