The market for deepwater and ultra-deepwater drilling could face some near-term challenges due to an oversupply of drilling rigs, as well as slower than expected growth in rig rental expenditures across the upstream oil and gas industry. We believe that Transocean (NYSE:RIG) could bear the brunt of this cyclical downturn, given its large exposure to the deepwater and ultra-deepwater space, as well as its fleet of older and less sophisticated rigs. In light of this, we are revising our price estimate for the company from around $53 previously to about $45, which is still slightly ahead of the current market price. In this note, we discuss the rationale behind the revision as well as the corresponding changes to our valuation model.
A Cyclical Slowdown
Deepwater drilling activity has been strong over the last few years, supported by rising oil and natural gas prices. Some of the regions that have seen significant growth include the U.S. Gulf of Mexico, West Africa, Australia and Brazil. In 2012, over 75% of new offshore discoveries came from deepwater and ultra-deepwater wells.  Offshore drilling companies responded swiftly to the increasing activity, placing orders for a record number of ultra-deepwater rigs, which can often command day rates of over $525,000. However, it now seems the industry may have gotten ahead of itself, as supply has reached a point where it is beginning to outstrip demand. For instance, Credit Suisse estimates that rig rental capital expenditures by oil and gas companies will grow by just about 5% over the next three years, which is well below the 14% to 18% growth rate that would be required to keep the global fleet of rigs contracted. 
Why Transocean Could Be The Worst Affected
Transocean could be one of the worst hit by a glut in the deepwater drilling market for several reasons. Firstly, the company has the largest exposure of any offshore driller to the deepwater market, with a fleet of about 29 ultra-deepwater and 14 deepwater rigs. Secondly, the company has a total of 19 rigs (12 ultra-deepwater and 7 deepwater) that have contracts that will expire this year. This could prove to be an issue for the company since its fleet is older and likely less sophisticated, on average, when compared to some of its peers. Transocean's typical rigs are roughly 9 years old, compared to competitors such as Seadrill (NYSE:SDRL) and Ensco (NYSE:ESV), whose rigs have an average age of less than 4 years. It seems possible that some of the company's deepwater rigs (six of which were constructed in the 1970s and 1980s), could be idled as oil companies would choose to lease newer and more capable rigs in the oversupplied market. Even if the company's older rigs do find takers, its bargaining power in these contract negotiations is likely to be weaker.
Some of these factors have already begun impacting Transocean's earnings. During Q4 2013, the company's utilization rate for ultra-deepwater floaters, which is a ratio of the number of rigs working on contract to the total number of rigs, fell to 87% from around 94% a year ago, while average day rates for these rigs were also lower by about 3% sequentially at around $510,200.
New Build Order Is Speculative
Last week, the company announced that it had placed orders for 2 new ultra-deepwater drill ships at a cost of around $1.24 billion, without any leasing contracts in hand. The rigs will be delivered in 2017 and 2018. While we believe this is a positive step forward in reducing the average age of the company's fleet, it marks a significant departure from the company's previous practice of securing contracts for rigs before committing to building them. This could prove risky for the company given that the current oversupply situation isn't expected to ease until around 2016 as oil companies begin to ramp up their spending programs once again.
Summary of Key Model Changes
We have reduced our forecast for Transocean's utilization rate for the years 2015 and 2016 to around 76%, considering the possibility that some of the company's rigs that are currently in service could be idled this year as their contracts expire. However, over the long run, we expect rates to increase to over 80%. We have also reduced our day rates forecast to grow to $390,000 and $400,000 for these two years from a previous estimate of around $425,000, although we still expect rates to rise to around $440,000 by FY 2020. We have also increased our forecast for the company's capital expenditures to around $2.8 billion, or 45% of gross profits, by the year 2020. Breaking up the price impacts of our driver changes, the revised utilization rates reduced the price estimate by roughly $3 per share, while the lower day rates reduced the estimate by around $2 per share. The higher capital expenditures reduced our price estimate by a little over $3 per share.
Disclosure: No positions.