Transocean Will Lose The Battle Of Day Rates

Aug.15.14 | About: Transocean Ltd. (RIG)

Summary

Transocean was able to post better-than-expected second quarter results. However, going forward, the company is still facing significant headwinds.

The offshore drilling industry is witnessing an oversupply of ultra-deep-water rigs creating serious threats for Transocean as it has been deriving 50 percent of its revenues from ultra-deep-water rigs.

With the older age of its fleet the company seems to have less bargaining power to negotiate higher day rates.

Transocean (NYSE:RIG) is all set for the initial public offering of Transocean Partners LLC. In addition to the IPO announcement, the company has recently announced its second quarter earnings. The reported earnings are generally welcomed by the market. The company reported EPS of $1.61 beating the analysts' estimates of $1.02 per share. Given the weak environment for the rig industry these results are considered to be better than expected. Despite the fact that the company has beaten the analysts' expectations it is also facing significant headwinds in the near term. Therefore, it shall be desirable to discuss the company's future outlook in light of recently declared financial results.

Transocean and the Offshore Drilling Industry

The industry has been witnessing an oversupply of ultra-deep-water rigs. For Transocean, the scenario is worrisome as the ultra-deep-water rigs account for over half of the company's total revenues. With an increased focus on offshore drillers the number of ultra-deep-water rigs is expected to grow from approximately 120 in 2013 to over 160 by the end of 2014 and the demand is expected to be constant. The demand for offshore ultra-deep water is forecasted to remain at around 140 rigs by the end of 2014 creating an excess of 20 rigs.

The increased supply has had a considerable impact on Transocean's overall revenues as can be estimated from the decreased utilization rates. The company's utilization rate for the ultra-deep-water fleet has decreased from approximately 96% in the last year to around 88%. Going forward, the utilization rate is expected to further decline as contracts of 33 percent of the company's ultra-deep-water rigs, (9 out of 27 rigs) are reaching their expiry dates. Moreover, there are no current contracts to fill this gap. Despite the fact that the company is facing underutilization of ultra-deep-water rigs, it experienced an improvement in day rates.

Transocean witnessed an improvement of 6% from the previous year but declined by 1.5% from the previous quarter. Although, on a yearly basis, the company has managed to improve day rates, the current scenario seems not to be very favorable. The company was able to successfully close the contract for the Dhirubhai deep-water KG1 drillship. The drillship was awarded a three-year contract for work in Brazil at a rate of around $440,000 per day. The current rate is approximately 14% lower than the previous contract rate. Similarly, the Cajun Express semi-submersible rig also witnessed declines in day rates, which were nearly 24% lower than the current rates on a contract that is expected to start in October this year. The lower rates could be a great setback for the revenues of a company like Transocean whose 9 out of 27 rigs have contracts that will expire by the end of this year.

Going forward, the lower rates will significantly hurt the company. Considering the weak outlook of offshore drilling activity and the old age of its rigs, particularly in comparison with Seadrill (NYSE:SDRL), I believe that the company's bargaining power in negotiating new contracts will also weaken.

The operating and maintenance costs constitute the single largest cost driver for the company. In comparison with the industry average, the company's O&M costs are on high standing at over 50% of revenues. Recently the company has taken certain steps towards bringing the costs to a more manageable position. It recently downsized its shore-based support infrastructure. In addition, the company was able to eliminate some non-core functions. During the second quarter, the company was able to cut costs by roughly 11% on a yearly basis and approximately 5% from the previous quarter to around $1.21 billion. The decrease was primarily attributed to lower shipyard expenses. The company also improved its revenue efficiency numbers, which increased from around 93% a year ago to about 95%.

Concluding Remarks

Currently the offshore drilling industry has been witnessing an oversupply of rigs, which will continue to hurt the revenues of the company in 2014. Moreover, with the older age of the fleet the lower industrial growth will also negatively affect the company's ability to negotiate contracts on higher rates.

Some analysts believe that with the recently declared quarterly results the concerns about the company's ability to conduct efficient operations may end. However, there are several other analysts who believe otherwise. In my opinion, although the company has beaten analysts' estimates of quarterly results, it is too early to make any investment decisions.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.