I’ve been interested in having considerable exposure to oil for several years. In the search for undervalued oil reserves I have looked at a lot of Gulf of Mexico producers. After the BP spill many of them have had their enterprise values greatly reduced. As it becomes more apparent that the moratorium will not be extended past November 30 (in fact may well be lifted early) and that government legislation is not going to be crippling (we already know what Congress has passed, with the Senate proposal even less harmful) these lower stock prices become less justifiable.
During my reading last night I came across on the internet an interesting quarterly letter written by Grey Owl Capital. I’m not sure it is helpful to read things that support your general line of thinking, but nonetheless they are on the same page as me with respect to the GOM. They likened buying Transocean now to buying American Express during the salad oil scandal. I agree, but would say it is better than that because Buffett was just buying one company while we have a number of companies linked to the Gulf that are priced irrationally.
For your consideration from Grey Owl Capital:
“ In 1963, business for American Express was booming: half a billion dollars of traveler’s checks were in circulation and over one million people had American Express cards. Then, scandal hit. An Amex warehouse subsidiary had issued receipts to Allied Crude Vegetable Oil Refining for bogus tanks of salad oil. The receipts were used to obtain loans on which Allied subsequently defaulted. When the creditors came to seize their collateral, the bogus tanks were exposed. While perhaps not legally bound, American Express assumed moral responsibility and was on the hook for $150 million – more cash than the company had on hand. Following the incident, American Express stock fell from $60/share to $35.
As Amex’s share price fell, a little-known (at the time) investment manager named Warren Buffet purchased approximately 5% of the company. After determining that the scandal had no negative impact on cardholders’ propensity to use their Amex charge cards, Buffet concluded that the “salad oil scandal” was a one-time event from which the company could easily recover.1 His conviction was strong – at one point American Express accounted for more than 40% of his portfolio.
Transocean – Overcoming Tragedy in the Gulf of Mexico
We are not new to the Transocean story. In the middle of the last decade, interested by both the increasing use of energy in the modernizing economies of China and India and the increasing difficulty of oil production, we began to look for investments that would benefit from these trends. After examining the full oil production value-chain, we determined the owner/operators of the deep water drilling rigs presented the most compelling investment opportunity. Focused on discovering and extracting oil from the hardest to reach places, their businesses are highly levered to increasing oil demand and prices. The typical deep-water drilling rig costs in excess of $600mm dollars and takes several years to build. In addition, building and operation is a specialized business. These high barriers to entry allow the deep-water drillers to charge premium prices (“day rates” in the industry vernacular) leading to high operating margins (the historical 3-year average is over 42%). They are also able to lock in long term contracts with the large oil and gas companies that use their services (e.g. British Petroleum) leading to very predictable cash flow.
The investment worked well, but in the spring of 2008 with oil approaching its recent peak of over $120/barrel, we sold our stake in Transocean. While we continued to believe that oil demand would increase and supply would be more and more difficult to provide, $120/barrel seemed too high, particularly in the face of an accelerating credit crisis and global recession.
In late February of this year, we re-engaged with Transocean, initiating a small position. The stock had sold off after the company issued weaker than expected earnings guidance. We were looking to increase our exposure to inflation hedges, but wanted to do it in a way that could still work out well absent significant inflation. Oil is priced globally in dollars, thus US inflation (more dollars; each dollar less valuable) would cause the price of oil to increase. At the time, we thought Transocean was undervalued even if oil remained at $75/barrel, so we were getting the inflation hedge for free.
Then, at just before 10pm on April 20th, gas escaped a well in the Macondo Prospect in the Gulf of Mexico. The gas forced its way up from the wellhead through over 5000ft of water to the Transocean-owned Deepwater Horizon rig. There the gas ignited causing an explosion. The Deepwater Horizon caught fire and eventually sank. The well began to gush oil.
Our first priority was to determine the impact to our existing Transocean position. We began to research the details of the contract between Transocean and BP, as well as the complex ecosystem of distinct companies involved in the drilling process. What we quickly learned was twofold: 1) as is standard industry practice, BP indemnified Transocean from risks associated with blowouts in their contract with the exception of gross negligence; 2) an emerging fact pattern showed that BP had directed Transocean and other contractors to follow legal but less than “best practice” approaches to numerous drilling activities (e.g. the number of pipes used, the mud-circulation process, and the well cementing process) – gross negligence on Transocean’s part seemed unlikely. That being said, we recognize that in large-scale tragedies such as this, politicians and even the public want to find a villain to both blame and punish.
British Petroleum continues to take the brunt of this, but Transocean has been included in numerous lawsuits and will likely face some monetary repercussions. We have reviewed historical oil spill examples and the current environmental regulations to draw a box (albeit a very fuzzy one) around the cleanup costs and regulatory fines. We believe Transocean has the financial means to cover their pro-rata share ($1B of which would be covered by additional insurance). Which leads us to Transocean’s underlying business.
Transocean has a contracted revenue backlog of almost $30B resulting in a free cash flow backlog estimated to be just under $15B. Insurance covered the vast majority of the value of the Deepwater Horizon. Additionally, the Gulf of Mexico (GOM) drilling moratorium should have only modest impact on their revenues – over 75% of their contracted backlog is non-GOM. Within the GOM, it is likely companies will continue to either honor their leases or pay a breakage fee close to the full value of the contract. Should the moratorium be extended it takes about one month to move a rig to the coast of Brazil and two months to the coast of Africa where there is pent up demand for deep water drilling capability. We believe Transocean’s business is very much intact. “
If you are interested in a few more ideas that are tied to this spill please consider the following:
Most Near Term Upside - ATP Oil and Gas (ATPG)
Best Balance Sheet – Ensco Drilling (ESV)
Trading at 1X Cash Flow – Stone Energy (SGY)
Potential Long Term Homerun – Cobalt International (CIE)
Disclosure: I own ATPG/ESV/SGY/CIE