“How do you feel about Transocean (NYSE:RIG). Do you see it going above its 52 week high or staying right around where it is or going lower?” — Leeor
This is a complicated question. For starters, we have to assess the weight of pending litigation on RIG stock — never an easy task. Then we have to try and make a directional call on oil, since this driller is very much tied to the ebb and flow of crude oil demand and pricing. And of course then we have to look at this specific company among its peers to see how well it’s run.
The short analysis: I think it’s too risky to chase Transocean right now because of a host of unknowns and limited short-term upside. RIG might be a decent investment later this year or in early 2013 when the dust clears, but right now investors have to follow their guts instead of the facts on a lot of things.
As a guy who prefers hard facts to hunches, count me out.
That said, Transocean is one of the largest and most well-known names in offshore drilling services, and I believe in buying the best-in-breed stocks instead of second-tier companies. Many of the risks aren’t unique to RIG, so if you truly believe in a secular recovery for energy demand and crude oil prices, then this is your best bet among all the drillers in my mind.
On to the risks:
Transocean is infamous for the Deepwater Horizon disaster in the Gulf of Mexico. Halliburton (NYSE:HAL) and BP (NYSE:BP), of course, were the other major players in that April 2010 oil spill.
Though more than two years have lapsed since the disaster, the Gulf spill is very much a factor in RIG stock these days. In February, Transocean killed its dividend of 79 cents a quarter — a roughly 6% yield at the time — to free up cash to fund litigation related to the spill.
At the end of June, Transocean reportedly was near a final settlement with the Department of Justice. Details remain very hush-hush, but estimates are that RIG will pay between $700 million and $1.2 billion in fines — which is a lot, but much less than it could face in civil and criminal penalties if a settlement isn’t reached. Transocean has set aside $1 billion for spill-related costs.
The rumor mill indicates that a settlement is likely and that it will be digestible for Transocean. But as I mentioned before, I bristle at uncertainty. I don’t play biotechs gambling on the whims of the FDA, and I don’t trust pending lawsuits to always wind down favorably. Because if the fine is higher than expected, RIG will suffer.
And by the way, the settlement with the DoJ doesn’t guarantee this is the end of litigation. Consider that the feds are exploring charges against BP officials for allegedly making false statements to Congress about the rate at which oil was escaping from the well.
The bottom line is that there’s no way of knowing how lawyers and judges will handle this. Remember that before considering an investment.
Soft Near-Term Demand
I have written extensively about the challenges to the U.S. recovery, the economic slowdown in China and the very real threats of a prolonged and painful recession in Europe. (Check out my column “7 Reasons to Stop Trading Until Thanksgiving” for all the gory details.)
Energy is a cyclical business, and we have seen most oil stocks languish amid weak oil demand. Oil majors Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) have both lagged the Dow with a paltry 4% return in the past 12 months. Offshore drilling peers Noble Corporation (NYSE:NE) and ENSCO (NYSE:ESV) are up 3% or less in the same period. It hasn’t been a great environment for energy stocks, and shares have reflected this.
It doesn’t look pleasant for the rest of 2012 or even into next year. Growth in oil demand will slow in 2013, according to OPEC, and a decent supply cushion portends flat prices for some time to come.
I don’t see much of a turnaround in the energy market, and thus I don’t see a significant turnaround for RIG on the demand side anytime soon.
The Bullish Cash for TransOcean
Of course, if litigation is ended favorable and demand picks up, then Transocean will be sitting pretty. With a projection of $5.13 for its fiscal 2013 EPS, that gives the driller forward P/E of just 8.2. Not bad if it stands.
And longer term, a $16 billion market cap makes Transocean one of the most well-heeled drillers in the world. RIG is a great long-term play on the big-picture idea that the world’s easy-to-extract onshore oil is drained and deepwater finds will be increasingly important. Also, the political opposition to offshore oil has been steadily declining since Deepwater Horizon fervor, and a few more years of safe operation could mean the will to access more coastal U.S. fields for big profits.
And despite a soft energy market, RIG near-term is seeing strong orders. New contracts for just the two-month period between February and April totaled $834 million alone.
Then there’s the chance of the dividend returning down the road. This obviously will not be until the legal troubles are in the rearview mirror, but could be just a year or two away if things go well.
Last but not least: While there hasn’t been a lot of analyst activity in a while, the most recent moves earlier in 2012 were all upgrades with significantly higher targets. Of 22 analysts covering this stock according to Thomson/First Call, the mean price target is $63.39 and the median target is $65 — 30% to 40% up from here.
So if you want to stick your neck on the legal front and bank on favorable settlements or if you like the long-term prospect of offshore oil, RIG is a good play. But I have to reiterate that the short-term risks are very clear and very significant — so the prudent thing might be to sit and watch if you don’t own shares.
Do you have a stock that’s on your mind? Drop me a line at email@example.com and I’ll take a look at it.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not hold a position in any of the aforementioned securities.