Transocean - Increasingly Bullish Outlook If Newbuild Issues Can Be Addressed

Summary

• Discussing recent fleet status and earnings reports. Management more bullish than ever before in its expectations for near-term industry recovery.
• Delayed delivery dates for newbuild drillships "Deepwater Titan" and "Deepwater Atlas" entitle customers to terminate the respective drilling contracts which would be a disaster for the company.
• Transocean might be required to take delivery of the rigs even in case customers decide to walk away. Discussions with customers and shipyard are ongoing.
• With increased demand finally meeting materially reduced rig supply, pricing power should return as the industry moves into 2022.
• Wait for the serious newbuild overhang to be resolved before placing your bets on Transocean. Speculative investors looking for near-term industry exposure should consider Valaris which recently emerged from bankruptcy with ample liquidity and a strong balance sheet with no net debt.

Photo by Ion-Creations/iStock Editorial via Getty Images

Note:

I have covered Transocean (NYSE:RIG) previously, so investors should view this as an update to my earlier articles on the company.

Last week, leading offshore driller Transocean published another uninspiring fleet status report followed by an earnings report largely in line with expectations on Monday. While the company managed to find some short-term work for two previously warm-stacked rigs and customers exercised a number of one-well options, backlog decreased by another $440 million to $7.4 billion. In addition, the report also contained some negative developments.

1. Drillship "Deepwater Asgard" was awarded a three-well contract, plus a one-well option in the U.S. Gulf of Mexico with Beacon Offshore Energy at a dayrate of $240,000. In July and August, the rig will provide managed pressure drilling ("MPD") services thus resulting in a temporary dayrate increase to $280,000.
2. Customer BHP Billiton (BHP) exercised a one-well option for the drillship "Deepwater Invictus" which will keep the rig working until August at a substantially increased dayrate of $215,000 (previously $157,000).
3. The 5th generation semi-submersible rig "Deepwater Nautilus" secured new work from Korean energy giant POSCO until August at a dayrate of $135,000.
4. Equinor (EQNR) exercised a one-well option for the modern harsh-environment semi-submersible rig "Transocean Norge" at a dayrate of $297,000.
5. Contract start for the newbuild ultra-deepwater drillship "Deepwater Titan" is now expected for H2/2022 (previously H1/2022).
6. The final investment decision for Beacon Offshore Energy's Shenandoah project in the Gulf of Mexico has been delayed from March 31 to July 31 which causes ongoing uncertainty regarding the conditional $250 million contract for the newbuild ultra-deepwater drillship "Deepwater Atlas".

Particularly the delayed contract start for the Deepwater Titan has resulted in new problems for Transocean. Keep in mind that the company is planning to issue approximately $400 million in secured debt against this contract but the rig usually needs to be in service for some time before the securitization can take place.

In the past, it took Transocean between two and four quarters after the contract started to arrange secured debt financing.

During the question-and-answer session of Tuesday's earnings conference call, management basically admitted to the issue ("quite realistically, you could see it in 2023").

While the company ended Q1/2021 with unrestricted cash and cash equivalents of $1.07 billion, Transocean is facing almost $1.4 billion in remaining capex commitments for newbuild drillships "Deepwater Titan" and "Deepwater Atlas" in 2021 and 2022:

Source: Company SEC-Filings

Transocean currently projects total liquidity of $1.2 to $1.4 billion at the end of FY2022, which actually includes both the company's currently undrawn $1.3 billion secured credit facility and the $400 million in secured debt expected to be issued against the Deepwater Titan contract.

But with the expected contract start now delayed to H2/2022, the secured debt raise is unlikely to occur before 2023 which would leave Transocean being entirely dependent on its secured debt facility next year.

Unfortunately, the facility is scheduled to mature in June 2023, and negotiations with banks are likely to commence way before this date.

With most of the rigs in the collateral package currently either sitting idle (Deepwater Orion, Deepwater Inspiration, Dhirubhai Deepwater KG2), working on short-term contracts (Deepwater Asgard, Development Driller III, Deepwater Invictus), or scheduled to roll off a legacy ultra-high margin contract later this year (Deepwater Skyros), Transocean would likely have to pledge additional assets, but the company simply does not have more to offer to banks at this point with all of the company's legacy high-margin contracts already having been monetized in the secured debt markets and the unencumbered remainder of the fleet mostly working on short-term contracts at rather low rates or being stacked.

Raising $400 million in additional liquidity ahead of the upcoming negotiations with banks would certainly help Transocean's case, but with the above-discussed contract delay, the company will likely need a material market recovery for banks to consider an extension.

Even worse, according to the 10-Q, both the Deepwater Titan and the Deepwater Atlas are now expected to be delivered "outside of the contractual delivery windows for the rigs" which would provide Chevron (CVX) with the right to terminate the $830 million Deepwater Titan drilling contract. With the final investment decision on the Deepwater Atlas contract still outstanding, customer Beacon Offshore Energy remains free to decide against using the rig anyway.

Suffice to say, this outcome would be a disaster for Transocean, particularly in case the company wouldn't be able to terminate the newbuild contracts which have been delayed by the shipyard at the request of Transocean several times already. Neither management on the call nor the 10-Q provided any hints regarding this issue.

