The tragedy in the Gulf has decimated the stocks of the companies involved. Cumulatively, the three main players – BP, Transocean Offshore, and Halliburton – have lost $125 billion in market value since the Deepwater Horizon explosion. BP and RIG have each been roughly halved.  The final tally for repair, clean up, and damages won’t be known for decades, but we do know who is on the hook for it, and it is not Transocean. BP’s immediate and adamant ongoing claim of responsibility for the disaster’s costs creates a unique opportunity in Transocean, we believe.

Transocean Offshore is the unquestionable global leader in offshore drilling.  RIG owns and operates a diversified portfolio of 138 off-shore drilling units – 14 of which (or slightly over 10% of the fleet) are currently operating in the Gulf of Mexico.  The other rigs are under contract around the world from Brazil to the North Sea, from Angola to Vietnam.  Oil producers rely heavily on RIG’s assets for accessing hard to reach reserve locations, such as basins found in deepwater, ultra-deepwater, and harsh environments.  Rigs are contracted for many years and at operating day-rates that approach $500,000 depending on the asset, so the company’s cash flow is both predictable and significant.

We acknowledge the likelihood that Transocean will be named in many of the imminent lawsuits related to the accident.  However, we believe RIG is insulated from significant liability through the contractual indemnification of the rig operator by the contracting company (BP) – a longstanding industry practice.   In a May 28 conference call, RIG CEO, Stephen Newman stated, “BP takes responsibility for hydrocarbon emanating from the well. Their responsibility extends to controlling the well, and all of the cleanup efforts, and all of the economic damages associated with the cleanup efforts.  So all of that responsibility rests with BP. Over the last several weeks, as I have been in front of Congress, I have typically been seated next to BP’s president and CEO for BP America, Mr. Lamar McKay, and he has been repeatedly questioned on that point.  And he has repeatedly asserted that BP accepts that responsibility.” When pressed by an analyst regarding liability as a result of potential findings of a faulty rig design or operational fault, Newman reiterated, “The indemnity under the contract from BP to Transocean is extremely broad.”

We expect the company to earn between $2.4 billion and $2.8 billion this year and $3 billion in 2011. As the negative sentiment fades and investors fully recognize the limit of RIG’s potential liability, we believe the stock can return to a more reasonable valuation of  9 – 10 times earnings (recent historic range has been 6-11 time earnings), which would result in a share price closer to $90 (currently $48).  Additionally, last year the company announced a significant dividend payable this summer to return a portion of its growing cash hoard.  We believe the board favors an ongoing dividend policy in the future.

There is risk associated with the stock, and it will likely take time for our thesis to play out.  However, our research leads to the conclusion that the upside-downside potential is heavily skewed in favor of gains – justifying what we believe is a well-calculated risk in RIG at these levels.

Peloton Wealth Strategists owns the common stock of Transocean as well as the bonds of BP.  Peloton Wealth Strategists does not own the securities of Halliburton.  The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities.  Peloton Wealth Strategists assumes no liability for losses pursuant to investment actions entered into as a result of opinions expressed herein.  Changes in economic and capital market conditions and the unique objectives of each investor should be considered before investing in securities.