Is This Energy Stock About To Pop?

As oil has recovered from its epic fall from above $100 to below $30 in 2014/15, many oil related stocks have also regained lost ground. The recovery in stocks, however has been far from even. Some, like Diamondback Energy (FANG) recovered to hit record highs, but others have still yet to recover at all. Transocean (RIG) is in that second group. That is for good reason, but it does leave plenty of room for a big jump, and a strong case can be made right now that one is coming.

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The main reason RIG has lagged far behind the general recovery in energy stocks is simple. They are an offshore specialist, an area that itself has been slow to recover. The improvements in fracking technology that we have heard so much about have made recovering oil on land easier and cheaper, making the cost and problems with offshore drilling less and less attractive on a relative basis. That has showed in RIG’s results.

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While most energy companies have put losses behind them, Transocean has posted negative EPS in each of the last four quarters. Despite that though, the stock has been showing some signs of recovery over the last year, gaining well over fifty percent. In part that is because in this case, EPS is only part of the story. The company has a lot of cash on hand (close to $2.9 billion) and has positive levered free cash flow of around $650 million. That strong cash position results in part from restructuring and rationalization and that is no doubt why the stock has lagged so badly over the longer-term. Nobody wants to invest in a shrinking company.

That shrinkage, however, was not just needed in the circumstances, but also a smart move. It has left Transocean leaner and more focused, and, as the strong cash flow suggests, well placed to make money when the costs of restructuring dissipate. In that sense, the stock should now be looked at in its own right, not as compared to what it was, and, on that basis, it is a buy.

Even more appealing to me than the long-term fundamental case in many ways though are the short-term market dynamics that suggest a pop in the stock is imminent. As the stock has recovered over the last year, so the short interest has risen, and now stands at 18.85% of the float. That indicates that if the stock does start to gain ground, any move will likely be exaggerated as those shorts get squeezed.

Transocean is scheduled to release earnings on August 1st, and a squeeze as that date approaches would make sense. WTI was above $65 for most of last quarter and above $70 for a while, making a significant improvement in revenue likely, and with restructuring costs declining that suggests that a beat of the -$0.17 consensus EPS expectation is on the cards. Whether it materializes or not, the potential for good news combined with a large short interest makes a compelling case for buying RIG.

I should stress that this is not necessarily a long-term idea. I think a beat of earnings expectations is likely, but the release could contain other, less positive news, particularly in terms of forward guidance from what has recently been a conservative management team. The reality, however, is not the point. This is a trade designed to benefit from what I consider to be the most potent short-term influences on a stock’s price, market dynamics and positioning.

On the surface, the earnings picture looks to be positive and there is the distinct possibility of a short squeeze going into the release. In addition, the supply issues that are driving oil higher look set to continue, so I am expecting crude to go higher before it turns. That makes a clean break above $14 likely in the coming weeks with a strong chance that any upward move is exaggerated as shorts cut their losses. On that basis, RIG looks like a buy.