How Various Oil Price Scenarios Could Impact Transocean

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Transocean

The last few quarters have been tough on the offshore drilling industry, as low crude oil prices resulted in a sharp decline in deepwater and ultra-deepwater exploration and related rig contracting activity. Transocean (NYSE:RIG), the largest offshore driller, has been particularly impacted owing to its older-than-average fleet and weak contract coverage, which expose its future revenues to a high level of uncertainty. The company’s stock price is down by close to 50% over the last 12 months. Transocean has been taking several steps to rein in costs, while aggressively right-sizing its fleet to better cope with the downturn. However, the ultimate recovery in the company’s sales and earnings growth will hinge on the recovery of crude oil prices, which would in turn improve the sentiment among oil companies to undertake high-hurdle rate offshore projects. Brent crude prices are currently trading at around $65/barrel, recovering by about 40% over the last few months, on the back of large cutbacks in exploration and production by most major oil companies, a moderation in supply growth from North America and recent geopolitical tensions in the Middle East. However, prices could remain vulnerable in the medium-term given service cost deflation and growing production capacity in the Middle East. In this note, we take a look at the oil price forecasts driving our price estimate for Transocean and two potential scenarios that could meaningfully alter the value of the stock.

See Our Complete Analysis For Transocean Here

Trefis has a $20 price estimate for Transocean, which is slightly ahead of the current market price.

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What’s Driving Our $20 Estimate

Exploring and producing from 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. While these projects typically have lower break-even costs compared to onshore shale wells, they have longer planning cycles and significantly higher upfront costs, which are making oil companies more circumspect about committing to these projects in the current environment. Rig rental dollars are drying up in the offshore market and customers have significantly better bargaining power in negotiating new contracts and extensions, leading to lower day rates and an oversupply of rigs. According to IHS Petrodata, the number of rigs contracted globally has fallen from 737 a year ago to 673. [1] Day rates on new ultra-deepwater contracts are down by more than 20% from their pre-cycle levels.

We currently expect Brent crude prices to average around $70/barrel for this year, although they should increase gradually to about $80/barrel over the next two years, as supply becomes tighter due to the cutbacks in upstream capital spending (15%-30% expected for CY’15) and also as demand growth picks up to more normalized levels. However, despite the projected improvement in oil prices in the medium term, we still believe that things could remain challenging for Transocean through 2016, as the full effects of the presently weak contracting activity reflect on the company’s earnings. Additionally, Transocean’s weak contract coverage means that it will have to negotiate contracts at lower rates or idle rigs as existing contracts expire. As of Mid-April 2015, about 36%, 56% and 69% of Transocean’s high-specification floaters remained uncommitted for 2015, 2016 and 2017, respectively. Our $20 price estimate for the company estimates that day rates will decline to about $380k this year, while falling further to about $360k next year after which they will rise to about $410k by the end of the forecast period (CY2021). We expect the annual effective rig count to decline to about 71 rigs this year, while improving gradually to around 85 rigs by the end of the forecast period. We expect gross margins to decline to levels of about 31% in 2016, although they should improve to about 37% going forward.

Bull Case: V-Shaped Recovery In Oil Prices (+30%)

There is a possibility of a much sharper, V-shaped recovery in global oil prices if the growth in demand for oil products picks up significantly on the back of lower oil prices or increased economic activity in China. Oil production could also decline because of a sharp and sustained slowdown in drilling activity. The U.S. EIA reports that oil production from the seven major U.S. shale plays is expected to fall by a total of 86,000 barrels a day in June, with production from the prolific Eagle Ford and Bakken shales taking the largest cuts. If the cuts continue going forward, it could help to bolster oil prices. Additionally, if the OPEC – which accounts for about a third of global crude oil output – decides to change its current stance and reduces its production, this would also have a very positive impact on oil prices, providing significant tailwinds for oil-linked equities, including offshore drillers. If oil prices see a V-shaped recovery, rising to levels of close to $90/barrel by next year, this would incentivize oil companies to bolster their exploration and production spends and undertake more expensive and challenging plays. Under this scenario, demand for Transocean’s ultra-deepwater and deepwater rigs could improve meaningfully. If  the company’s dayrates stand at $390k in 2015 while rising to about $435k by the end of the forecast period, while margins and utilization rates rise to about 40% and 86%, respectively, by the end of the forecast period, this would increase our price estimate by 30% to about $26.

Bear Case: Sustained Low Oil Prices (-20%)

On the other hand, OPEC could maintain its current stance and demand for crude oil could remain suppressed because of a continued slowdown in economic activity in China or the increased use of alternative fuels. If this were to occur, the recent decline in oil prices could sustain for a much longer period. Additionally, upstream service cost deflation for oil companies could help to reduce the overall cost structure of the oil industry, leading to more robust non-OPEC supply growth despite the slump in oil prices. If this results in oil prices remaining at levels of $60 to $70/barrel over the next several years, it could result in significant headwinds for the oilfield services and offshore drilling industries. Under this situation, if Transocean’s average daily revenues fall to about $356k by 2016 and recover at a slower pace to about $390k by the end of the forecast period, while margins and utilization rates improve to just about 35% and about 80%, respectively, by the end of the forecast period, this could result in a 20% downside to our price estimate, implying a $16 price estimate.

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Notes:
  1. IHS Petrodata Weekly Rig Count, IHS []