Transocean Is A Buy

Jim Brown
 
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After a thorough review of the details surrounding the sinking of the Deepwater Horizon rig and the news to date I am convinced that Transocean is a buy at this level.

To recap the Transocean Deepwater Horizon was leased to (BP) to drill a well in 5,000 feet of water 50 miles offshore in the Gulf of Mexico. BP was a 65% operating partner in the well along with Anadarko Petroleum as a 25% partner and Mitsui as a 10% partner. The rig was using a Cameron International (CAM) blow out preventer (BOP). The drilling to 18,800 feet had been completed and BP estimated the well at roughly 8,000 bpd. Halliburton (HAL) had been hired to cement the casing and plug the well until another rig could come in and complete it.

Twenty hours after Halliburton cemented the casing the well suffered a blowout that killed 11 workers and injured 17, several critically. Based on all the known facts today it appears the Halliburton cement job was the cause of the blowout. When cement hardens it generates heat and that heat deep underwater can reach almost to the boiling point. The maximum heat is generated between 14-16 hours after the cement is poured.

Methane gas deep under the gulf is compressed into the sea floor where the temperatures are only a degree or two above freezing. Basically the gas is highly compressed in a frozen state. When the cement hardens in a deepwater well the heat generated can melt the frozen compressed gas in the surrounding seabed, which then becomes wildly uncompressed in its heated state. If there are any faults in the casing cement the rapidly expanding gas will force a blowout with deadly results. Apparently Halliburton could be liable for cementing the casing incorrectly. Over the last 14 years there have been 39 blowouts in the gulf and 18 were the result of bad cement jobs.

Regardless of the cement problems the blow out preventer (BOP) manufactured by Cameron is supposed to automatically kick in and close the well when the blowout is detected. In this instance the BOP failed to operate properly and the blowout ran wild. Cameron has $500 million in liability insurance.

Anadarko (APC) is not an "operating partner" and may not share prorata in the oil spill cleanup. APC only has $177 million in insurance and they have acknowledged in statements that they expect to be dinged for cleanup costs. Since the actual costs could run into $10 billion or more the hit to APC could be way over their $177 million in insurance.

BP was the "operator" of the well and is therefore responsible for the leak/spill from the well. There are several precedents in law that make BP responsible as well as their contract with Transocean. U.S. statutory law states that the operator of the lease is responsible for all pollution liabilities and damages.

According to Transocean their contract with BP contains the following clause:

Under our drilling contract for Deepwater Horizon, the operator has agreed, among other things, to assume full responsibility for and defend, release and indemnify us from any loss, expense, claim, fine, penalty or liability for pollution or contamination, including control and removal thereof, arising out of or connected with operations under the contract.

Obviously indemnifications in the contract are only as good as the deep pockets on the operator and fortunately for Transocean the BP pockets are deep. BP has said repeatedly they are responsible.

Transocean

For Transocean it is a tough proposition but one it can handle. Their liability to the disaster is to the 17 injured and 11 deaths. They have $950 million in insurance against personal injury liability with a $10 million deductible per occurrence. That means their maximum liability for injuries is $10 million.

They also have environmental remediation insurance with a $700 million cap. Based on U.S. law and the contract with BP they don't have any environmental exposure but should some slip through this should be enough to handle it.

Transocean also has insurance on the rig that will cover up to $800 million for rig destruction and removal. In this case it appears they will receive $576 million for the rig destruction. They announced today they have already received $401 million from the insurer we partial payment for the loss. The rig only cost $365 million when built although replacement cost today would be closer to $700 million. Transocean will not experience any loss on the rig but there could be some expenses if they try to raise it for salvage. How much of that would be covered by the "removal" clause in that policy is unknown.

Where Transocean will lose money is the loss of lease income. The Horizon was leased to BP for roughly $500,000 per day through 2013. That will equate to a loss of $181 million per year in lease income. However, there are costs associated with the operation of the rig and after deducting the impact of those costs Transocean will only see a $50 million decline in profits on an annual basis. They do not have any insurance on lost rental revenue and the sinking of the rig automatically terminates the BP contract.

Transocean was trading at a PE of 9+ before the accident. If you subtract the impact to earnings the associated decline in market cap should be in the range of $450 million. To date Transocean has seen their market cap decline by $5 billion. This is serious overkill.

I believe that a lack of liability for any environmental damage or cleanup plus the insurance in place for employee liability and rig loss suggests that Transocean is severely oversold.

The wild card here is the potential for a drilling halt or slowdown in the gulf. If the BP attempts at installing the concrete domes and piping the oil to a waiting tanker fail and we get 90 days of additional leakage before the relief wells are completed then the government could be in full regulation fury by then. If the domes work and the leaks are controlled then the spill will be old news a month from now and there will probably be new requirements for blow out preventers but otherwise business as usual.

If any drilling restrictions occur then lessees can claim force majeure and stop making lease payments. That is the only real risk I see for Transocean today.

With peak oil still on schedule to beat the end of the Mayan calendar in December 2012 the rising price of oil will only make deepwater drilling more important as that date approaches. There will be a rig shortage in 2011 and that shortage will only increase as Petrobras adds 14-20 deepwater rigs over the next couple years.

I am recommending a BUY on Transocean (RIG) but be aware there will be plenty of questionable press ahead. This may not be for the faint of heart. One earnings headline today proclaimed "Profit Sinks for Oil-Spill Villain." Since Transocean's only villainous activity was to lease the rig to BP you can see where the press mindset is currently headed.

Jim Brown

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