Offshore Drillers Hit Bottom

 | Aug 08, 2014 | 11:00 AM EDT
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A strong earnings report from Transocean (RIG) has everyone understandably wondering: is it finally time to buy the offshore drillers? I have been exceedingly cautious about offshore and particularly the deepwater offshore opportunity that Transocean delivers, yet share prices are starting to reach such low levels that there is a case to be made for "bond-like" buying of Transocean shares here. Let's look at both sides of the offshore case again, now that various offshore names are seeing 52-week lows. 

It was before the shale oil craze, all the way back in 2007, that Transocean was the world beater in energy. With a near-monopoly in deepwater rigs to lease and with oil soaring towards $150 a barrel, the company couldn't build or lease out its specialized fleet fast enough. But with the increased production of shale oil that began in the Bakken, which in 2011 translated even more deeply into Eagle Ford and finally the Permian basin production, interest in new deepwater projects was practically abandoned. The economics are simple: oil from shale can cost less than $50 a barrel to retrieve, sometimes even going as low as $30 a barrel, but drilling a well four miles down, seven miles off the coast of Texas or Louisiana, is going to run nearly 50% more, with a higher and more costly failure rate, should the project fizzle.

And therein, as simply as I can represent it, lies the difficulty that offshore firms found themselves in. Having issued massive paper in building, upgrading and maintaining super sophisticated offshore fleets, the premium for the use of those rigs -- the day rates -- began to swoon. And have continued to do so for the past two years. Bonds of Transocean and other offshore drillers, barely above junk, and dividends which, having been promised, were difficult to cut (RIG did that disastrously once), put super pressure on shares, despite a stock market that has soared. 

Now let's look at the bright side: one thing that we can be sure of is that offshore is not in a permanent swoon. The opportunities and reserve estimates of some of the offshore assets in the Gulf of Mexico, off the coast of Brazil and Mozambique, in Vietnam, Mexico and Indonesia -- these are bankable assets that the oil world will have to return to, when the economics are again right, like they were four years ago.

But is it happening now? Recent results from Transocean, blowing out estimated earnings, give some indication that some of these negative trends are bottoming. Some day rates have been reported to be increasing, including one expensive lease from Total (TOT), more convinced than most that the bottom is near if not already past. But earnings good news this quarter from Transocean is more of a smoke and mirror game of cutting costs and unlocking value through their recent Master Limited Partnership (MLP) offering Transocean Partners (RIGP), than a full turnaround. Their risks remain the unwinding of long-term leases and what new leases will be available and at what rates they will command -- if they lease out at all. This remains the overhang I do not see changing so quickly, at least today.

However. (Taking big breath)

Transocean is in reasonable enough shape for me to proclaim their 6.6% dividend safe. (Full disclosure: the last time I said precisely that -- on CNBC air -- I was 100% wrong. But RIG, I don't believe, can again risk the shareholder uproar that accompanied their last major dividend cut).  No one can catch a falling knife and I can't do that here, but I have stayed away so long from the sector that I must imagine the worst losses on this sector are most definitely in. Where can RIG go to? $32?  $30? It's trading decisively under $40 a share now. 

Finally, when I turned negative on offshore I was very much alone -- now virtually every analyst is also negative offshore drillers. That's always a decent sign to me that it's time to perhaps adjust my view. My trader's motto: everyone can't be right at once. 

Bottom line:  With a longer-term outlook, I think  you can start to buy Transocean shares here -- and start looking at some others as well, like SeaDrill (SDRL), Diamond Offshore Drilling (DO) and Ensco (ESV). I take off my hex on RIG shares here at $38. Finally. 

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