Transocean Q1 Preview: Lower UDW Day Rates, Weaker Utilization Will Hurt Results

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Transocean (NYSE:RIG), the largest offshore driller, is expected to publish its Q1 2015 earnings on May 7, reporting on a quarter that saw the company scrap and idle several rigs amid weak demand and chronic oversupply in the global ultra-deepwater (UDW) drilling markets. We expect quarterly adjusted earnings to decline on sequential as well as year-over-year bases owing to weaker utilization rates and dayrates. On a GAAP basis, the numbers will be further weighed down by non-cash charges (possibly upwards of $400 million) related to rig disposals. That said, the full impact of the current market conditions will only factor into earnings in the quarters to come, as higher-priced contracts end and as a greater number of rigs remain idle or work at lower rates (related: What Does 2015 Have In Store For Transocean?). During Q4 2014, the company’s performance held up reasonably well with drilling revenues falling by just about 1.5% year-over-year to $2.17 billion, while net income rose by about 32% to $344 million owing partly to lower operating and maintenance costs. [1] Here’s a quick look at some of the current trends in the offshore markets and what to expect when the company reports earnings.

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Trefis has a $20 price estimate for Transocean, which is about 20% ahead of the current market price. We will be revisiting our price estimate for the company following the earnings release.

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Downturn In The Ultra-Deepwater Markets

Crude oil prices are down by about half since mid-June 2014, putting significant stress on the earnings and cash flows of oil and gas players. On average, upstream companies have cut their exploration and production budgets by about 20% for 2015. Companies have also been refocusing their capital budgets away from drilling and exploration activity towards improving flow rates and well productivity. The offshore ultra-deepwater market has been particularly badly impacted by the current oil price environment. Exploring and producing from 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 the high risks. For example, a single ultra-deepwater well can cost as much as $300 million, while onshore shale wells can be drilled and completed for less than $10 million each. Offshore projects also have much longer capex planning cycles compared to onshore projects, and customers are a lot more circumspect about committing to new offshore projects at the moment, given the uncertain outlook for oil prices. While offshore drillers have been adjusting rig supply by scrapping and stacking older and less efficient rigs, the markets are still far from equilibrium. For instance, analysts at Cowen estimate that about 32 floating rigs have been designated for retirement over the past 6 months and they estimate that another 100 floaters would need to be removed from supply to balance the market. ((Offshore Drillers: 100 Units Should Be Removed, Barrons, April 2015))

Poor Contract Coverage And Older Fleet

Transocean has been bearing the brunt of the current downturn owing to its heavy exposure to the ultra-deepwater market (about 27 out of its 68 rigs are UDW), its older than average fleet and a large number of upcoming contract expirations. Transocean’s monthly fleet status report for the period ended April 16 indicates that it added just about $26 million in contract extensions, with no new contracts signed on rigs. During the same period a year ago, the company added more than $200 million worth of contracts. Transocean has been aggressively right-sizing its fleet with plans to scrap a total of 19 floaters. However, despite the disposals, utilization rates are likely to remain under pressure given that the company has also been stacking and idling several other rigs. The company stacked 4 of its ultra-deepwater floaters last month (Discoverer Spirit, GSF Jack Ryan, Deepwater Discovery, Deepwater Pathfinder) and has idled 7 rigs year-to-date. Drilling contractors usually stack a rig when they believe that it cannot find work at day rates above the cash break even for an extended period of time. As of Q4 2014, Transocean’s fleet-wide utilization levels stood at 72%, down from around 75% a year ago.

The pricing environment also remains extremely challenging, as customers push for lower day rates in an oversupplied market. Average day rates for ultra-deepwater rigs  in the industry are down by more than 20% from their pre-cycle levels. Transocean may not see the full impact of the current day rates during this quarter, as it executes on older and higher value contracts. That said, the current market realities will hit revenues sharply going forward given the company’s weak contract coverage, which means that it will have to negotiate contracts at lower rates or idle rigs as its existing contracts expire. About 36%, 59% and 71% of Transocean’s high-specification floaters remaining uncommitted for 2015, 2016 and 2017 respectively, potentially weakening its bargaining power in contract negotiations. Additionally, there is likely to be an increase in supply of high-spec newbuild ultra-deepwater drillships which could further hurt the company’s contracting prospects in the current market.

Operating And Maintenance Costs Should Fall

Operating and maintenance costs are the single-largest cost driver for Transocean. While Transocean’s O&M costs are on the higher side compared to the industry average, standing at more than 55% of total revenues (compared to under 40% for rival SeaDrill), the company has been taking steps to bring them down by downsizing its shore-based support infrastructure and eliminating some non-core functions. During Q4 2014, O&M costs declined by around 10% year-over-year to $1.31 billion, owing to lower shipyard and maintenance costs. We expect the number to be still lower in Q1 2015, as  the company has been scrapping older rigs while also stacking rigs that remain uncompetitive in the current environment. However, operating expenses may continue to remain high as a percentage of revenues given a possible decline in day rates. Transocean had guided operating and maintenance expenses of between $4.5 billion to $4.7 billion for 2015, marking an 8% to 12% year-over-year decline.

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Notes:
  1. Transocean Q4 2014 Press Release []