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Maximum Pessimism: Opportunities In Oil & Gas

To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude but pays the greatest rewards.

In the short run, offshore drilling appears as the most distressed segment of equity markets since the crash of oil price and the rise of U.S shale production. In the long run, however, demand is expected on the rise for large, untapped reserves and higher NPVs offer excellent visibility and investment safety to producers.

Following significant cost-cutting and upgrades in technology, the drillers that service them should return to profitability as soon as the price per barrel hits the $60 mark – causing producers to unfreeze capital expenditures, orders to ramp-up and day rates to improve.

Against this backdrop, Diamond Offshore – majority-owned by the Tisch family – and Rowan Companies’ common stocks stand out as spectacular investment opportunities and perfect vehicles to ride the recovery.

Soundly capitalized, superbly managed, trading for a fraction of net asset value and six to eight times bottom-cycle cash earnings, both companies – shaken yet profitable – sport good backlogs and competitive fleets, in addition of satisfactory returns over the full cycle.

Bankruptcy is out of the picture, as their debts are well-structured, their liquidity plentiful and their interest charges amply covered.

A persistently low oil price or some misguided capital allocation – such as a the acquisition of a peer in distress with no turnaround in sight – constitute the two obvious risks.

Nevertheless, the situation presents an asymmetric bet that perfectly warrants an investment within a diversified portfolio.

(Was long DO and RDC at average prices of $11 and $12 a share; sold both at $20 following the takeover of Rowan by Ensco.)

In Europe, investors focused on big capitalizations trading for a steep discount on book value should be interested in Repsol, the Spanish major.

Among others features, the company looks able to withstand distress in upstream due to its profitable activities in downstream. A word of caution though: consolidated operations have historically generated subpar returns on capital and insufficient free cash-flow to cover the hefty dividend, paid in part by the sale of new stock.

Management seems determined to tackle the problem, and has just initiated a vast reorganization effort in the wake of the transformative acquisition of Talisman Energy – the Canadian E&P formerly part of British Petroleum.

Stakes are high: if the latter fails, billions will go up in smoke.

Valuing the business via a basic sum-of-the-parts, we know that Repsol paid 6,6 billion euros to acquire the 750 million barrels of Talisman’s proven reserves, or 9 euros per barrel – presumably a fair price if a recovery materializes. At such rate, total Repsol’s proven reserves of 2,3 billion barrels would roughly be worth 20 billion euros.

The downstream activities generated 2,4 billion euros in operating profit last year, albeit refining margins do flirt with their all-time highs as crude price lingers below $50 a barrel. A multiple of twelve times the last realized profit yields a rough value of 29 billion euros for these highly strategic assets.

As we subtract from the sum of both segments – 49 billion euros – the 15 billion of net debt and provisions, we get a fair but conservative value of 34 billion for the business as a whole, or 22 euros per share.

Should these back-of-the-envelope calculations prove not too off-the-mark, the discount on adjusted asset value rings large with a share price under 13 euros.

(No position.)

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