Transocean's Macondo Liabilities Overblown

Erik Kobayashi-Solomon: Hi, I am Erik Kobayashi-Solomon, Co-Editor of Morningstar's OptionInvestor. Today, it's my great pleasure to welcome Stephen Ellis, who is a Senior Equity Analyst here at Morningstar covering oil services and who is also the Co-Editor of a very interesting newsletter called Opportunistic Investor. Stephen thanks for coming.

Stephen Ellis: No, problem. Thanks for having me.

Kobayashi-Solomon: So, just recently, I did an option idea on a company you cover, Transocean, RIG, and wanted to ask you – I know that RIG was involved in the big Macondo spill, one of the three kind of primary parties. What do you see as Transocean's, kind of, legal repercussions from the Macondo spill?

Ellis: I mean, you know, there are three areas you need to think about right? A, if they happen to be – if they are found to be responsible, which is iffy, there is, A, they have $950 million worth of insurance that can be essentially used to cover any fines, liabilities. B, BP under the Oil Spill Pollution Act of 1990 had accepted responsibility as the responsible party for any discharges from the well. Transocean has accepted responsibility as a responsible party for any discharges from the rig. Clearly, discharges from the well are much, much greater compared to any oil discharges from the rig which is virtually nothing.

Kobayashi-Solomon: Any discharge from the rig is also covered by insurance if I understand correctly?

Ellis: So, the third area is Transocean's contract with BP basically indemnified Transocean from basically any type of liability, fines, anything like that, so in order for Transocean to be substantially exposed, that contract provision, the indemnification has to be sort of worked around or broken, and that would be quite interesting if that would happen because the secondary affect on the industry would be interesting because basically Transocean is a subcontractor.

Kobayashi-Solomon: Basically subcontractors would not want to take any more jobs if the subcontractors are found to be -- they can't indemnify.

Ellis: Exactly.

Kobayashi-Solomon: Can't be indemnified.

Ellis: I mean Transocean is working on BP directly, so it would be pretty unusual event for the industry.

Kobayashi-Solomon: So, from your perspective, it looks like Transocean is pretty well protected from a large financial liability?

Ellis: Right.

Kobayashi-Solomon: So, in reading your report, Transocean, one of the attractive things about Transocean is their deepwater fleet and it seems like you're making a real bet on deepwater drilling with Transocean. What are the big deepwater projects that are kind of coming online right now and how is Transocean positioned for these projects?

Ellis: Well, if we think about deepwater drilling, we talk about you know what's referred to as the, 'Golden Triangle,' where you know basically 70% of the world's deepwater drilling is concentrated in the deepwater Gulf of Mexico, West Africa, and Brazil. Brazil has been one of the more interesting areas over the past couple of years because they've announced billions of barrels of discoveries and reserves in the Santos Basin.

Kobayashi-Solomon: Right. Santos Basin is really the new kid on the block I think, right?

Ellis: And if we think about it in terms of how Transocean is positioned to benefit from that you know, clearly, any new discovery is made, particularly of this size, it will need a number of rigs over many decades to fully exploit them. All of these discoveries are deepwater and Transocean has twice the number of deepwater rigs as anybody else out there. They also have the most experience doing the deepwater drilling. So, if a contractor or an oil and gas company is looking for a driller, they are going to want to find someone who is experienced and who has a quality rig available. Transocean is probably going to be the top choice.

Kobayashi-Solomon: So, it seems like they are really kind of in the sweet spot in terms of getting contracts for the Brazil, the Santos Basin drilling. All right. So, your fair value is $100 I think. Right now, Transocean is trading substantially below that. What is the market missing?

Ellis: I think that you know a couple of areas they are missing; A, there is probably some overhang of Macondo, you know, "Is Transocean going to be liable?" even though we have talked about that, and I don't think it's a serious issue.

Kobayashi-Solomon: So, kind of an irrational fear about legal liabilities, that's one. Okay.

Ellis: B, they have a large jack-up fleet which is – the jack-up operates in shallower water and the fleet is older, which means it's not earning particularly attractive day rates and a lot of the rigs have been stacked, not working. So, that's sort of you know holding back some of the earnings power as they sort of have to upgrade those rigs or find – expose them and find new ones.

Kobayashi-Solomon: The second thing is those shallow waters rigs, let say jack-up rigs, the rates are not very good and that's kind of a drag for them?

Ellis: It's kind of a drag for them, but it's not the main driver, right? I mean, deepwater rigs are the main drivers here for, you know, the future. So, you know, as Transocean, spends the money to upgrade their rig fleet and upgrade their jack-ups, we think that could be sort of an incremental upside for them on the jack-up side. The third thing, of course, is with permitting pace in the Gulf, the Macondo of course, the U.S. government basically announced that they were going to – you know, there was a moratorium and they are going to revisit how they issue permits in the deepwater Gulf of Mexico, and what's happened is, you know, the permitting pace, at much, much slower than the past. We're on track for maybe 200 permits this year, in the deepwater permits, versus maybe 350 to 450 in 2006 to 2008, so it's about half of the pace.

Kobayashi-Solomon: So, of those things – so certainly the permitting is a worry, but that's not all of Transocean's business by any means. The jack-up rigs, they are kind of incremental and then the legal liability you think is really not a worry long-term at all?

Ellis: I think the key thing to think about is, you know, these issues are temporary in nature. They are short-term. It's going to – not particularly look great for Transocean 2011, but if we think about the where the earning power of this fleet is long-term, you know, where the picture is for deepwater drilling long-term is much, much brighter, and Transocean as the industry leader should really be well placed to benefit.

Kobayashi-Solomon: Thanks for coming in and explaining it, Stephen, and thank you for joining us. Please stop by the Morningstar OptionInvestor website where you will find more ways to protect your portfolio and generate income using options.