Even in this Rich Market, Transocean Is Offering Investors Value

Markets Motley Fool

Any price-conscious investor out there is likely looking at the valuation of today's market and saying "no thanks." With this bull market heading into its eighth (!) year, and the S&P 500 valued at a cyclically adjusted price to earnings ratio of 30 (!!!) it seems like the word "value" doesn't really apply anymore. Luckily, the aggregate valuation of the market doesn't apply to every stock, and there's a fair share of companies in out-of-favor industries, or that Wall Street just isn't too keen on.

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One company no one can argue is overvalued today is offshore rig company Transocean (NYSE: RIG). As it stands today, shares of Transocean trade at a price to tangible book value of just 0.2 times. That's akin to saying the market thinks the company is worth $0.20 on the dollar for its assets after it has paid off all of its debts.

It's no shocker that the oil market is going through a tough time, but this share price seems like an egregious overreaction from the market. Let's take a look at why there's so much bearish sentiment from Wall Street and why it looks like there's a lot of value in shares today.

Iceberg ahead!

Ever since oil prices started to decline back in 2014, shares of Transocean have declined a jaw-dropping 70%. The simplest explanation would be to say "because of oil prices," clap our hands, and walk away. In reality, though, the issue is much more nuanced than that. That doesn't explain why other oil companies have rebounded since then or why others didn't drop that much in the first place. 

The most important factor isn't the price of oil or gas. Instead, it's the cost to extract a barrel of oil. Even though oil prices have declined, many companies have found ways to reduce the cost of their production such that they can turn a modest return at today's prices. A great example is shale drilling the U.S. In some instances, shale producers can generate better rates of return with oil at $50 a barrel today than what they could generate back in 2012, when oil was north of $90 a barrel.

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Offshore drilling, unfortunately, has not been able to replicate those kind of cost reductions yet. The amount of design work with these projects and the equipment needed for offshore projects -- production platforms, subsea collection equipment, etc. -- mean the upfront costs for these projects are much higher than drilling wells on land. 

The other thing holding back offshore drilling is that producers have the option of allocating capital to shale development instead of offshore fields. Shale has proven to be an incredibly resilient resource that can generate a modest return today and put cash in the bank quickly. The average shale well can now go from a fallow field to a productive asset within a couple of weeks. Compare that to the timeline for an offshore project: ExxonMobil's (NYSE: XOM) Liza field in Guyana will go from first exploratory work to a producing asset in five years. That is one of the fastest development schedules ever for an offshore project.

Producers hard up for cash are going to look to assets like shale drilling to replenish their cash coffers and pay down debt during times like this, and it will come at the expense of offshore drillers. For Transocean, that means three-plus years of completing contracts and not having new work in the wings to maintain revenue.

RIG Revenue (TTM) data by YCharts.

Sprinkle in some competitors looking at filing for bankruptcy and a general consensus that offshore drilling will take several more years before we see any significant rebound, and you get a market that is extremely bearish on Transocean's stock.

The way out of this mess

The macro environment for offshore drilling doesn't look pretty, and anyone thinking they can make a quick buck on this depressed stock price will likely be disappointed. Those looking over the long term, though, will find that Transocean has both the fleet and the financial strength to get through this market swoon.

Even though capital spending has poured into the shale patch over the past year or so, overall spending levels in the oil industry have been way down for more than three years. According to most oil services executives, the level of investments today isn't sufficient. While shale can take some market share in this environment, it likely won't be able to absorb global production declines and increasing demand for much longer. That means producers will start investing in other sources, like offshore, again.

When that day comes, Transocean should be more ready than almost every other rig owner. Thanks to management's decisions to retire many of its older assets to preserve cash and focus on its fleet of high-specification rigs, Transocean has a young, capable fleet that can handle any ultra-deepwater or harsh environment job anyone may want to pursue. Also, thanks to prudent financial management, the company has enough cash on hand and a revenue backlog that it could withstand not winning any new work for two years and still have enough to pay off any debts coming due in that time.

That's a big financial cushion to fall on, and it should keep Tranocean's head above water while many of its peers likely fall to the wayside.

What a Fool believes

I'll admit that an investment in Transocean isn't a slam-dunk. There's a chance North American share could capture way more market than I'm giving it credit for and extend this low-price environment for several more years. If this low-price oil environment were to extend into 2020 and beyond, then offshore drilling could be hard up. Then again, the cost for offshore developments is going way down. ExxonMobil estimates the breakeven cost for the Liza project is less than $10 a barrel.

Investing in Transocean will require a lot of patience and an iron stomach because the next year or two will likely be rough. Beyond that, though, things will likely get much better for the company, and investors willing to buy now could extract a lot of value from Transocean's depressed shares.

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Tyler Crowe owns shares of ExxonMobil. The Motley Fool owns shares of ExxonMobil. The Motley Fool has a disclosure policy.