Transocean, Inc. — A Case Study of Risk and Reward

The current issue of Barron’s has a feature story by Andrew Bary, Crude Calculations, that points investors to the group of offshore drillers, two of which, Transocean, Inc.(RIG) and GlobalSantaFe Corporation (GSF), we own both for individual clients and in our funds.  Let us look first to Bary’s observations.  We will then compare that to our own risk/reward analysis.  He writes:

These and similar stocks
trade for 7-to-11 times estimated 2007 earnings, and 6-to-7 times 2008
projections, among the lowest P/Es anywhere.

The drillers carry such low valuations because Wall
Street is concerned the current profit boom won’t last as a slew of new
rigs hits the market by 2010. The industry historically has had
volatile profits, reflecting wide swings in daily rig-leasing rates, or
"day" rates. The drillers operated at around breakeven as recently as

Uh-oh!!  That must look risky to many investors.  Is this danger or opportunity?  Let us digress to consider risk and reward — and time frames!

The Objective of the Game Determines Time Frame

CNBC’s stock contest has hundreds of thousands of entrants and gets hourly publicity on the station.  Each  program has a celebrity (full disclosure — the old guy doesn’t know all of these supposed heavyweights.  I need help from Ryan and Renae) that gets on and makes picks.  It seems like anyone watching should be able to understand a few key ideas:

  1. The celebrities do not know anything about stocks.
  2. The rules of the contest require that participants beat a million other folks in a short time period.
  3. The only way to do this is to take risk — big-time risk — and get lucky.
  4. No investment manager could pass the Series 7 without understanding all of this.

Does it surprise anyone that plenty of those in the audience are trying to follow the winners?  Not us?  As participants in plenty of cocktail party conversations we have learned that everyone wants a "hot tip".  No one has ever asked me for suggestions about risk-adjusted return!

Roll the Dice

Bill Luby at VIX and More  has been doing a nice job with one of his entries.  (He is an expert on sentiment, options, and many topics that take us back to our own CBOE days.  We have been following Bill’s blog and now add it to our list of recommended sites.)  Bill would not buy RIG or GSF for the contest, since there is not enough short-term potential.

The time frame of the investment is crucial, as we discussed here, and Bill also did here.

Bill was alarmed to discover that a reader was putting his IRA money into one of his high-beta "shots."  Maybe the reader was joking, and maybe he was not.  After all, more than 30% of the people cannot name the Vice-President.  Some County Treasurer in Michigan invested in a Nigerian scam.

Risk Control

At the other end of the risk spectrum is the wonderful job being done by David Merkel on his blog.  David carefully explained how investors that managed risk had better long-run performance than those who did not.  We would add that David’s investors also sleep well — very well.  The drillers probably do not fit David’s criteria very well either.

Why We Like RIG and GSF

When analyzing stocks on the fundamentals, we look for two things — an inefficient market and a catalyst.

Inefficiency.  The market is too focused on the past and the overall cyclical nature of the business.  Few have done the requisite homework.  These stocks have a solid earnings base of locked-in contracts for two years, with plenty of upside.  Do you think that oil prices are dropping below $35/barrel?  We don’t either.  More from the Bary article:

Some investors fear a drop in oil and gas
prices will send day rates plunging; they have weakened recently for
rigs that operate in the shallow waters of the Gulf of Mexico. But
Transocean CEO Bob Long downplayed worries in a November conference
call, saying "we’re pretty comfortable that…oil prices down to $40 a
barrel and maybe even down to $35 would have little or no impact on the
deepwater market."

A Catalyst.  This is always a problem.  The consistently-excellent Kirk Report recently discussed William F. Eng’s book (which we have not yet reviewed).  Charles summarized the rules and we were struck by #46 —  yes, we read the entire list.

46.  The smarter you are the longer it takes.

Put another way, deep insight requires patience.

Here is Bary’s suggestion for a catalyst.

One way the drillers could boost their
share prices is by paying higher dividends, as Ole Slorer, an
oil-services analyst at Morgan Stanley, advocates. Slorer figures their
shares could rise 50% if they adopt a policy of paying out most of
their earnings.

Back to the Risk/Reward

There are two ways of looking at risk in the offshore drillers — absolute risk and volatility.

Absolute Risk.  Since we do not believe that oil is going back to below $35/barrel, and we like the locked-in earnings.  We see the absolute risk as very low.

