Transocean Ltd. (RIG)

[Timothy Smith]

Transocean [NYSE: RIG] is now notorious for being the company that operated the fateful Deepwater Horizon drilling rig for BP.

But it's much more than that.

Transocean is the world's largest offshore drilling contractor with 140 rigs operating around the world. Locations include Africa, the North Sea, South America, Southeast Asia, and of course the Gulf.

It contracts the operation of these rigs to oil companies like BP, ExxonMobil, and Anadark. These companies pay Transocean a dayrate ranging from $50,000 to $650,000 per day, depending on the type of rig. Ultra-deepwater rigs (those that can drill in water up to 40,000 feet) command the most, while standard jackups command the least

First, let's state the obvious risks

Unfortunately for the company, 11 of its 12 rigs in the Gulf are ultra-deepwater and right now, most are not operating.

When (or if) all these rigs can get back to work isn't known yet, despite the U.S. government lifting its moratorium on drilling in the Gulf. Tougher regulations will certainly be coming, which will cost money to satisfy. And now Europe is considering toughening its regulations, with other regions likely following suit.

Another concern is the ability to negotiate high dayrates going forward. Many rigs have moved out of the Gulf, increasing competition elsewhere. If Transocean follows, that competition could hold down what it can charge.

Finally, there is the legal liability. Despite having indemnity clauses in its contracts, investors are concerned that Transocean will be found partially responsible for the oil spill in the Gulf. How much that liability might be is unknown, but it could potentially run into the billions.

So why should you consider buying?

Transocean brought in roughly $765 million in free cash flow over the past four quarters.

Now consider the following. Over the past five years, Transocean has grown free cash flow by roughly 42% per year.

Given the concerns above, yes, it might have a bit of a problem growing free cash flow for the next couple of years. But, a lot of that concern is going to be resolved over the next few years with the likelihood of higher expectations baked into the price.

Among its competitors, it has the lowest expectations at current prices.

All of which means...

Transocean provides a compelling opportunity to take advantage of some really low market expectations.

I believe Transocean will either be able to restart those rigs in the Gulf or move them. Plus, it's about to bring three more rigs on board.

The world's demand for oil is not declining despite what happened in the Gulf, and Transocean will continue to play a leading role in extracting it while adapting to new regulations.

Warren Buffett reminds us that we pay a hefty price for a cheery consensus. There is definitely no cheery consensus surrounding Transocean today, but waiting until the risks are resolved will not serve us well.

If you're interested in this company, I recommend you follow my lead with a mid-sized position because of the legitimate legal risks Transocean faces and its debt level compared to its peers'.

There's one more energy stock that would make a solid addition to your portfolio today. It's a dominant player in its specialty, and without it, most oil and gas companies wouldn't be able to operate.

This post is for DD purposes only and not a recommendation to buy or sell.