My Favorite Long-Term Bet on Oil

No one knows where oil is going to be 18 months from now. But that doesn’t stop people from guessing… 

According to the U.S. Department of Energy, crude prices will average over $100 a barrel for the next two years. Research firms Merrill Lynch and Goldman Sachs see crude prices pushing through the $120 mark by 2013.

I take forecasts in this industry with a grain of salt. After all, Goldman called for $200 oil prices in 2008. After touching $150, prices collapsed below $50 a barrel about six months later.

Even without knowing exactly where oil will trade over the next few years, the long term looks good for one “picks and shovels” energy stock… 

Transocean (RIG) is the largest offshore driller in the world. Two years ago, one of its deepwater rigs caught fire in the Gulf of Mexico. This caused one of the largest offshore oil spills in history.

After the disaster, the U.S. government imposed an offshore drilling ban for six months. There were reports speculating that the spill could cost Transocean tens of billions of dollars in regulatory and clean-up charges. Shares collapsed from $90 to under $45 in 2010. They recovered rapidly, but lost all their gains and more in 2011.

Today, shares are beginning to gain momentum. As you can see from the chart, the stock is trading over $50.

 

I don’t think you missed the boat on this one. In fact, I believe Transocean could test the $90 level again within 12-18 months.

You see, Transocean makes money by charging customers like ExxonMobil and Chevron to use its ships. The rate is calculated on a daily basis. The industry term is “dayrates.” 

Right now, dayrates are soaring. For example, Saudi Aramco – one of the largest oil companies in the world – signed a two-year contract with Transocean to use one of its deepwater drilling rigs. The contract is for two years at a rate of $650,000 per day.

To put this rate in perspective, it’s near the record amount Transocean was charging for its deepwater rigs in 2008. Back then, the stock traded over $150 a share.

Transocean also contracted two of its older rigs at exceptionally high dayrates in the past few weeks.

At an energy conference on Monday, Transocean said higher dayrates will continue. Demand for deepwater drilling in West Africa, Asia, India, and Australia is surging. These underwater areas are largely untapped. With oil prices high, costs are more than covered.

Growth is not the only reason I like the stock. Shares are trading at just 11 times earnings. It’s the uncertainty. The full damage assessments regarding the oil spill from two years ago are still ongoing. But the fears are overblown.

A recent ruling suggested Transocean will not be held liable for pollution damages for oil originating underwater. Damages are now expected to be under $2 billion. That’s one-fifth the estimates that came out right after the incident occurred.

Transocean has plenty of cash on its balance sheet to cover these costs. Also, the company suspended its dividend, which will provide more cash to help pay potential damages. Once the litigation concludes, Transocean will likely begin paying a dividend again.

I wouldn’t wait long to buy Transocean. Sure, the stock has had a nice run off its lows. But shares are trading almost $100 cheaper than the last time dayrates were this high.  

Even if oil defies predictions and prices push lower, I don’t see international demand for deepwater drilling slowing any time soon.