Forget BP: Buy This Instead

Ryan Fuhrmann's picture

Monday, August 9, 2010 - 4:57pm

by Ryan Fuhrmann

The oil spill disaster in the Gulf of Mexico will alter the landscape for offshore drilling for decades to come. Uncertainty over new regulations, lawsuits and the near-term hit to business in the region have sent the share prices of many major players in the industry to multi-year lows.

But at current valuations, shares of these major players are pricing in extremely negative outcomes and don't take into consideration that Gulf drilling is a small and declining percentage of global activity. As a result, I've found one major industry player that qualifies as "The Bargain Stock of the Year."

After several months of high-level drama and extreme uncertainty, the oil spill in the Gulf appears to finally be under control. BP plc (NYSE: BP) is in the midst of completing its "static kill" cap that should stem the leak from the Macondo well permanently.

In addition to the devastation the disaster has brought to the Gulf region, share prices of BP and its partners in the well, which include Anadarko Petroleum (NYSE: APC) and Mitsui, which owned about 25% and 10% of the well, respectively, remain well off their pre-spill highs. The same goes for Transocean Ltd (NYSE: RIG), which leased the Deepwater Horizon rig to BP and its partners.

It will take many years to reach a final tally, but the cleanup and compensation costs from the disaster will be staggering. BP took a $32.2 billion charge during its most recent quarter as it faces fines from states in the region, the U.S. Clean Water Act, and lawsuits from lives and livelihoods lost.

Bickering will ensue as to what each partner is responsible for. So far, BP has fronted all of the costs, but expects Anadarko and Mitsui to pay for their fair share. Additionally, Transocean recently claimed to have received 249 legal actions against it since the April 22 disaster.

Of the parties involved, Transocean's potential liabilities look to be the least severe. Insurance will reimburse the company for the rig (it has already received $560 million) and in its most recent quarterly filing with the SEC, the firm stated that the operator of the rig is bound to indemnify Transocean against fines, penalties or related losses.

Even when taking the stoppage of drilling in the Gulf into account, it is important to remember that Transocean only has two rigs operating in the area. And as my colleague Nathan Slaughter has pointed out, the company has nearly $30 billion backlog of contracts with oil giants like Petrobras (NYSE: PZE) and Exxon Mobil (NYSE: XOM) who are willing to pay upwards of $600,000 a day.

Given this information, the -37% hit to Transocean's share price since the disaster appears to be way overdone. The stock is up about 15 points from its lowest point since the spill, but should continue to recover and has considerable upside given the downside risk looks limited from here.

A method to value deepwater drilling firms is based off the replacement value of the rigs they own and rent to major oil operators. Replacement value is just what it says -- it represents the cost to rebuild the rigs in today's dollars. One analysis placed replacement value at more than $120 a share. At the very least, Transocean should trade well above book value, which is the accounting value of its assets and other adjustments that make it differ from market value. Book value, as of the most recent quarter end, was about $65 per share -- above Transocean's recent price.

Transocean is also a steal by looking at its earnings potential. Analysts currently project $7.72 a share in earnings for all of 2010, which places the forward P/E multiple at 7.5. This is a bargain-basement level off of earnings that are depressed due to the disaster, the temporary halting of drilling in the Gulf, and a down economy that has had a negative impact on oil prices.

Just last year Transocean reported close to $10 in earnings per share and posted in excess of $14 per share in 2007, prior to the recession. This speaks to the firm's profit potential during periods of economic strength -- and we could easily see the firm return to this kind of earnings power if the economy improves, oil prices spike, or both.

Action to Take ---> Transocean's Horizon rig may have been the culprit for the oil spill, but it is BP that will likely continue to bear the brunt of the blame. The level of uncertainty being subjected to Transocean is leaving its shares unduly punished.

Transocean's all-time high was more than $160 per share in early 2008. Those shares trade for less than $60 today. This speaks to the kind of stunning potential that exists for investors willing to tolerate a bit of near-term, but bearable uncertainty. To get back to a more reasonable $90 per share, Transocean would return more than +58% to investors.

The share price should continue to recover as clarity from the barrage of lawsuits and claims begins to emerge. Longer term, shares could move back above $100, perhaps doubling in pretty quick order, making it one of the most undervalued stocks on the market today.

Ryan Fuhrmann does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.