While offshore drilling has been expanding globally over the last two years, the stocks of many large offshore drillers have seen a sharp sell-off in recent months. Transocean (NYSE:RIG), the world’s largest offshore drilling company, has seen its stock price fall from around $55 during Q4 2013 to current levels of under $44. We believe that this is due to concerns that the offshore drilling contractors could be facing some growing pains, in the form of excess deepwater rig capacity and a consequent decline in pricing power for their most lucrative rigs.
Strong Growth, But An Oversupply of Rigs Could Dent Industry Pricing Power
Offshore drilling activity has been strong over the last few years, on the back of stable oil prices as well as rising natural gas prices in most parts of the world. Higher hydrocarbon prices increase the incentive for oil and gas companies to undertake more challenging and complex offshore exploration. According to data from Baker Hughes, the average offshore rig count stood at close to 377 in 2013, up from around 355 a year ago. Additionally, more of the offshore discoveries have been coming from deeper waters. For instance, in 2012, around 28% of new offshore discoveries (in terms of volumes) came from deepwater plays, while around 49% came from ultra-deepwater plays.((Transocean Presentation)) The outlook for deepwater spending also looks bright, rising from around $43 billion in 2012 to about $114 billion by 2022, according to consulting firm Wood Mackenzie. 
Offshore drillers have responded swiftly to the growing activity, investing record sums in constructing new deepwater and ultra-deepwater rigs, which can often command day rates of over $525,000. However, presently, supply seems to be outstripping demand. There are around 38 ultra-deepwater rigs across the world that currently remain un-contracted, up from around 22 rigs a year ago.  Additionally, according to Credit Suisse, rig rental capital expenditure is expected to grow at below the 18% rate that is required to keep the global fleet of floaters utilized in 2014.  This could strengthen the bargaining power of oil companies and put drillers at a weaker position given the excess supply in the market.
Older Fleet And Larger Number of Contracts Coming Up For Renewal Are A Negative For Transocean
Offshore drillers typically have a sizable amount of their future revenues coming from already contracted rigs. Although Transocean had a revenue backlog of about $29 billion as of October 2013, we estimate that around 35% of this comes from its new-build ultra-deepwater drillships that are contracted to Shell and Chevron, which will begin service only in 2016. In the near term the company could face pricing pressures as several contracts come up for renewal over the next year or so. About 12 of the company’s 26 ultra-deepwater floaters have contracts that will expire this year, while around 7 out of 8 of the company’s contracted deepwater floaters will also have to look for new work by the end of this year.  Transocean’s bargaining power in new contract negotiations is likely to be weaker, even when compared to some of the other large offshore drillers, since the company’s fleet is older and is likely to be less technically sophisticated. Transocean’s typical rigs are roughly 9.5 years old, compared to Sea Drill and Ensco, whose rigs have an average age of under 4 years. Notes: