Why We Think Transocean Is Worth $56

The last two years have been difficult for Transocean (NYSE:RIG), the world’s largest offshore drilling contractor, which saw its revenues and profits decline due to subdued demand for offshore drilling, low rig utilization levels and impairment charges. The firm’s stock has also been treading a volatile path, falling from about $90 in 2010 to the current levels of $46. We however believe the firm could be poised for a turnaround on improved market conditions in the offshore drilling industry and its realigned asset strategy which focuses on higher specification rigs.

Strong Demand Is Helping To Garner Better Rates

Demand for offshore and particularly deepwater drilling has been strong this year as technological developments and higher oil prices are making it feasible and cost effective for oil companies to explore in deeper waters. The industry witnessed a total of 46 ultra-deepwater contracts being executed this year, the highest number seen since 2008. ^[1]

Higher demand for offshore drilling gives the firm better bargaining power with customers, allowing it to realize better day rates on contracts. In its most recent fleet update issued in November, Transocean reported new contracts at rates between 20% and 70% higher than that for previous contracts.  ((Transocean Fleet Update Summary)) The strong demand will also help the firm boost its utilization rates, which are a measure of how many of the company’s rigs are working on contracts in comparison to total fleet size. These rates are an important metric given the high capital expenditure that the firm incurs in constructing these rigs, much of which is funded by debt. Utilization rates rose to 77% last quarter compared to the average rate of 57% last year.

However, in the long run, as the demand for deepwater and ultra-deepwater drilling increases, the number of rigs is also likely to increase globally, possibly impacting the firm’s cost base as offshore drillers compete for talent causing training and employee retention costs to increase.

Asset Realignment Strategy

Transocean recently divested its fleet of 38 standard jack-up rigs to focus on high specification jack-ups and deepwater floaters like ultra-deepwater drillships . The firm inked a record $7.6 billion contract with Royal Dutch Shell to provide 4 new-build ultra deepwater drill ships in Q3 and has 2 other drill ships under construction. High specification floaters have higher day rates (typically between $400k to $600k) and have historically displayed better utilization rates for the firm. They also face less competition from smaller contractors, giving Transocean better pricing power and better margins.

Brazil And African Opportunities

As the world’s largest offshore driller, the firm has a wide geographic presence and looks well-positioned to gain from growing offshore activity in Brazil and Africa. Brazil has emerged as one of the most sought-after regions for oil exploration, following sizable discoveries in offshore sub-salt areas by government controlled energy giant Petrobras. Some experts estimate that reserves in the sub-salt regions could be as high as 100 billion barrels (proven reserves stand at around 13 billion barrels). ^[2] Transocean has a good relationship with Petrobras, having contracted 8 rigs to the firm and could leverage this relationship to expand its footprint in the country.

Africa is another promising region for Transocean with the number of offshore rigs in the region having doubled over the last 4 years.  The company has a good market reach with over 15 rigs under contract in the West African countries of Nigeria and Angola and could see demand for deepwater exploration grow in East Africa as well, following the discovery of massive gas fields in the Offshore area 1 of Mozambique.

We have a $56 price estimate for Transocean, which is about 24% ahead of the current market price.

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1. Transocean Q3 2012 Earnings Call Transcripts, Seeking Alpha [↩]
2. Petrobras Makes Big Oil Find In Brazil’s Sub-salt-Partner, Reuters [↩]