Is The Recent Plunge Of Transocean Justified?
Oct. 23, 2017,Aristofanis Papadatos +++ Seeking Alpha +++
Summary
Transocean plunged 10% last week.
It signed a contract for a modern rig with a markedly disappointing dayrate.
Off-shore drillers have drastically reduced their break-even points during the ongoing downturn of the sector.
However, the time to bring offshore projects to production is still several years, whereas shale oil fields come to production in just a few months.
Transocean (RIG) plunged 10% last week and thus interrupted its rebound off its all-time lows. The major reason was the contract it signed for its ultra-deepwater drillship Deepwater Invictus at a dayrate of $145 K. The news was extremely disappointing, as the dayrate was 75% lower than the current rate while the drillship is a modern rig built in 2014. Nevertheless, the big question is whether the market has overreacted or the recent plunge is justified.
First of all, the shareholders of all the off-shore drillers have been experiencing endless pain during the last three years. To be sure, the stocks of all the off-shore drillers have been decimated during the ongoing downturn of the sector. For instance, Transocean has lost 80% in the last 4 years. However, it will be extremely risky to conclude that these stocks have become bargains thanks to their compression. As the shareholders of Seadrill (SDRL) have learnt the hard way, stocks do not always recover. Therefore, the shareholders of Transocean should carefully evaluate the business prospects of the company before deciding whether to hold their shares.
During the ongoing downturn in the oil market, off-shore drillers have managed to drastically reduce their costs. Consequently, they have reduced the average breakeven point for a series of offshore projects from $91 per barrel to $46 per barrel. However, in the meantime, shale oil producers have been doing the same and hence the output of shale oil producers has kept climbing and currently stands near its all-time highs. Moreover, the US Energy Information Administration currently expects a record output in 2018, with most of the new output coming from the Permian region. Therefore, despite the drastic cost cuts of off-shore drillers, the deepwater projects continue to face huge competitive pressure from shale oil producers.
As both off-shore drillers and shale oil producers have markedly lowered their breakeven points, most investors will erroneously conclude that it is uncertain which category will eventually prevail. The key is to realize that the time to bring offshore projects to production is still several years, whereas shale oil fields come to production in just a few months. This is a key differentiator between the two types of producers. As no-one can forecast future oil prices with any degree of accuracy, the great lag between investment and production renders offshore drilling a much riskier investing endeavor. As a result, oil producers are much more likely to invest in inland fields than in deepwater projects.
This key weakness of deepwater projects is already prominent. More precisely, Transocean recently announced that it will take a $1.4 B impairment charge in Q3 to cover the costs of retiring 6 rigs. In addition, offshore drillers junked more rigs in Q3 than they ever did in a 90-day period. Furthermore, the worst evidence for the pressure facing deepwater projects is the astonishingly low dayrate that Transocean booked for its new drillship, as mentioned in the beginning. This dayrate certainly leads to the conclusion that this investment of Transocean was very poorly timed and is not likely to prove profitable anytime soon.
It is also worth noting that Transocean has a markedly weak balance sheet. On the bright side, its current assets of $4.3 B by far exceed its current liabilities of $1.8 B so there is no short-term liquidity problem. However, on the other hand, its net debt (as per Buffett, net debt = total liabilities – cash – receivables) stands at $6.5 B and hence the interest expense clearly burdens the company. To be sure, during the first half of the year, the adjusted operating income of the company was $222 M while the interest expense was 256 M. Therefore, the interest expense “ate” the whole operating income and more and hence the company incurred losses. Even worse, as the revenues are expected to remain in a downtrend, the bottom line is only likely to deteriorate. The weak financial condition of Transocean is clearly reflected even in the outlook of its own management. More specifically, its management expects the cash of the company to decrease from its current level of $2.2 B to about $1.0 B within the next two years.
It is also remarkable that the company still has elevated capital expenses, which are estimated around $700 M for the next two years. This only proves the very poor timing of its past investment decisions. Nevertheless, apart from this poor timing, the management of Transocean is doing its best in reducing its cost base and in essence it is doing its best in everything it can influence. Unfortunately, this is the worst part for the company; more precisely, even if the company does its best from now on, it can hardly affect its own fate, as the latter largely depends on the future path of the oil price. If the price of oil does not experience a sustained rebound above $60, then Transocean will not enjoy a meaningful rebound in its business. And although OPEC has made great efforts in supporting the oil price, the cartel has lost most of its pricing power due to the boom of shale oil. As a result, whenever the price of oil rises above $50, the shale oil output increases and thus puts a cap on the oil price. Consequently, a sustainable rally of the oil price does not look likely on the horizon and hence Transocean should not expect its business conditions to improve anytime soon.
To sum up, the collapse of the dayrate of the ultra-deepwater drillship of Transocean is a confirmation of its gloomy prospects. Therefore, the recent plunge of the stock is justified. While the company is doing its best in the things it can affect, its fate is out of its control, as it depends on the future path of the oil price. Of course no-one can exclude a temporary rebound off the current depressed level of the stock. However, given the high leverage of the company and the absence of bottoming conditions in deepwater drilling, Transocean remains a highly risky, leveraged play on the oil price.