As a result, the company has commenced discussions with customers and the shipyard which "remain constructive" according to management's prepared remarks on the call:

As you might expect, the delay has a fairly broad impact, and we are in ongoing discussions with Sembcorp with a range of potential outcomes. Since we are actively engaged in discussions with all parties, we are unable to provide any additional detail at this time. However, I can tell you that the conversations with Chevron, Beacon, and Sembcorp remain constructive.

During the question-and-answer session of the call, Morgan Stanley analyst Connor Lynagh asked the right question but was more or less rebuffed by management (emphasis added by author):

Connor Lynagh

(...) I just wanted to return to the newbuilds just for a minute. Obviously, it's one of the most topical things we've discussed with investors on your stock right now. And I just wanted to confirm, or at least see if you could comment on the probability. There's obviously some concern that your customers could change their minds with delays and things like that.

So, I just wanted to get a temperature check on how you're thinking about your customer's willingness to move forward. And the probability of a worst case scenario where the customers walk, but you still have to pay to the shipyard. Do you think that's a reasonable possibility at all?

Jeremy Thigpen

So, really can't comment on this right now. What I will say -- I'll reiterate our conversations with Chevron, Beacon and Sembcorp are all constructive and are well along the way. And I will also reiterate that it is a very positive macro environment right now. So, if these projects look good to our customers, back when oil prices were depressed, you think they look better now, I can't speak for our customers at this point in time. I can tell you that our conversations with all parties involved are constructive, and we hope to have resolution in the coming weeks and months. And obviously, we'll publicly communicate that because this is -- we know it's forefront of your mind. It's definitely material to the company.

With CEO Jeremy Thigpen not outright denying the worst case scenario laid out by the analyst, we can assume that Transocean might indeed have to take delivery of the rigs even if Chevron (and/or Beacon) decide to terminate the contracts.

That said, management rightfully pointed to the improving macro environment and expectations for a substantial recovery in offshore drilling demand.

For the first time in many years, Transocean's management not only provided its usually bullish expectations on the conference call, but also included them in the 10-Q statement (emphasis added by author):

Over the last several months we have observed a steady recovery in economic and commodity outlooks supported by the delivery of effective vaccines, the deployment of economic stimulus packages and the improved economic activities associated with a more confident stance on defeating the pandemic. While remaining cautious in our optimism for the recovery of the global economy, we can see the path to pre-pandemic levels of activity. We also expect that demand for hydrocarbons may return to pre-pandemic levels within the next year or two. As a result, many of our customers are now shifting their focus to boosting exploration and production activities, and we are seeing many of those previously delayed projects now coming back to the table. With offshore activity increasing in almost every market, we are beginning to see positive trends similar to what was experienced in 2019. The key difference between 2019 and today is the significantly lower number of available drilling units and an increasing scarcity of the highest specification drilling units as customers look to secure the best equipment for their projects.

(...)

With deepwater and harsh environment fields offering increasingly competitive returns, we expect a significant portion of required spending in fossil fuel development will be for deepwater and harsh environment projects. The restructuring and subsequent consolidation of many of our competitors plus the accelerated retirement of units seen over the past several months and projected through the remainder of this year, should facilitate higher utilization of active assets and more efficient allocation of capital amongst restructured drilling contractors. In summary, our improving market dynamics combined with increasing demand for deepwater and harsh environment drilling have the potential to provide a materially better business environment for offshore drillers that weathered the effects of the pandemic and now move towards a more favorable outlook for 2022 and beyond.

In the prepared remarks, management actually made some encouraging statements regarding near-term contracting activity with potential long-term extensions for the drillships Deepwater Skyros and Petrobras 10000 and an unnamed IOC having submitted a request for proposal for potential multi-year contract awards for two of the company's highest specification rigs.

In addition, Transocean expects the entire fleet of active rigs in the Gulf of Mexico "to be sold out" later this year:

This is something that the industry hasn't even contemplated since 2014, and clearly supports a meaningful inflection in dayrates from current levels.

(...)

The stage is being set for a strong recovery in offshore drilling, with demand for rigs increasing and the marketable supply of rigs simultaneously decreasing. If the market plays out the way we currently think it will dayrates could, and for Transocean should significantly increase as we move into 2022 and beyond.

While CEO Jeremy Thigpen's notoriously optimistic projections should always be taken with a grain of salt, I am actually willing to give management the benefit of the doubt this time.

Bottom Line:

At least according to management, the offshore drilling industry and particularly, Transocean appears to be very close to an inflection point with increased demand in basically all regions now meeting materially decreased rig supply which should finally result in improved pricing power going forward.

Without the serious overhang from the above-discussed newbuild delivery delays, I would advise speculative investors to consider scaling into the company's shares.

At this point, I would expect Transocean to come to terms with customers on the delays albeit likely at the price of some dayrate concessions.

Investors should closely monitor the company's press releases over the next couple of weeks for a potential resolution of the issue.

With the rising tide likely to lift all boats, competitor Valaris (VAL) looks like a credible alternative after emerging from bankruptcy with ample liquidity, a strong balance sheet with zero net debt, and the world's largest fleet of offshore drilling rigs.

Analyst’s 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.