I have been looking for bargains in the oil and gas industry recently. One sector of the industry which appears to offer some significantly undervalued equities (compared to the value of their assets) is the oil and gas drilling sector.
A cyclical sector
I first started looking into this sector around 2010. Back then, the oil and gas industry was riding high off the back of soaring oil prices, cheap credit and an improving economic outlook after the financial crisis. Companies such as Seadrill were binging on cheap debt and unique financial structures, which allowed them to build massive new fleets of drillships and rigs which they could then contract out at ever-rising rates.
The bubble burst in 2014. The combination of falling oil and gas prices, the shale oil boom and skeptical investors stemmed the flow of easy credit and the demand for new-build vessels. Why would banks and investors want to be part of offshore drilling, which is expensive and time-consuming, when they can be part of shale oil, where wells take a few weeks to drill and bring into production at significantly lower costs?
After this shock, between 2016 and 2019, the oil and gas drilling industry went through a period of consolidation. Indebted companies collapsed, and others merged. Many struggled to keep their heads above water.
Then the pandemic arrived. This proved to be yet another hammer blow for the industry, but I think it has thrown up an exciting opportunity for investors.
The crash brought the sector to its knees in 2020. However, coming out of the pandemic, the combination of constrained supply and rising demand has sent oil prices skyrocketing. Moreover, pressure from climate activists has curbed investment in the sector, suggesting demand could exceed supply for some time.
The ESG movement and pandemic have hurt shares in companies like Transocean (RIG, Financial), but this stock, in particular, looks incredibly cheap compared to the industry's outlook.
A cheap stock
At the time of writing, Transocean's stock is trading at a price-book ratio of just 2. It is trading at a price-to-free-cash-flow ratio of 6.
Rising oil prices and increasing demand are already having an impact on the company's operating performance. Total fleet average daily revenue for the company's drilling units rose to around $370,000 in the first half of 2021, compared to an average of approximately $311,000 in the same period of 2020. Meanwhile, total fleet average utilization increased from 53% in the first quarter of 2021 to 55% in the second quarter.
By deferring capital spending, the company was able to generate around $150 million in free cash flow for the second quarter, money that was used to reduce debt. These numbers illustrate how the company is heading in the right direction.
Still, I should point out that it remains highly indebted. The debt-to-equity ratio is around 70%, and capital spending cannot remain depressed forever. By delaying the delivery of two new drillships, the company could defer $450 million of near-term capital spending in the quarter, which will need to be funded at some point.
If rig rates and utilization continue to increase, cash flow will also increase, providing the company with much-needed funding to reduce debt further.
Transocean is also at an advantage because it is one of the largest and most experienced operators that remain alive after the past decade of industry turmoil. This should give it an advantage in the current upcycle, especially if demand for drilling vessels suddenly increases as companies try and take advantage of high oil prices.
Management also holds this view. CEO Jeremy Thigpen noted in the company's second-quarter results that "assuming oil prices remain supportive, we see utilization and dayrates for our ultra-deepwater assets materially improving as we move into 2022."
This company might not be suitable for the faint-hearted, but it could be worth a closer look as a deep value investment.
