3 Reasons Transocean LTD Stock Could Soar

The last year has been a brutal one for the offshore oil drilling industry, especially for older drillers with aging fleets. 

RIG Total Return Price data by YCharts.

In two recent articles I've covered Transocean LTD's (RIG -2.29%) struggle to rebuild itself into a more modern company and restore growth in an increasingly weak offshore oil drilling market. In the past, I've written extensively about why long-term investors should choose younger competitors such as Seadrill LTD (SDRL) and Ensco PLC (VAL) over older legacy drillers like Transocean, Diamond Offshore Drilling Inc (DO), and Noble Corp PLC (NEBLQ). While I still believe Seadrill and Ensco are among the best choices in the industry, I also believe good investing requires looking at every opportunity from both sides, both the good and the bad. Therefore, in this article, I'll explain three reasons why Transocean and the industry at large might make excellent long-term investments.

Fundamental growth catalyst intact

Source: Seadrill 2014 Howard Weil Energy Conference presentation.

The simple fact is, the world's population is growing, and our energy demand is increasing quickly, as developing nations such as China, Brazil, and India rapidly develop their economies. According to the U.S. Department of Energy, by 2050 the world's population will reach 9.4 billion, and per capita income will double, along with energy usage. 

For better or worse, oil will continue to provide the majority of the world's fuel needs for decades to come. In fact, according to a study by Morgan Stanley and Rystad Energy, by 2035, the world's oil demand will increase 15%-26% to 100 million-110 million barrels/day.

As the above chart illustrates, ultra-deepwater (UDW) oil production is expected to grow 19 times faster than conventional land-based production, and that means oil companies are going to have to pony up the money to get that oil, as they've increasingly been doing for the past decade. 

Source: Schlumberger.

As this table from oil service giant Schlumberger shows, oil companies spent nearly $700 billion in 2013 to explore, find, and increase production. Though many oil giants such as ExxonMobil and Chevron have committed to holding the line on further spending growth, the simple fact is, spending will have to increase substantially to reach that 100 million-110 million barrel production level. Because offshore production is expected to be the fastest-growing subsector of oil production, this likely means spending on offshore drilling will be a long-term trend within one of the most important industries on earth -- a trend that will fuel the long-term growth of the offshore drilling sector. 

Dividends will pay you to wait

Source: Yahoo! Finance.

As the above table shows, because of the beating the industry has suffered recently, certain offshore drillers including Seadrill, North Atlantic Drilling, and Transocean are yielding near or over double digits. Given the fact that the S&P 500 has historically (1871-2013) returned 9.2% (with dividend reinvestment), yields like that can not only be fantastic for income investors, but they can result in superior, market-crushing total returns, if they prove sustainable. 

I've recently written about why I believe Seadrill's dividend is safe, but regarding North Atlantic Drilling, a warning is in order.

The reason North Atlantic Drilling's yield is so high is that it suffered a precipitous price decline in the wake of CEO John Fredriksen warning investors that international sanctions against Russia threaten to kill its recently announced $4.25 billion dollar deal with Russian oil giant Rosneft. Just days prior to to the sanctions being expanded to include Russia's energy sector, Rosneft signed a five-year contract for six rigs. Investor uncertainty about the sustainability of the current dividend is the likely cause of the price collapse. Although this unfortunate turn of events makes North Atlantic Drilling riskier than Seadrill, it also offers a potential buying opportunity for long-term investors should the deal go through as planned. 

Though Transocean's dividend is also, in my opinion, riskier than Seadrill's, I still believe it to be safe for two reasons. First, the company's management, who have the best insights in the financial situation of the company, only recently raised the dividend. Though I disagree with this decision, given management's recent statements about market weakness getting worse and the downturn being longer than initially anticipated, I don't believe they would have made this decision had they feared future cash flows could not cover the payout. 

Also, Transocean's recent MLP spinoff, Transocean Partners, offers an alternative financing option to help raise funds should the need arise. Transocean has several state-of-the-art UDW rigs that it's recently secured lucrative three-year contracts for, and it has the option of selling these to its MLP to recoup the cost of construction. That, in turn, can be used to secure the dividend (should the downturn continue longer than expected) or pay down long-term debt, thus strengthening the balance sheet and increasing the company's flexibility going forward. 

Massive valuation means a great buying opportunity

Sources: S&P Capital IQ, Yahoo! Finance, Multpl.com.

The above table indicates several important facts. First, the market seems to be anticipating negative or slow earnings growth for almost the entire offshore drilling industry. Given recent statements from management at Transocean and Seadrill's decision to suspend new rig orders until market conditions improve, I believe these lower growth expectations are warranted. 

However, with the industry trading at an average P/E just 65% of its 21-year historical norm (Transocean is trading at 73% of its historical ratio), I believe short-term market panic over the future of the industry is overblown. Citing "evidence of positive developments in the number of tenders that have materialized for 2015, 2016 and ongoing," Seadrill's CEO Per Wullf gives me confidence that the current downturn in the offshore drilling industry represents an extraordinary buying opportunity for long-term investors. 

If Mr. Wullf is right, then within a year or two, market conditions will improve, and growth estimates will increase. The market, being a forward-looking mechanism, might re-inflate the valuations on these companies, resulting in substantial capital gains. In the meantime, I believe investors in Seadrill, Ensco (and to a lesser extent, Transocean and North Atlantic Drilling) are being paid for their patience with safe dividends.

Bottom line
Though the risk of this industry downturn exists, especially should another market correction or global recession cause a prolonged fall in the price of oil, I believe the long-term outlook for offshore oil drillers remains positive. Therefore, given today's historically low valuations and sky-high yields, both growth and income investors should consider these companies as part of their diversified portfolios.