Transocean: Well Positioned For A Deepwater Recovery, But May Be A Very Long-Term Story (NYSE:RIG)

Summary

Transocean has been working to high-grade its fleet over the past six years.
This could give the company an advantage when the offshore drilling industry finally recovers.
The number of ultra-deepwater contracts being offered has been increasing, so we are already seeing signs of a recovery.
There is some evidence that shale oil production growth is slowing down and will continue to do so with offshore taking its place.
This could be a very long-term play, and it is critical for the company to hold out until then.
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On Wednesday, February 26, 2020, ultra-deepwater drilling giant Transocean Ltd. (NYSE:RIG) gave a presentation at the SpareBank 1 Energy Conference. As is usual for presentations like this, the company devoted a great deal of effort into making an investment case for itself to the analysts who were in attendance. Naturally, it did this by providing an overview of its business and discussing the advantages that it has over its competitors. The biggest problems that Transocean is facing today though are industry-wide as low dayrates and limited contracting activity have made it difficult to generate either revenue or cash flow. Transocean did discuss these dynamics somewhat in its presentation along with why it will improve going forward. I will discuss this as well over the course of the article, but may need to add information from other sources to provide a more complete analysis. While the macroeconomic pressures afflicting the company will likely ease over time, it looks likely that the company will continue to struggle over the medium term. As such, a company like Transocean is probably not a good investment for a risk-averse investor.

Transocean is one of the largest companies in the offshore drilling industry. The company's fleet consists of 44 ultra-deepwater drilling rigs and three harsh-environment jackups. This is a very different make-up and a much smaller fleet than it had six years ago. We can see this here:

Source: Transocean

This change was driven by numerous disposals of rigs over the intervening period. Since 2014, the company either scrapped or sold 15 ultra-deepwater, 38 deepwater and midwater, and 15 jackup rigs. This was in direct response to the conditions that we have been seeing in the industry. As I have discussed in numerous previous articles, the exploration & production companies that make up the customer base of the industry have shown a marked preference for modern rigs due to their superior safety and efficiency characteristics relative to older rigs. This preference was reinforced by both the Deepwater Horizon disaster and the oil bear market that have occurred over the past decade. Transocean had a number of older and less capable rigs in operation in the early stages of the last decade. These are the ones that it disposed of in response to this preference. This is also one of the reasons that its average fleet age went down so much over the period. Thus, the company's fleet should now be somewhat more appealing to customers than it used to be.

One thing that we notice is that Transocean is betting almost exclusively on the recovery of the ultra-deepwater sector. However, as I pointed out in a recent article on fellow drilling contractor Valaris (VAL), the shallow-water environment has been showing much more strength over the past year or two. This is not atypical though. As I explained in the past, the shallow-water sector typically leads the other sectors through the drilling cycle due to its shorter contract terms and lower costs. The fact that we have been seeing shallow-water recover relatively strongly off of its lows could thus be a positive sign.

We can in fact see some evidence that the ultra-deepwater environment has begun to recover. We can see this in the number of floaters being contracted by the major exploration & production companies. This is shown here:

Source: Transocean

As we can see here, the demand for ultra-deepwater rigs from the largest companies in the industry has been growing over the past few years. If current projections prove to be correct, then demand will have grown at a 15% compound annual growth rate. There is reason to believe that these projections will prove to be correct since many of the exploration and development projects that will be driving this demand growth have already been sanctioned. With that said though, we can see that demand will still remain below the levels that we saw during the previous industry upcycle. Thus, it may be a while before we see a recovery in dayrates.

The opportunities that will drive this demand growth are located all over the world. This is something that Transocean noted in its presentation:

Source: Transocean

There are a few reasons why this can be a good thing. One of the most significant ones is that it provides a degree of protection against regime risk. Regime risk is the risk that a given national government or other authority will take some action that proves adverse to a company's plans or operations. We saw this when the Obama Administration temporarily suspended drilling in the Gulf of Mexico following the Deepwater Horizon disaster. In such a case, a company may be able to take advantage of opportunities elsewhere in the world. Thus, it can be nice to see that such opportunities are actually available.

Transocean boasts the largest ultra-deepwater fleet in the world. We can see this here:

Source: Transocean

This positions the company quite well to take advantage of these opportunities. One reason for this is that being the largest operator in the space may make it the first company that customers go to when they wish to contract an ultra-deepwater drilling rig, which would naturally give it the first chance to bid on a given contract. However, exploration and production companies usually use a competitive bidding process when they wish to contract a rig, which would give multiple companies the opportunity to bid. Transocean's large fleet could still give it an advantage in this case, however. This is due to the fact that it increases the chance that Transocean has a rig available to meet the customer's needs and a competitor does not. In such a case, Transocean would receive the contract by default.

One of the biggest factors that has been weighing on the offshore drilling industry has been the rising production coming out of various U.S. shale plays. For the most part, energy companies have been reluctant to increase offshore production and drive down the price of oil due to oversupply from the rising shale production. However, as I have argued in the past, there are reasons to believe that the shale oil production growth is unsustainable. One of the biggest reasons for this is that shale oil wells have an incredibly high decline rate. In fact, as we can see here, a shale oil well's production declines by 69% in the first year alone, and by the end of the second year, the well will only produce about 10% as much oil as it did when first drilled:

Source: Econbrowser.com

This means that in order to maintain production, the operators in the region need to be constantly drilling new wells. This makes shale oil production very expensive. In fact, in many cases, it is cheaper to produce oil from an ultra-deepwater well than it is to produce in North America's shale plays. We can see this here:

Source: Arctic Securities, Transocean

This is almost certainly one reason why nearly all U.S. shale producers cannot generate positive cash flow. In fact, as we can see here, the industry on average generates negative to weak cash flow:

Source: Rystad Energy, Clarksons Platou, Transocean

Many of these companies have been financing their operations by using the extremely accommodative market conditions by taking on large quantities of debt. In fact, shale operators have been some of the largest issuers of high-yield (junk) bonds over the past decade. It stands to reason that as economic conditions change and the market becomes less accommodating that we will see either shale production slow down or numerous bankruptcies in the space. In fact, we may already be seeing this. According to Goldman Sachs Investment Research, shale oil production growth peaked in 2018 and will be going down going forward:

Source: Goldman Sachs Investment Research, Transocean

As we can see here, the investment bank expects that shale oil production will even begin to decline in certain areas within the next few years. It will be upon offshore production growth to make up the difference due to the fact that most conventional onshore oil plays have already been exploited. This should prove positive for Transocean going forward.

In conclusion, Transocean appears to be well positioned to take advantage of the eventual recovery in the offshore drilling industry. The company has devoted a great deal of effort to high-grading its fleet over the past half-decade, and this is something that is nice to see. Unfortunately though, it does not appear that this recovery will occur within a short time frame, and it does not look likely that dayrates will return to anything close to their levels during the last upcycle. As such, Transocean will probably continue to struggle over the next few years while this story plays out.

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This article was written by

Power Hedge

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