What Does 2015 Have In Store For Transocean?

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Transocean (NYSE:RIG), the world’s largest offshore driller, had a difficult 2014. The company’s stock price has plummeted by about 60% through the year, on the back of a glut in the ultra-deepwater drilling markets and also due to tumbling crude oil prices. While the market turmoil did not meaningfully weigh on the company’s operational performance during 2014, given the contract-driven nature of the offshore industry, we believe that 2015 could prove more challenging. We have reduced our price estimate for the company to $26 (14x our FY 2015 EPS estimates), to account for the weaker near-term outlook. Our price estimate still represents a more than 30% upside to the current market price. Our long-term view for Transocean and the offshore drilling industry remains reasonably positive, given the gradual shift of hydrocarbon exploration to deeper waters and also due to the company’s manageable debt load and its focus on the high end of the offshore markets. In this note, we take a look at what to expect from Transocean going into 2015.

See Our Complete Analysis For Transocean Here

Weaker Crude Prices Will Continue To Hurt Bargaining Power

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Exploring and producing from offshore deepwater and ultra-deepwater wells involves significant capital expenditures and needs to be supported by high oil prices that can yield attractive returns on investments and justify risks.  For example, a single ultra-deepwater well can cost as much as $300 million, while onshore shale wells can be completed for less than $10 million each. The current oil pricing environment may not be conducive to growth in offshore activity, given that benchmark Brent crude prices have fallen by over 40% since mid-June to levels of around $60 per barrel owing to strong output from U.S. shale fields, higher output from Libya and sluggish forecasts for oil consumption growth. Prices could remain under pressure through early next year as well, owing to further growth in U.S. production. The near-term situation doesn’t bode particularly well for offshore drilling contractors since oil and gas companies are seeing their cash flows come under significant pressure, leading them to become more circumspect about their capital spending plans for 2015. While we do not see the volume of ultra-deepwater and deepwater contracting activity being significantly impacted by weak oil prices, given that offshore projects have much longer capex planning cycles compared to onshore projects, customers will have significantly better leverage in negotiating new contracts and extensions, leading to less favorable contract terms and day rates.

Oversupply Of Ultra-Deepwater Rigs Will Persist Into Late 2015

The effect of the weaker oil prices is likely to be compounded by the strong supply of ultra-deepwater rigs in the industry. Ultra-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 growth in activity by investing record sums in constructing new deepwater and ultra-deepwater rigs. However, the industry has gotten ahead of itself, with ultra-deepwater supply creeping well ahead of demand. According to data from Fearnley Offshore, the number of ultra-deepwater rigs globally is expected to approach 180 units by the end of 2015, while demand from existing contracts and requirements is projected to stand at below 160 units. The supply of rigs is expected to outpace demand by roughly 20 units through much of next year. [1] The glut is also likely to make customers more selective about the rigs they deploy, and this could prove to be an issue for Transocean, since its rigs are older and less sophisticated, on average, compared to peers such as SeaDrill and Ensco.

Lower Dayrates, Utilization Rates

As of Q3 2014, Transocean saw its fleet-wide utilization rates decline to about 75%, from around 83% last year and 78% during Q2 2014, impacted by weaker usage of the company’s high-specification floaters. We believe that utilization rates could decline further going into 2015. We estimate that the company has around 11 rigs coming off contract during the first half of next year, and some of these rigs may find it difficult to find work in an oversupplied offshore market. Lower rig utilization rates will have a direct impact on the company’s revenues and operating margins, since an idled rig typically continues to incur similar costs compared to actively working rigs, since they retain most of their crew so that they can be deployed readily as demand arises. Day rates are also likely to come under further pressure given the weak oil pricing environment and the oversupplied ultra-deepwater drilling market. Day rate figures from the company’s recent fleet status reports haven’t been particularly encouraging. For instance, the Dhirubhai Deepwater KG2 rig was awarded a contract extension in India at a dayrate of $395,000, which is almost 25% below the previous day rate. The Leader harsh-environment rig was awarded a four year contract at an initial rate of $335,000 compared to a previous rate of $400,000.

Right-Sizing Fleet By Scrapping And Cold-Stacking Older Rigs

Transocean has been aggressively right-sizing its fleet, recently outlining plans to scrap 11 low-specification midwater and deepwater floaters including the Sedco 710, Sovereign Explorer, Sedco 700, Sedco 601, J.W. McLean, GSF Arctic I, and Falcon 100. The company intends to take a non-cash charge of $100 million to $140 million, net of taxes, during the fourth quarter to account for this. The move should help the company bring down operating and maintenance costs while also freeing up some liquidity. We believe that the company will scrap more rigs going into 2015 as well. While most of Transocean’s rigs built in the 1970s have been cold-stacked or scrapped, the company has a few mid-water rigs that were built in the early 1980s, which could come off contract during 2015 making them potential candidates for cold-stacking or scrapping. Drilling contractors usually cold stack a rig when they believe that the rig cannot find work at day rates above the cash breakeven for an extended period of time. [2] Transocean is unlikely to add any new rigs to its portfolio next year, given that its 12 newbuild orders –  which include 7 ultra-deepwater rigs and 5 high-specification jack up rigs – will only begin to enter service from 2016 onwards. [3]

Possible Dividend Cut Next Year

We believe that Transocean may be forced to trim its $0.75/share quarterly dividend next year, since its free cash flows are likely to come under significant stress due to a weaker business environment and also due to the company’s need to invest in upgrading its aging fleet. The company’s operating cash flows have averaged around $2.15 billion over the last three years, and it seems likely that they will deteriorate going into next year, given the weaker dayrates and utilization rates for ultra-deepwater rigs. The company’s capital expenditure guidance for FY 2015 stands at $1.9 billion, largely related to milestone payments for the company’s newbuild program. This means that the company is likely to see free cash flows (operating cash flows, less capex) of under $250 million, which would be insufficient to fund its $1.1 billion annual dividend. Additionally, the trailing twelve month dividend yield presently stands at over 15%. The fact the the yield is well ahead of the company’s cost of capital could be an indicator that the dividends are due for a cut, since shareholders may actually be better off with share repurchases.

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Notes:
  1. Transocean Cowen Ultimate Energy Conference Presentation []
  2. Offshore Rig Status Descriptions, Rigzone []
  3. Newbuilds, Transocean []