Events Trader #58: How you could make 75% on this hated oil rigger

8th June 2010

How you could make 75% on this hated oil rigger

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It's been a remarkable two days of trading in oil services. Seven weeks into the oil spill and offshore drillers have been taking another serious kicking. Transcoean, the rig operater in the Gulf of Mexico, has now fallen 40% since the Deepwater Horizon went up in flames.

We've already bought into BP. But I think we have another great buying opportunity now in Transocean. BP has managed to put a cap on the spewing well. And the latest updates suggest that most of the leak is now being collected.

It might be months before the well is closed off. But as far as Transocean is concerned, I think the market has hugely overreacted to this crisis.

In fact today I'll explain why I think Transocean has a potential upside of 75% from here.

Profit from the return to Deep Sea Drilling

Right now, the market is writing off hopes of a quick recovery for the oil groups involved in this crisis. Barack Obama is doing his best to let everyone know he will come down hard on those involved.

But the truth is that oil groups will be back drilling in deep waters again very soon. The fact is that the US has no choice but to allow deep-sea exploration for oil. It has two alternatives. It can either use less oil (impossible). Or it can pay enemy regimes like Venezuela, Iran or Saudi Arabia for it.

A lot of hard lessons have also been learnt during this disaster. BP floundered as it struggled to find a way to deal with the massive leak. But if we were to see a repeat in the future, the field operator would be in a far better position to rectify the problem. Regulators will enforce more stringent safety rules. But that won't stop deep sea exploration.

So if we assume that the deep sea oil exploration will resume. And that it will expand to provide an increasing share of US, Asian and European oil consumption, then we need to find a trade on this recovery. We need to find a company that is a leader in the sector, One that is cheap on price earnings and has potential to rebound because the stock has been battered down recently.

Transocean (RIG US) fits all these conditions.

Why Transcoean could soon trade at $80 a share

Now you could accuse me of literally playing with fire here. After all, Transocean was the owner of the oil rig that blew up in the Gulf. But I do like these situations where an event puts pressure on the stock without materially affecting the survival or profitability of the company.

The cleanup operation will cost around $10bn - with much of that for compensations to the local economy. It is a big sum. But it is not enough to threaten the survival of Transocean.

Transocean is the largest supplier of oil platforms for the drilling and extraction of hydrocarbons. It owns a fleet of over 140 modern rigs, and it is the market leader in deep water extraction (water between 1.000 and 10.000 feet) and ultra deep water extraction (over 10.000 feet of water). It is also a leader in sub arctic conditions, where it owns semi submersible rigs capable of operating all year round and in the harshest conditions.

The stock was trading at nearly $100 before the blast on the Deepwater rigs. It currently sells for $45.71. And considering that this year it is expected to make about $8 per share (down from $9 last year), it is now selling for 6 times earnings.

On top of that the balance sheet of the company is incredibly solid. It has total assets of $36bn - financed by $21bn in equity and only $15bn in debt. This is an extraordinary situation as other comparable companies like shipping or airlines use debt and leasing contracts to finance the purchase of their main assets ships and airplanes.

As you can imagine the stock has been hammered after the incident in the gulf of Mexico in tandem with BP. However if you use a target P/E of 10 times earnings, you arrive at a reasonable valuation of $80 for the stock. I think that this will be where it will rebound to once the whole situation calms down later on in the year.

So my advice is to buy some now at $45.71. It is best to buy the physical stock with a normal broker, I would advise against using spread betting on this one as the timeframe is a few months and the volatility high - which means that you could hit your margin requirements.

The risks with this strategy are high and I think you will need some patience. The main risk is that we get in too early like in BP. Something might occur that pushes the price even lower, but in that case I reckon it would be worth not cutting out. We will not include a stop loss in this instance.

This is a possibility that we can't discount as the market is overreacting on this story and the markets are very irrational. But in a few months once the waters calm down the valuation points to a much higher price.

There is also another risk inherent with this company, taxes. The company relocated a few years ago from the US to Zug in Switzerland to pay less taxes. So it has a few issues with the IRS and other tax authorities. In the latest quarter they had a tax related impairment that reduced the net earnings. But given the price I think it is a risk that we can bear.

Before I let you go I had a question from a reader a few weeks ago that asked me what was the best way to learn about the companies mentioned in this newsletter. I suggest you take a look at the investor relations section of a company website, which is usually full of interesting information.

You can view Transoceans by clicking here.

That's all from me this week. You can contact me at eventstrader@moneyweek.com, I will be happy to answer any questions.

Riccardo Marzi

Events Trader

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