Transocean Revised To $33 On Ultra-Deepwater Oversupply And Demand Concerns

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The offshore drilling market has been facing significant headwinds of late due to an oversupply of ultra-deepwater drilling rigs, slower than expected growth in rig rental expenditures by oil companies and plummeting crude oil prices. Transocean (NYSE:RIG), the largest offshore drilling contractor,  is likely to bear the brunt of this downturn, owing to its large exposure to the oversupplied ultra-deepwater rig market and its older fleet. In light of this, we have revised our price estimate for the company from around $42 to about $33, which represents a slight premium to the current market price. In this note, we take a look at the key rationale behind our price revision and the specific changes to our valuation model.

See Our Complete Analysis For Transocean Here

Strong Rig Supply Will Impact Utilization And Dayrates

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Deepwater drilling activity was strong over the last few years, driven by stable to increasing commodity prices and several exploration successes. Offshore drilling contractors responded quickly to the growing activity, investing record sums in constructing new deepwater and ultra-deepwater rigs. However, the industry may have gotten ahead of itself, as supply is outstripping demand. According to data from Fearnley Offshore, the number of ultra-deepwater rigs globally is expected to grow to around 160 units by the end of 2014 while demand – including existing contracts, options as well as possible contracts – is expected to come in at under 140 rigs, translating into significant oversupply. The trend could persist through 2015 as well, since supply is expected to cross 180 units by the end of 2015, while demand is projected to stand at below 160 units.

The strong supply is impacting Transocean’s business, with utilization rates for its ultra-deepwater fleet falling from around 96% a year ago to about 88% as of Q2 2014. Transocean announced that it would idle its Jack Ryan drillship, and the company also has another 3 ultra-deepwater rigs that have contracts that will end before this year. [1] The glut is likely to make customers more selective about the rigs they deploy, which will likely prove an issue for Transocean, since its rigs are older and less sophisticated, on average, compared to peers such as SeaDrill and Ensco. We believe that this could possibly result in an even greater number of idle rigs going into 2015. Lower rig utilization rates have a direct impact on revenues and operating margins, since an idled rig typically continues to incur similar costs compared to actively working rigs, as they retain most of their crew so that they can be deployed readily as demand arises.

Day rates are also likely to take a hit given the oversupplied market and the company’s consequently weaker bargaining power in contract negotiations. Indicators of day rates from the company’s recent fleet status reports haven’t been particularly encouraging. For instance, the Dhirubhai Deepwater KG1 drillship was recently awarded a three-year contract for work in Brazil at a rate of around $440,000, which is about 14% lower than the previous contract rate. The Cajun Express semi-submersible rig will also see rates that are nearly 24% lower than previously contracted rates. While one of the company’s deepwater rigs – the Jack Bates – was recently awarded a  higher day rate of $440,000 compared to a prior dayrate was $380,000, this was likely due to the fact that the contract is short-term and is located in the higher-cost Australian market.

Lower Oil Prices May Cloud The Outlook For Rig Demand

Upstream activity and investments are largely driven by the outlook for oil prices. Since exploring and producing from deepwater wells involves significant capital expenditures, it needs to be supported by higher oil prices that can yield attractive returns and justify the risks. The current oil pricing environment may not be conducive to growth in rig contracting activity, given that benchmark Brent crude has fallen by about 25% over the last four months to levels of around $85 due to strong output from U.S. shale fields, higher output from Libya and Saudi Arabia and sluggish forecasts for oil consumption growth. Prices are projected to fall further next year as well. While ultra-deepwater and deepwater activity may not be directly impacted by short term variations in oil prices, considering the lower production costs and longer planning cycles compared to onshore wells, investments could be scaled back if oil prices remain under pressure.  Deepwater projects call for much higher upfront investments and operating costs (over $150 million/year compared to costs of under $10 million/year for shale wells), and oil companies may be reluctant to undertake new projects in an uncertain pricing environment. ((The Great Oil Debate: Deepwater vs. Shale, Wall Street Daily, May))

Summary Of Key Model Changes And Price Impact:

  • Reduced utilization rates for CY2015 to about 72% compared to a previous estimate of 75%. We now expect utilization rates to rise to  77.5% by 2021 compared to a previous estimate of around 79.5%. (- $2 impact on price estimate)
  • Reduced forecast for day rates to about $360,000 in 2015 from a previous estimate of around $380,000. We expect the number to rise to around  $420,000 in 2021, compared to a previous estimate of about $430,000. (-$1 impact)
  • Reduced contract drilling gross margins to about 40% for 2015, rising to about 42% by 2021. (-$3 impact)
  • Changes to net working capital, capital expenditures and general expenses forecasts. (-$3 impact)

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Notes:
  1. Transocean Reveals Some Offshore Drilling Interesting Industry Trends, Seeking Alpha, October 2014 []