Volatility.  Drilling stocks are part of various energy ETF’s.  Many hedge funds, not schooled in the Chicago futures tradition, do not use futures in their trading.  Many financial consultants also make aggressive moves in these ETF’s since the transaction costs are low.  Stocks like RIG and GSF swing around based upon the front-month oil spot price, even though this has little to do with their long-term prospects.  In fact, the oil futures forward curve, the best read on market prices, shows little backwardation.  The stocks caught up in this thrashing about show unwarranted volatility, and this exaggerates traditional risk measures like the Sharpe ratio.

Reward.  The catalyst might require market recognition of the factors we cite.  In the case of GSF, there is also buyout speculation, although we never use this as a fundamental buying rule.  Bary notes this:

Investors also could benefit from takeover
activity or leveraged buyouts in the sector. Seadrill (SDRLF.PK), a
fast-growing Norwegian driller with the highest P/E ratio in the group,
is believed to be weighing acquisitions. In a recent note, Citigroup
analyst Geoff Kieburtz identified GlobalSantaFe and Noble as the most likely targets for Seadrill.

Conclusion and Full Disclosure

These offshore drillers are among our favorite positions.  The market is wrong on risk as well as reward.  We hold them in all accounts.  We bought RIG two years ago, so we have a near-double already, but the stock has languished recently.  While we make trades in them at the margin, the overall risk/reward balance is so favorable that it would take a massive repricing for us to sell the entire position.

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  • Bill April 22, 2007  

    Thanks for the mention Jeff, even if I am juxtaposed to one of those Nigerian scams…
    For the record, I just happen to own GSF for my ‘real money’ portfolio and think the drillers are a good play right now, even though they won’t bring me the type of returns that one needs in the CNBC contest unless Seadrill finally decides to buy one.
    P.S. I get your posts via Bloglines every day and have enjoyed your thoughts on the Fed Model, but your recent comment on productivity and reality checks is the one that stuck with me the longest

  • marlyn trades April 23, 2007  

    The problem with the suggestion that the drillers use their profits for dividends is that they do just that – the money they pour into the RNC is a dividend (of sorts). They are some of the largest political contributors (for obvious reasons) of any.

  • David Merkel April 23, 2007  

    I’ve had an energy overweight for the last four years, because I have felt that trends in the sector were underdiscounted. My portfolio in full is available at (To get there easily there is a link at my blog on the “My Portfolios” page.) I do hold a few drillers, but I have bought them on weakness. I currently own HP, PTEN, and BRNC. I realize these are land drillers, and their rates have a greater tendency to float at spot rates, but demand is pretty perky for even land rigs at present. I don’t see oil returning to the $40s so long as global growth continues.
    Anyway, that’s what I am up to with the drillers — they make up 8% of a diversified portfolio, and less in my balanced mandates.
    I will have one more “spring cleaning” article on that should be freely available soon, dealing with asset allocation issues.
    Thanks for mentioning me.

  • Camerata Meiga April 24, 2007  

    Nice post. I own RIG and I’m quite optimistic about them.
    One question. You mention that “a slew of new rigs hits the market by 2010”.
    In your opinion, which would be the best players building those new rigs?

  • Jeff April 24, 2007  

    Bill and David —
    Thanks for stopping with your comments. I’ll check out the rest of your holdings!

  • REW April 25, 2007  

    A well-developed post.
    My question, or concern is the paragraph on Volatility. I completely agree that hedge funds and others are whipsawing ETFs and subsequently some of the underlying issues, such as your riggers. My concern is that you seem to easily dismiss this as unwarranted. The volatility is real, it is there as a result of the hedge funds, and thus it should be heeded, not dismissed. Can you shed more light on your thinking here.

  • Jeff April 25, 2007  

    Russ — Thanks for your comment!
    You are correct in saying that the volatility is real, whatever the cause. We do regular volatility forecasting as a basis for options trading, and these stocks are certainly candidates.
    But I’m not sure what you mean by “heed.” I actually had this discussion with my dad once. He ran a foundry that made high-quality cookware as a part of a larger, stable business. Their stock price did not move much, exhibiting a slow growth in line with the stable business.
    Now let us suppose that we put this stock in the XLE. It would gain a lot of volatility, even though there was no change in the underlying business.
    I think that the upstream energy stocks should trade on oil prices that are years out on the futures curve. These are less volatile than front-month prices.
    The volatility does not seem to carry its traditional message about risk.
    Thanks for the good question.