Why Transocean Will Soar Higher

| About: Transocean Ltd. (RIG)

Summary

Despite end-market difficulties, Transocean has continued to land new contracts in offshore drilling hotspots such as India, where it recently won a new contract from state-run company ONGC.

This new contract win will drive Transocean’s business in the long run as ONGC will spend around $4 billion to $5 billion in the coming three years on offshore development.

Transocean will also witness strength in demand from other areas such as Latin America and Africa, where $173 billion will be spent on offshore projects.

Offshore oil development will continue in the long run since oil reserves are going down but demand is going up, and there are 400 offshore oil discoveries ready for development.

Just over a month ago, I had recommended that investors should be buying offshore driller Transocean (NYSE:RIG). I had said so because the company has been able to keep its efficiency levels at strong levels by aggressively fighting for new contracts, while a low cost base has allowed it to keep its margins and cash flow in good shape.

Cut to the present and Transocean shares have gained almost 14% since my article. I believe that this rally is not going to be short-term in nature since there are a number of factors that could help Transocean drive its performance in the long run. In this article, we will be taking a look at those factors.

Winning contracts in offshore hotspots

A couple of weeks ago, it was reported that Transocean has won a rig contract in India from ONGC, a state-run oil and gas company, for a semi-submersible rig. Transocean bid aggressively for this contract and asked for a day rate of $127,000, which allowed it to emerge as the lowest bidder. By doing so, Transocean has put another of its rigs into use, which will allow the company to reduce downtime and avoid idling costs associated with cold stacking rigs.

In my opinion, this contract win is an important one for Transocean as India is one of the few bright spots in the offshore drilling industry, along with Africa and Latin America. This is because ONGC is on track to increase its exploration and production spending going forward in order to meet India's power needs.

In fact, ONGC believes that it will spend to the tune of $4 billion to $5 billion in the coming three years, primarily in the offshore. Thus, by landing a contract in this region, even at a lower day rate, Transocean has made a smart move from a long-term perspective.

Growth is still present in the offshore

India is not the only market where offshore investment is still alive. In all, over the next decade, it is estimated that $484 billion will be spent in offshore oil investments, especially in Latin America and Africa. In fact, by 2019, $173 billion will be spent on offshore projects in Africa and Latin America, so the prospects in the next three years of this market are strong as well.

More specifically, it is estimated that Brazilian oil giant Petrobras (NYSE:PBR) will be the biggest spender in the offshore, which is good news for Transocean as Petrobras is a key customer as the company's latest fleet status update indicates. Additionally, Transocean should also see an improvement in the Gulf of Mexico, where oil production in the offshore is expected to increase in the next couple of years.

According to the EIA, the Gulf of Mexico will see a bump in production from 1.63 million barrels a day in 2016 to 1.91 million barrels a day next year. This increase in production in the Gulf of Mexico will be driven by the start-up of new projects, as a result of which offshore oil production will contribute 18% to U.S. oil production in 2016 and 21% in 2017. A look at the following table shows the projects expected to go online in the Gulf of Mexico by next year:

Source: EIA

Additionally, I think that investors should not be missing the fact that the deep cuts in oil and gas spending will lead to a production shortage in the long run as demand increases. This year, capital spending by oil and gas companies will down 12% to $522 billion, which is the lowest since 2010. Due to the drop in oil and gas investments, reserves have been on the decline. As Forbes reports:

"Of the 125 oil and gas companies in my database that reported proved reserves to the SEC, 92 reported declines in their proved oil reserves. The largest decline was reported by Royal Dutch Shell, which saw a decline of 827 million barrels in its proved oil reserves in 2015. Other large declines were recorded by Occidental (461 million barrels), Hess HES +2.09% (246 million barrels), Apache APA +4.66% (225 million barrels), and Anadarko (216 million barrels).

Cumulatively, these 92 oil companies reported a decline in reserves for 2015 of about 3 billion barrels (11 billion barrels of oil equivalent if natural gas proved reserves are included)."

Concurrent with the decline in oil production, the demand for the commodity will keep improving in the long run. According to McKinsey, by 2030, oil demand will rise to 100 million bpd as compared to 94 million bpd currently, while in the short run, demand will rise by 1.5 million bpd-1.8 million bpd in 2016.

To meet this decline in production and the rise in demand, offshore oil production will eventually return, especially considering the fact that more than 400 offshore oil discoveries are in the pre-development phase. Therefore, it won't be surprising to see an increase in offshore oil spending going forward as the discoveries are developed for production.

Conclusion

As the points discussed above indicate, there are certain pockets of strength in the offshore oil industry that will prove to be a tailwind for Transocean in the long run. Moreover, as I had discussed in my previous article, the company is making the right moves in order to overcome the current weakness in the end-market. Thus, given Transocean's resilience and a possible recovery in offshore oil drilling, investors should consider staying long.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.