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Transocean Inc. (NYSE:RIG)

Q2 2008 Earnings Call

August 6, 2008 10:00 am ET

Executives

Gregory Panagos - Vice President of Investor Relations and Communications

Bob Long - Chief Executive Officer

Steven Newman - Chief Operating Officer

Greg Cauthen - Senior Vice President and Chief Financial Officer

Terry Bonno - Vice President, Marketing & Planning.

Analysts

Robin Schumacher - Citigroup

Geoff Kieburtz - Weeden & Co

Lee Cooperman - Omega Advisors

Tom Curran - Wachovia

Alan Laws - Merrill Lynch

Jeff Tillery - Tudor Pickering & Holt

Roger Read - Natixis

Bill Sanchez - Howard Weil

Kurt Hallead - RBC Capital Markets

Operator

Please standby, we are about to begin. Good day everyone, and welcome to the second quarter 2008 results conference call for Transocean Inc. Today’s conference is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Mr. Gregory Panagos, Vice President of Investor Relations and Communications. Please go ahead sir.

Gregory Panagos – Vice President of Investor Relations and Communications

Thank you, [Nikki] and good morning ladies and gentlemen. Welcome to Transocean’s second-quarter 2008 Earnings Conference Call. A copy of the second quarter press release covering our financial results, along with supporting statements and schedules, is posted on the company’s website at deepwater.com.

We have also posted a file containing four charts that will be discussed during this morning’s call. That file can be found on the company’s website by selecting Investor Relations, followed quarterly tool kit. With me on this morning’s call are Bob Long, our Chief Executive Officer; Steven Newman, our Chief Operating Officer; Greg Cauthen, Senior Vice President and Chief Financial Officer; Terry Bonno, Vice President, Marketing & Planning.

Before I turn the call over to Bob Long, I would like to point out that during the course of this conference call, participants may make certain forward-looking statements regarding various matters related to our business and company that are not historical facts, including future financial performance, operating results, and the prospects for the contract drilling business.

As you know, it is inherently difficult to make projections or other forward-looking statements in a cyclical industry since the risks, assumptions, and uncertainties involved in these forward-looking statements include the level of crude oil and natural gas prices, rig demand, and operational and other risks, which are described in the company’s most recent Form 10-K and other filings with the US Securities and Exchange Commission.

Should one or more of these risks and uncertainties materialize or underlying assumptions prove incorrect, actual results may vary materially from those indicated. Also note that we will use various numerical measures on the call today that are or may be considered non-GAAP financial measures under Reg G.

You will find the required supplemental financial disclosure for these measures, including the most directly comparable GAAP measure and an associated reconciliation, on our website, under Investor Relations, Non-GAAP Financial Measures and Reconciliations. And for your convenience, non-GAAP financial measures and reconciliation tables are included with today’s press release.

Our website also includes schedules detailing operating and maintenance costs, other revenue, deferred revenue, and revenue efficiency at Investor Relations Financial Reports. Finally under news and events and webcasts and presentations, we posted slides detailing average contracted day rate by rig type, out of service rig months operating and maintenance cost trends and contract backlog. That concludes the preliminary details. I will now turn the call over to Bob.

Bob Long – Chief Executive Officer

Thanks, Greg. Good morning, everyone, we have another strong quarter with earnings of $3.45 per share about 7% of our consented expectations due to number of factors that Greg Cauthen will cover here shortly. We continue to enjoy an exceptionally favorable market conditions particularly in the floater market, where we have seen new record day rates for deepwater rigs. In keeping with our normal format, Greg Cauthen will take you through numbers in some detail and Terry will give you some color on the market. Steven Newman, our President and COO, is here to help answer any questions you might have. Before I turn it over to Greg, I will comment briefly on three things, first our merger integration efforts, my views on the market, and then anticipating a few questions on this, where we are in our thinking about possible return of cash to shareholders. First on the integration efforts, this continues to go exceptionally well. Our teams around the world are working together as though they have always been one company. The systems conversions are going really well and the process of getting everyone up to speed on common policies and procedures is also going as planned.

In regards to the market, the floater market continues to be supply-constrained and day rates are going up. We signed a number of excellent contracts since our last call with the Pathfinder at 600,000 and [750,000] a day for five years, Marianas at $565,000 a day for two years, and the Expedition for three years at $640,000 a day. All of those contracts starting in 2010.

You may remember that earlier, we had announced contracts on the Polar Pioneer and the Explorer commencing in 2010, so we are seeing high-spec floater capacity tighten considerably from availability in that time period. We do still have a number of deepwater rigs that come available in 2010 and already having discussions with operators about all of them. We also signed significant new contracts with Petrobras. One 10-year contract with a 10-year option for the option for a deepwater newbuild, and that is a record term for us; and renewal of four rigs currently operating in Brazil. Total backlog for those contracts exceeds $4.5 billion. Turning to the midwater floater market, that also remains exceptionally strong. During our last call, I had indicated that rates for midwater rigs were in the high $300,000 a day to high $400,000 a day range and that continues to be the case.

We have yet to contract our newbuild that is under construction at Hyundai. We continue to see interest from multiple operators for this rig and remain extremely confident about the rig’s prospects. And by the way, I would also mention that our newbuild construction program for all 10 rigs continues to go well. I think it’s also interesting to note that we started to see a number of operators tender for Deepwater rigs and indicate that, while the tender might be for only one or in some cases two rigs, they could decide to contract multiple rigs on each tender. Looking at the backup market, that is presently good and we recently got some very nice rates in West Africa. Overall, rates seem to be holding steady despite the number of speculative newbuilds. We continue to think 2008 will remain good, but just don’t have much visibility into 2009. Finally, because of the continued strength of the market, our backlog is up considerably and we are starting to give a lot of thought to if, when, and how we might return cash to shareholders. As before when we went through this, we will consider all available alternatives from regular dividends to special dividends to stock repurchase. Greg is going to give you some detail on our revenue backlog and our estimated cash flow backlog relative to a total debt and I will turn it over to him now. Greg?

Greg Cauthen – Senior Vice President and Chief Financial Officer

Thanks Bob, and good morning to everyone. In the second quarter of 2008 we had net income of $1.107 billion or $3.45 per diluted share. This compares to net income of $1.189 billion or $3.71 per diluted share in the first quarter of 2008. Contract drilling revenues for the second quarter were $2.587 billion as compared to $2.640 billion in the first quarter. The decrease was primarily related to our previously planned increase in shipyard, which was partially offset by the commencement of higher day rate contracts in the second quarter. Our revenue efficiency for the second quarter was 95.3% versus 95.9% in the first quarter. Other revenues increased in the second quarter to $325 million from $346 million in the first quarter. This increase was primarily related to an increase in activity related to drilling management services, net of elimination.

Total revenues were $3.102 billion for the second quarter, compared to $3.110 billion for the first quarter with the decreases in contract drilling revenue and contract intangible revenues partially offset by increases in other revenue.

We expect to experience further day rate increases in the second half of 2008 as a result of the commencement of higher day rate contracts, as shown on chart one. The second half of 2008 revenue should also benefit from the expected decrease in out-of-service time as shown on chart 2. These expected increases in revenue in the second half of 2008 will be partially offset by an expected continued decrease in non-cash contract drilling and tangible revenues, as detailed on the schedules we have posted on our website. Revenues in 2009 will continue to benefit from the commencement of higher day rate contracts as well as from the expected commencement of our remaining deepwater upgrade and the first four ultra-deepwater new builds. Partially offsetting this will be the continued decrease in non-cash contract intangible drilling revenues. Although we expect 2009 out-of-service time to be lower than 2008, a significant decrease in jack up out-of-service time is partially offset by an increase in floater out-of-service time resulting in an expected net neutral impact on 2009 revenues versus 2008 revenues.

We, expect other revenues in 2008 to be roughly $1.1 billion to $1.15 billion with approximately $725 million related to the non-contract drilling segment net of eliminations, approximately $200 million related to integrated services, and approximately $200 million related to recharge revenues. Operating and maintenance expenses in the second quarter were $1.364 billion versus $1.157 billion in the first quarter as shown on chart 3.

The, increase in operating and maintenance expenses were primarily attributable to our previously planned increase in shipyard and major maintenance projects across the fleet, as well as scheduled pay increases. Despite the increase, our operating and maintenance expenses in the second quarter were lower than we had anticipated as we continued to see postponements of shipyard and major maintenance projects till later in the year.

This is the primary reason that our earnings in the second quarter were higher than expected. We expect our total operating and maintenance costs for 2008 to be between approximately $5.25 billion and $5.4 billion, which includes approximately $1 billion of expected cost related to low-margin other revenue items, including our drilling management services, oil and gas, integrated services, and recharges, all net of eliminations.

The increase of $100 million in our total 2008 operating maintenance cost guidance range since last quarter’s call is predominately related to increasing costs related to these low margin items and is completely offset by the related increase in expected low margin revenue.

However, we are seeing increasing pressures on most of the components of our operating maintenance expense driven by continued strong offshore drilling conditions, a resurgence in land drilling, and higher steel prices. Although we have not completed our budget process for 2009, we would now expect year-over-year inflation to be trending higher than that seen in 2008, possibly into the mid-teens. Remember that many factors in addition to inflation will affect our year-over-year increase in operating maintenance expenses, including newbuilds going into service and shipyard activity.

General administrative expenses were $44 million in the second quarter compared to $49 million in the first quarter, with the decrease primarily related to a decrease in merger-related compensation costs relative to the first quarter. We expect general administrative expenses for the second half of 2008 to be roughly $45 million per quarter. Depreciation expense was $337 million in the second quarter, compared to $367 million in the first quarter. This decrease was related to the discontinuance of depreciation on rigs that were sold or reclassified to held-for-sale during the first and second quarter.

For the second half of 2008, we continue to expect depreciation expense to average roughly $345 million per quarter. Capital expenditures in the second quarter of 2008 were $420 million versus $769 million in the first quarter, with a decrease primarily related to the timing of shipyard payments. We continue to expect capital expenditures for the full year 2008 to be roughly $3 billion with approximately $2 billion related to our 10 newbuild rigs, roughly $200 million related to our two upgrades, all including capitalized interest; and the remaining $800 million related to contractually required upgrades, fleet spares, sustaining capital equipment, non-drilling segment capital facilities, and information technologies.

Interest expense, net of amount capitalized and interest income, decreased $101 million in the second quarter versus $124 million in the first quarter. The decrease primarily related to our continued repayment of debt. Our total debt decreased by $1.3 billion in the second quarter from $16.6 billion at March 31 to $15.3 billion at June 30.

We expect our interest expense, net of amounts capitalized and net of interest income, to continue to decrease in each of the third and fourth quarters of 2008 as we continue to repay our debt and should fall to roughly $80 million for the fourth quarter of 2008, which was net of an estimated $40 million of expected capitalized interest. This assumes continued repayment of debt and no additional newbuild commitments or asset sales.

Included in our debt is $6.6 billion of convertible notes. US GAAP rules have recently changed to require that accounting for convertible notes be split between their equity and debt components. This change is effective in 2009 and will require retroactive restatement of our prior year financials. If this change were in effect for 2008, our interest expense, net of amounts capitalized, in the second quarter 2008 would have increased by roughly $43 million and our total debt and total equity at June 30, 2008, would have decreased and increased, respectively, by roughly $725 million.

Although significance to GAAP earnings, clearly this change in accounting for convertible notes has no impact on our cash interest expense and would not have changed our decision regarding using these (inaudible) our capital structure. We will include additional information on the expected change of this in accounting on our Form 10-Q. For the first, for the second quarter and first half of 2008, our annual effective tax rate was 11.4% and 12.5%, respectively versus 13.5% in the firs quarter. We expect our annual effective tax rate for the second half of 2008 to be between 12% and 13%.

Finally, I would like to highlight our record $40.7 billion of revenue backlog as we have shown on chart four, which is based on the latest fleet sales reports. We continue to monitor our free cash flow backlog determined by netting the related direct operating costs, local overhead, local cash taxes, sustaining CapEx and newbuild CapEx against this revenue backlog.

Since the merger, our free cash flow backlog has grown from roughly $15 billion to roughly $18 billion today, while our total debt has declined from $17 billion to $15 billion. We are carefully monitoring this relationship as we continue to target a level of total debt that is no more than $5 billion less than our free cash flow backlog. As Bob has indicated, we are beginning to consider if, when, and how we might return cash to shareholders as we approach our $5 billion target.

With that, I will turn it over to Terry for the marketing outlook.

Terry Bonno – Vice President, Marketing & Planning

Thanks, Greg, and good morning to everyone. Since our last conference call, we have experienced a record-setting period in several respects. We, contracted leading day rates for floaters and our backlog has grown by an impressive $7 billion over the period to a record $41 billion. Considering the revenues were over $3 billion for the period, we actually signed contracts worth $2 billion of total estimated revenue.

Now, I would like to begin with a discussion of our most recent addition to our newbuilds program, the Petrobras 2,000 will be acquired through a 20-year capital lease arrangement with a 10-year contract commencing Q3/2009 at $460,000 a day, which is inclusive of a possible 12% bonus. The contract can be further extended with a 10-year option at mutually agreed rates.

This brings our total newbuild program to 10 ultra-deepwater units with ex-shipyard deliveries from Q1 2009 to Q4 2010. We have also received from BP an extension of the contract for the newbuild Discoverer Luanda from five years at $460,000 a day to seven years at $430,000 a day. While we have not contracted the newbuild at HHI, we are in the advanced discussions with several clients and the interest in this uniquely designed dual-activity enhanced, subsea-handling capable drill ship remains very high.

Moving on to our existing high-specification fleet, which includes our deepwater and harsh environment rigs, we also experienced market-leading contract rates and activity. For example, the Deepwater Expedition was awarded a three-year contract in Malaysia at $640,000 a day starting Q4 2010. The GSF Development Driller II contract was extended in the Gulf of Mexico by five years at $580,000 a day. This extension is expected to commence at Q4 2008 and will keep the rig operating until late 2013.

The Deepwater Pathfinder was awarded a five-year contract in the Gulf of Mexico at $650,000 a day with a start date estimated to be Q1 2010 and the Transocean Marianas was awarded a two-year contract in the Gulf of Mexico at $565,000 a day commencing Q1 2010. When we think back to 2004, we recall being impressed by day rates of over $200,000 a day.

Now due to the tightness in the availability of the ultra-deepwater market, we are currently signing day rates in excess of $600,000 a day. While these rates are certainly impressive based on where we have been historically, supply/demand economics continue to move the market to new highs. Over the next six months, we expect supply to become more limited for rigs with availability in 2009 and 2010, and we would not be surprised to see day rates continue to improve.

We also expect that on contracted newbuild unit deliveries will be absorbed by the increased deepwater demand. In the core deepwater markets of the Gulf of Mexico, West Africa, and Brazil, we continue to see substantial incremental demand for appraisal and subsequent development drilling. We recently secured a long-term package deal with Petrobras in Brazil for four rigs, the Sedco 700, the Sedco 710, the Deepwater Navigator, and the Transocean Driller with late 2009 to 2011 commencement dates.

This added 22 years of term contract backlog and $3 billion of total estimated revenues, which is inclusive of a possible 15% bonus. We also continue to experience growing demand in emerging deepwater areas of India, as evidenced by the placement of three of our newbuilds and the recent outstanding tender for additional deepwater capacity with ONGC.

We are also in discussions with several clients who do require incremental capacity, offshore Angola, Nigeria, and the Gulf of Mexico. One, emerging area that we haven’t highlighted previously is the Canadian Arctic. Recently, sales and work commitments from operators in the Canadian Beaufort Sea have created new potential for offshore floating rigs capable of seasonal operations in the Arctic. Our, dedicated Arctic team is working very hard on the project and we expect to be in a position to meet client requirements as they develop. The Norwegian market is also showing some strength with two outstanding tenders for harsh environment units.

Moving on to the mid-water floater market, we continue to experience strong demand in the North Sea, Australia, Brazil, and now Libya. For example, in the North Sea we were recently awarded a 300-day contract for a mid-water floater at $416,000 a day commencing Q1 2010. We are also currently in contract negotiations, which we expect to conclude within the next few weeks, for over 50% of our rigs that have availability remaining in 2008 and 2009, which are currently operating at below-market rates.

Moving to the jackup market, we have experienced another very active quarter evidenced by a number of fixtures at attractive rates and terms. For example, some recent short-term jackup fixtures include the Adriatic VI for one well in Equatorial Guinea for Noble energy at $244,500 a day; the Adriatic 11 for a one-well extension in Vietnam at $221,279 a day; and, finally, the Galaxy II with [ParinCo] in the UK for one well at $250,000 a day. Our recent jackup fixtures for term include the GlobalSantaFe rig 136 in Malaysia for one year at $175,000 a day. The GSS Adriatic VIII and the GSF Baltic with Exxon Mobil in Nigeria each received a one-year extension at $220,000 a day and $240,000 a day, respectively. Finally, the GSF Key Singapore at $172,000 a day for two years, the Key Manhattan at $172,000 a day for one year, and the Adriatic X at $182,000 a day for two years all contracted with Petrobel in Egypt.

Overall, we continue to see jackup demand remaining strong to the end of 2008 in the Middle East, Mexico, Southeast Asia, North Sea, and West Africa, with additional supply being absorbed by the market. US, Gulf of Mexico rates in term are improving, but may not, may still not be able to compel operators to return to the area. Significant term is being offered in Angola with the outstanding tender of four rigs for three years per unit, and in the Middle East with the outstanding tender for five rigs for three years per unit.

We expect these tenders to be heavily sought-after for the term placement due to the impending delivery of newbuild jackup. The lack of visibility in the jackup sector due to the short-term nature of jackup contracts coupled with the scheduled delivery of many speculative jackup newbuild units in 2009 have caused us to remain cautious toward the jackup market beyond early 2009. That concludes my discussion on the market, so I will turn it back to you, Bob.

Bob Long - Chief Executive Officer

Thanks, Terry. I think with that, we are ready to answer some questions.

Question-and-Answer-Session

Operator

(Operator Instructions) And, we will take our first question from Robin Schumacher with Citigroup. Please go ahead.

Robin Schumacher

Bob, I wanted to ask you about or actually Greg, maybe, the formula you described for the level of debt that you are comfortable with, the total debt less free cash flow, it seems that that number is around $10 billion. Is that correct?

Greg Cauthen

No, that is not correct. Today, as I described, our free cash flow backlog is about $18 billion. So, if you expect that to hold, we get to a level of debt of around $13 billion and we would meet that criteria, if the backlog holds. Now, the backlog could hold or could go up or down, so as we have seen this quarter, we have seen a rapid increase in that free cash flow backlog. So but right now, given the backlog, we would be looking at $13 billion of debt before we reach that target and we should reach that sometime in the first quarter. Now, I would caution you, this is a guideline. This is one of the factors we will use among many or market conditions or prospects for reinvestment, economic conditions, etc., as to what we start doing with our cash once we beat that target.

So, it’s not a black box that we are going to plug all this number in and then cash starts returning to shareholders the day we beat it. So, it’s a target. It’s good news that we are almost six months ahead of where we expected to be, because of the backlog growing, not because of debt shrinking faster than we expected. But let’s be cautious that it is just one of many factors.

Robin Schumacher

Okay. So, then the asset sales proceeds that you will have, will those be applied to reduce debt further, kind of getting you towards your goal?

Greg Cauthen

They will be, but remember the sale of the Arctic II and Arctic IV are seller-financed, so we are not going to get any cash from that sale immediately. That, will come over a couple of years. So, now the proceeds from the Nordic, you are exactly right. We will reduce debt and that will help us move towards the target quicker.

Robin Schumacher

Okay. And, just staying on the asset sale theme, you have mentioned on the past that, like the jackups you sold earlier this year, you might find opportunities to sell smaller packages of jackups. Given your uncertainty about the market for jackups in 2009, is that -- are you proceeding actively in that arena or is this something that is more opportunistic, if you will?

Bob Long

I think, Robin, it’s fair to say it’s more opportunistic. We have a couple of potential jackup sales that could take place, but we have found that many of our jackups will have several years of contracts. When we look at the cash flow that is generated from the contracts, it’s pretty good. And, look at what the market seems to be willing to pay, so far we haven’t found very many opportunities that we think really make financial sense for us. So, we have decided to hold onto the assets. I wouldn’t encourage you to think that if there are any sales there are going to be very many. At this point I think we are likely to only see a very few additional jackup sales in the future.

Robin Schumacher

Okay, thank you.

Operator

And, our next question comes from Geoff Kieburtz with Weeden & Co.

Geoff Kieburtz

Thanks, good morning. Bob, you made a comment in your opening remarks about, I just wanted you to clarify, something about the operators may contract for more rigs than they are tendering for. Could you elaborate a little bit on what you meant there?

Bob Long

Yeah Jeff, I think we saw that, I think, the first time here is significantly when Petrobras had tendered for a handful of rigs and wound up using that tender to contract 12 rigs. Since that time, we have seen one or two additional instances where an operator has tendered for a rig and in discussions with them they have indicated that they could well decide to take more than the one or, in one case, the tenders for two rigs. They have indicated that they may decide to contract more than just the one or two rigs that they have tendered for. I think it’s an interesting development in terms of how operators are thinking about the deepwater market.

Geoff Kieburtz

Does that suggest to you that there are more and more operators kind of looking at this market the way Petrobras seems to be?

Bob Long

I wouldn’t say that, Jeff. Petrobras is in a unique position where they have got a tremendous amount of activity that they are absolutely certain they are going to have for a very long time. So, the amount of capacity that they know they are going to need is significant. And, I think that puts them in a different position than most of the other operators out there.

Geoff Kieburtz

Just on the Petrobras, when the contract details were being discussed there, I know that you are including in your commentary the potential bonus. What has been the actual history in terms of percentage of potential bonus that is actually earned?

Greg Cauthen

This is a unique bonus on the Petrobras 10,000. It has a relatively low threshold of utilization that you meet that bonus, and so it’s every bonus arrangement with Petrobras is different. So, that is why we haven’t normally included the bonus in our announcement, but we are highly confident we will earn 90%-plus of this bonus based upon our normal deepwater utilization. So that is why we have included it in our announcement.

Geoff Kieburtz

Just as a broad statement, though, Greg, if we see bonus potential, what is the history then across the board, maybe excluding this somewhat unique circumstance?

Greg Cauthen

Frankly, I have never calculated it that way. It would be lower than 90%, probably higher than 50%. Somewhere in there, but I haven’t ever calculated it. But, this bonus is much better than the typical bonus from our perspective in terms of our ability to meet it.

Geoff Kieburtz

Great, thank you.

Operator

And, our next question comes from Lee Cooperman with Omega Advisors. Please go ahead.

Lee Cooperman

Thank you. Just, I apologize if I ask a question that was redundant, but I had to leave the call for a few minutes. I have two questions. Your contract back, I’m sorry, okay, You contract backlog is now $40.7 billion and our estimate that the cash margin is about $24.4 billion. If we back out the $4 billion in remaining newbuild CapEx, that leaves about $20.4 billion, which now I guess compares to debt of around $15.3 billion. So, this issue of returning money to shareholders I assume is going to be an issue that will be discussed sometime this year. Is that a reasonable view?

Bob Long

I think it’s reasonable to say that it will be discussed this year. We are already thinking hard about what we are going to do there, Lee. On your numbers, I think you are a little bit high with your net and I suspect what you have left out is cash taxes and some allocated local costs.

Lee Cooperman

Got, you. Okay. But in principle this is a possible this year type of discussion?

Bob Long

It’s definitely a this year type of discussion. I won’t promise you that we will make a decision to do anything this year, but.

Lee Cooperman

My only promise I want from you is that we don’t buy back overvalued stock. If we go the route of stock repurchase, we want to make sure that it’s undervalued.

Bob Long

Understood.

Lee Cooperman

Okay. Now, the second question, when we first met three or four years ago we talked about the issues that would determine the outlook for the Company, and some of the issues. We talked about the importance of the commodity price and you had said back then that deepwater drilling was economic down to prices as low as $35 a barrel.

Second, you said important for prospectivity, in other words that if we don’t find stuff the customer is not going to come back and keep drilling. Third was the risk of over builds. I’m just wondering how you would see these three issues today in other deepwater is economic down to prices as low as X given the inflation in oil country goods, second how is prospectivity lined up, in my own advantage point it looks like the only place that’s undiscovered -- deposits exist is deepwater offshore, which is terrific for us. Third, this financial environment we are in would seem to suggest that overbuilding, if it’s a risk, would be a risk that is being pushed out somewhat because of the constrained credit environment. But I would love your inputs on these three items as you gave several years ago.

Bob Long

Okay, I will take a stab at it. But on the price of oil that will justify deepwater, it’s difficult to say based on some input from a few operators that we hear consistently. My guess would be -- and it’s obviously a total guess -- is that $35 a barrel range is probably up now to the $60 or $65 a barrel range, maybe higher in certain areas. But I’m guessing its somewhat in that range. On the prospectivity its seems to me and this maybe the result of the escalation of the old prices that prospectivity has not been problem that potentially it could have been, in part they also be due to technology, but clearly the success rate that the operators are having, particularly in deepwater, has been significant. There is a big backlog of development and appraisal opportunities out there. There is also a growing need for additional deepwater exploratory efforts. I think many of the operators have been concerned about the inability to get drilling capacity to dedicate to an exploration program. So I don’t think that prospectivity is going to be an issue in any kind of a near-term future. On overbuilding, I think that we have seen such an increase in demand that despite the fact that we have had a lot of new construction in the floater business, 70% or more of that is already contracted. I am very confident that the rest of the speculative newbuilds, given the demand we see out there, is going to get contracted. And given the shipyard delivery times now, I think the last deepwater rig that was ordered has a 2012 delivery. You are not going to see much additional capacity come into this business for the next four years. So I think your characterization that some of these risks have been pushed out is accurate.

Lee Cooperman

Thank you very much. Let me just take a moment to thank you and your whole team for doing such a wonderful job for the shareholders.

Bob Long

Thank you.

Operator

And our next question comes from Tom Curran with Wachovia. Please go ahead.

Tom Curran

Good morning guys.

Bob Long

Good morning.

Tom Curran

Bob, starting with the increase in the estimated out of service days for 2009, given the magnitude of it, I was wondering did this arise out of some sort of mid-year review, first? Then, secondly, could you break it down between how much is associated with a more comprehensive overview of the needs of the GlobalSantaFe rigs? Then how much has arisen out of your standard sources of increased down tide needs over the last few months, such as mobilizations associated with recent awards, contract prep modifications, repairs, and then special periodic surveys?

Bob Long

Tom, I have seen a number of the flash reports that came out this morning before the call where people seemed to be surprised about the amount of out-of-service time. But this is the first time that we have given guidance for 2009, in part because we were taking a careful look at the new combined fleet. But I am a little bit surprised that there is -- that the number was a surprise to the financial community. It’s actually less time, fairly significant amount less, than the out-of-service time then we have this year. So that quite sure what analyst were using to make their models and estimates of the out-of-service time. As Greg said its probably going to be revenue neutral because despite the fact that’s its significantly less out of the service time then in ‘08 there is more out of the service time for floaters and less with jackups. So the impact on the revenue, given the higher day rates for floaters will be somewhat more, but net-net about a wash and I would guess that going forward people ought to be looking at us having out of service time in future years that’s somewhere in the ballpark of the average of ‘08 and ‘09 absent some specific guidance from us that there is something unusual going on. I don’t think we have discovered any significant issues or surprises on our rigs, so I am not sure I could say much more than that without going into a whole lot of detail. It probably isn’t worth it.

Tom Curran

Agreed, and I appreciate that color. I was really just trying to clarify should we assume that as a result of this increase you now feel you have gotten a good read or at least a good first read on what the needs are likely to be of the GlobalSantaFe fleet in ‘09?

Bob Long

I think we are pretty comfortable that we understand the conditions of the rigs and what we need to do. Both the Legacy Global fleet and the Legacy Transocean fleet.

Tom Curran

Great, great. Secondly, Bob, I guess this would be for Terry as well are your marketing guys aware, current, anywhere in the world within the ultra-deepwater segment of any contractors, including yourself, but you don’t have to tell us who, that have yet pushed for a day rate with a $700,000 handle or are expected to soon?

Bob Long

I am not sure how to answer -- we obviously don’t know what our competitors are bidding.

Tom Curran

Sometimes you do it?

Bob Long

Well, sometimes after the fact we find out. But have we indicated rates in excess of $700,000 to some of our customers? Yes.

Tom Curran

And do you --? Based on the response you have gotten thus far, do you expect to eventually secure an ultra-deepwater day rate with a $700,000 handle?

Bob Long

I don’t like the word expect. Hope is there, obviously, but I couldn’t really tell you whether or not the market will get there. But clearly we are not far from it with the recent pitches at $650,000 a day and, as I have said before, I think the real catalyst for a significant increase in day rates is shrinking supply. If you look at what is happening to the available rigs in 2010, that available supply is getting smaller and smaller, which would suggest that if demand continues the way it is, that rates are going to go up.

Tom Curran

Okay, that is very helpful. Thanks for the color, guys. I will turn it back.

Operator

And our next question comes from Alan Laws with Merrill Lynch. Please go ahead.

Alan Laws

Good morning. . I have a follow-up question here to Lee’s question, actually. Since you have this return of cash decision remaining determined by the dynamic debt factor, I guess more specifically could you give us some color around how the debate at the board level is going with this issue? What are the factors you are bandying about when you are discussing this?

Bob Long

I don’t want to tell you what the debate at the Board level is. But, obviously, there are a lot of factors to take into account when we start to consider. One, whether it’s time to start returning cash to shareholders and two, what mechanism would be best to do that. We do a lot of analysis around all of that, but as Greg said, this thumb rule we have is just that. It’s just one other factor in the picture to put that into the considerations because we want to have significant financial capacity to take advantage of opportunities as and when they present themselves. And particularly if a downturn ever surfaced, they come very quickly in this business. So, there are a lot of factors in the decision about when to return the cash which revolve around our longer-term outlook and near-term outlook for market, as well as reinvestment opportunities that we see. In terms of the method, we do a lot of analysis looking and a lot of the discussions with shareholders in terms of their view on the preference for dividend buyback on the real value of a sustaining quarterly dividend. So, there are a lot of different factors that go into that. It’s a fairly long discussion and a lot of analysis.

Alan Laws

Sure, so the dynamic debt formula is more like the frame to the whole picture, then? And you could change the frame at any time? Is that fair?

Bob Long

Absolutely.

Alan Laws

Okay, then as far as discussing the potential return and what form it would come in, is that done with an external advisor too, or is it something you are just doing internally plus your major shareholders?

Bob Long

Well, we went through this before. We talked to a number of investment banks, a number of financial professions. I think we got as much input as we could get. How much more of that we will do as we reconsider this that is kind of an open question at the time.

Alan Laws

Okay, and if it was to be a special dividend, is some of the discussion about being able to keep it consistent? We have seen some of your peers instate one and then pull it, and it hasn’t had a really good impact on their equity value is that consideration as well?

Bob Long

Clearly any time you talk about dividends, whatever considerations is whether or not failure to follow through will continue with and will impact the stock price, so certainly it’s a consideration.

Alan Laws

Alright, great that’s all I have thank you.

Operator

And our next question comes from Jeff Tillery with Tudor Pickering & Holt. Please go ahead.

Jeff Tillery

Hi, good morning.

Bob Long

Good morning.

Jeff Tillery

Bob and Greg you talked about down year -- your down time in ‘09 being revenue neutral, just given ship chart inflation and the balance of down days year-over-year do you think that’s expense neutral in ‘09?

Bob Long

Probably not, and that’s why when I was talking about looking forward to ‘09, I had indicated there are other factors where we are frankly still working through our budgets on those shipyards and everything but certainly shipyard inflation is going to be higher than normal inflation, steel prices are higher and shipyards continue to be capacity constrained so its hard to settle that together but it will, I would not expect it to be cost neutral but would expect our shipyard cost to be higher and higher than about more than our normal inflation rate next year.

Jeff Tillery

Thanks for that. And so from a higher level you have got inflation generally kind of you said what maybe mid teens levels you are going to add partial years of several new built next year, just conceptually expenses shouldn’t run less than 15% year-over-year increase. Is that thinking about it the right way?

Greg Cauthen

Probably, but make sure you do your math right. One time we gave a percentage estimate like that and everybody applied it on January 1. That is not how inflation works. I mean, that is an annualized increase and every quarter will be different. If you look at the chart we included, our shipyard activity is actually going to be very low in the fourth quarter and the first quarter. So, you won’t see a big pressure on cost. Second, quarter shipyard activity goes up, and that happens to be when we give our pay raises. Personnel costs are over 50% of our costs. So, every quarter is different, and so that is an annualized assumption. And, we haven’t done our budgets. We are going to be doing all sorts of things. So, I caution you to be too quick off of that. Having said that, we are seeing increasing pressure on costs, so we wanted to make sure everybody was aware of that as well.

Jeff Tillery

That is very helpful. And, my last question just regarding assets M&A market, you guys have been successful doing some creative deals, the Tanker Pacific deal, the deal with Petrobras. Could you just provide some color around how you see the potential for additional creative deals and acquiring new assets?

Bob Long

I think that the opportunity set out there is fairly limited and I wouldn’t be very optimistic that we are going to be able to do much of anything. Certainly we are not going to be doing anything until we contract the new build that we have at Hyundai, because we don’t want to take on the obligation. It’s some kind of a creative situation like we did with the Tanker Pacific, where we would be marketing a joint venture rig against our own. So, right now I would say that the likelihood of some additional deals is very small.

Jeff Tillery

Okay, thank you very much.

Operator

And, our next question comes from Roger Read with Natixis. Please go ahead.

Roger Read

Hi, good morning gentlemen.

Bob Long

Good morning, Roger.

Roger Read

A real quick question for you on the jack up market, given that today it’s certainly stronger than I think any of us would have predicted 12 or 24 months ago, what do you need to see end of this year/beginning of next year to bring you confidence that that market is going to let’s say hold together at least as well as it has been if not better? One of the reasons I ask this is going through your rig status sheet from yesterday, I couldn’t find any jackups where the rates were lower on the next contract than they were on the prior contract, other than I think maybe there was one short-term change. Can, you kind of help us with what would be the signposts we should consider?

Bob Long

That is a little bit tough to say, Roger. We have not seen any backwardation of the day rates. The, market has continued to be stable. I don’t think that we could say that we have had opportunities to push day rates higher. The, surprise in the jack up market for me has been the continued steady increase in demand, and it hasn’t been a big new area with all of a sudden somebody wanted 50 or 20 jackups. It has been a couple here and a couple there, and four in Egypt and three someplace else. I think if that market continues like that, we are going to continue in a frame where we are kind of cautious about the market, and yet it could still continue to be good through ‘09. An indicator that would say, okay, I guess this is really going to be a good market clearly through ,09 would be some big new area. If in the Persian Gulf, instead of looking for an additional four or five rigs, they tendered for 20 rigs, or some other place like that which came up with a very significant incremental demand, which frankly I don’t see happening. But that is the only thing that I could see that would be a clear trigger so that you could say, yes, I am pretty comfortable this market is going to continue good through 2009 and into 2010.

Roger Read

Okay, then my second question for Greg. Greg, if you could help us a little bit on the OpEx, maybe walk through what percentage is sort of the labor and maybe an idea of an increase in shipyard costs year-over and how much of that we could consider as -- in kind of getting to Jeff’s question before about are you neutral, revenue neutral versus the OpEx? Which ones you could get recovery out of your higher -- the pass-along and the higher day rates via the contract terms?

Greg Cauthen

Well, OpEx inflation in many of our contracts and certainly most of our deep -- ultra-deepwater long-term contracts is recovered through cost inflation that we have cautioned in the past, like cost inflation seems to be only about two-thirds 70% effective because there is a lag being calculated against everything typically those kind of cost escalations don’t cover shipyards, although in some of our newer contracts, we are seeing more coverage in day rate protection or whatever on shipyards. So that is helpful. In terms of the cost inflation, let me clarify, the 15% was our average. At one end of that average are the shipyard inflation that is certainly more than 15%. Rope, soap, and dope inflation we think will be at a lower end of that average range, especially because of our supply chain ability. But, again we have not run all the detailed budgets, so, frankly, I can’t give you a lot of detail about all the components other than that right now we are expecting that year-over-year inflation to run about 15% there is going to be higher cost because we are going to have more rigs operating with four newbuilds and an upgrade but we are going to continue to push for supply chain benefit, so we just don’t know how all of that is going to net out yet for 2009. So, you just need to bear with us. We will certainly be in a position on the next call to give more guidance for 2009. But, right now those are the trends we are seeing.

Roger Read

Okay, then just my last question as you look at the drilling management, the oil and gas piece that was left over from GlobalSantaFe, is that a business we should expect to remain kind of relatively steady with where it has been? Is there any desire to upgrade that or expand it or whatever at this point?

Bob Long

I will tell you, Roger, that business has historically been focused on the Gulf of Mexico and the North Sea. We are working really hard with those folks to leverage the relationships we have around the world, where clients find themselves in need of the special capabilities and the competencies, the experience, and the skill set that ADTI and CMI can bring to operations everywhere we operate. So I am anticipating to see that business expand in terms of their geographic areas. I think that will be positive for the whole company.

Greg Cauthen

One short-term caution. The second quarter benefited from both an increase in activity, but also it benefited because during the second quarter ADTI did not use many Transocean rigs. So, the normal elimination/deferral that we normally see wasn’t there. But for the rest of the year we know they will be using Transocean rigs, and so that elimination/deferral will kick in. So, for the second half of the year, please use our guidance not the second quarter trended out for the rest of the year.

Roger Read

Alright, thank you. That is helpful.

Operator

And our next question comes from Bill Sanchez with Howard Weil. Please go ahead.

Bill Sanchez

Good morning. Bob, can you talk to us? You have been certainly talking a lot about return of cash to shareholders. Can you just talk about incremental newbuild opportunities and the appetite right now for that in the market in general by Transocean?

Bob Long

Well, I guess in terms of the appetite by Transocean, we are obviously always interested in talking to customers who insist on talking about a newbuild. There is still some interest out there in newbuilds. If we can get contracts that meet our payback criteria then we would proceed. Right now I would say that there is a possibility that by the end of the year we might have another newbuild. I wouldn’t want to try and handicap that and tell you whether there is a high possibility or low possibility but there is that possibility. So, I think that is about all the color I can get you on it.

Bill Sanchez

Okay, does the ranking, though, in terms of uses of cash from here really, It seems like you are more clearly, for the balance of this year paying down debt and then perhaps a special dividend or a share repurchase program. It seems to me it’s a higher priority, and maybe the returns are better certainly there than incremental newbuilds at this point. Is that a fair comment?

Bob Long

I wouldn’t say that is a fair comment. I think that the incremental newbuilds are almost insignificant in terms of the question of returning cash to shareholders, given that it takes four years to build these and that with our payback criteria the impact on our cash flow backlog is fairly small, if we are going to get at least 80% simple payback. So, it really doesn’t turn into be much of a factor. They are almost like self funding issues.

Bill Sanchez

Okay, so it’s not an either/or. It can be both?

Bob Long

I think for sure it can be both. The newbuild would not impact our decision much on whether or not to return cash to shareholders.

Bill Sanchez

Okay. Thank you, Bob.

Bob Long

I think we have time for one more question.

Operator

And our final question comes from Kurt Hallead with RBC Capital Markets. Please go ahead.

Kurt Hallead

That’s alright. I’ll end it here. I’ll take it offline. Thanks.

Bob Long

Okay, thank you, everyone. I appreciate you joining us and we will do it again next quarter.

Operator

And ladies and gentlemen, that does conclude today’s conference. Thank you for your participation. You may now disconnect.

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Source: Transocean Inc. Q2 2008 Earnings Call Transcript
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