Transocean: Get Ready For The Dayrate Inflection Point (RIG)

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Investment Thesis

The E&P sector saw outsized returns in 2021 but oilfield services (or OFS) and drilling lagged behind because the higher oil prices didn’t spur more capex so far. Comparing the relative performance of the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) to that of its Oil & Gas Equipment & Services counterpart (XES) illustrates this point:

Chart
Data by YCharts

Inevitably, capex will return. If not, the market logic dictates that oil prices will keep rising until E&P players are sufficiently incentivized to invest in new capacity. Since many E&P stocks are already close to or above their pre-pandemic levels, it makes sense to survey the OFS space for undervalued opportunities that may still have strong rebound potential.

Within OFS, offshore drilling has been one of the worst performing segments since 2014, so the recovery potential is arguably the biggest (seismic data services may be a contender for the worst performer too as I have argued here). Transocean Ltd. (RIG), in turn, is one of the main players in the drilling space and its stock price chart illustrates well the past woes of the segment:

Chart
Data by YCharts

Unlike many of its peers (which aren’t charted above, as they completely wiped out their old shareholders), Transocean has so far avoided bankruptcy and its balance sheet is still very levered. Perhaps counterintuitively, this makes Transocean a very interesting play on a possible drilling rebound because topline improvements will be magnified severalfold at the bottom line for equity holders due to the leverage effect.

The offshore drilling environment has indeed been improving and utilizations have been steadily going up as the excess rigs with which the industry found itself in 2014 have been gradually retired. Dayrates have also been recovering slowly, but they are still nowhere close to the pre-2014 days even in nominal, non-inflation adjusted terms. The investor frustration with offshore drillers is completely understandable, but it is important to point out that historically the utilization improvements have not had a linear effect on dayrates. As utilization rates increase, dayrates may initially not move much as long as there are idle rigs sitting on the side. However, once utilizations get close to 85%-90%, an “inflection point” seems to occur that can send dayrates much higher.

Based on the industry sources I survey below, we seem to be finally getting close to this inflection point. When the point is reached, the change in dayrates will be rapid and will filter down quickly to the equity prices, so to capitalize on this investment opportunity one would need to move before the news. While drillers which underwent bankruptcy such as Valaris Limited (VAL) have much stronger balance sheets, in the anticipation of a dayrate upswing RIG could be seen as a better opportunity due to the greater marginal effect on its equity. On a pure operational level, Transocean may also have advantages. RIG focuses exclusively on the deepwater segment where its state-of-the-art rigs can command premiums as for certain offshore projects there may be no technological alternative available from a competitor.

My minimum case for Transocean is that we will see again the $5 stock price level from July 2021 which would be a 50% to 60% upside from where we stand now. On the high end, I think the stock can reach the low double digits which would make it a potential “multibagger.” Of course, it needs to be emphasized heavily that Transocean is an extremely risky investment. If dayrates don’t inflect soon, the high leverage may result into restructuring although based on RIG’s credit rating and historical default ratios, the probability of bankruptcy should be less than 20% now.

All things considered, I think Transocean is worth a look from investors who have the risk tolerance and want to capitalize on the second stage of the energy recovery, which logically should result in (relatively) greater gains for the OFS laggards rather than the E&Ps who already had an outstanding year. I highly doubt that RIG would rise enough for someone who held it since 2014 to recover their capital, but for a new investor entering at today’s price point it could be a great opportunity.

Background

Transocean doesn’t need introduction, but the company is basically one of the principal offshore contract drilling services providers worldwide and focuses on the deepwater segment. The companies’ customers are E&P players with deepwater assets whose capex ends up being Transocean’s revenue. The low capex aspect of the 2021 oil recovery has therefore been hurting Transocean just as it hurts the broader OFS sector. The services providers’ woes really started back in 2014, but offshore drillers were the worst hit because deepwater projects with long development cycles were displaced by onshore shale which offered quicker payback times. This is why diversified OFS players have done relatively better than the drillers. However, as the oil narrative is now switching from oversupply to scarcity and shale production remains suppressed relative to 2019, deepwater appears to be back on the agenda.

As of December 2021, Transocean had 39 drilling units, including 29 ultra-deepwater (two of which under construction) and 10 harsh environment floaters. Over the last years the company removed its jackup rigs (used in shallow waters) and some older rigs, which brought down the average age of its fleet:

Transocean; drilling rigs; fleet transformation; Transocean investor presentation Source: Investor Presentation

A younger fleet is considered more desirable by operators because it offers better specifications that could be useful in technologically challenging conditions. The main market opportunities for Transocean’s deepwater rigs now are the Brazil pre-salt oil region, West Africa, the Gulf of Mexico and the North Sea. From Transocean’s latest fleet status report, we can see that the company’s customers currently include, among others, Chevron (CVX), Shell (RDS.B), BHP Group (BHP), Hess (HES) and Petrobras (PBR).

Transocean; drilling rigs; floater market opportunities; Transocean investor presentation

Source: Investor Presentation

Petrobras recently awarded drilling contracts to Seadrill Limited (OTCPK:SDRLF), a Transocean competitor. Hess announced a capex increase, part of which is related to Guyana. Shell made a deepwater discovery in the Gulf of Mexico last month. These news reports should be positive for the drillers.

The oil and gas sector has historically been characterized by boom-bust cycles as the industry swings between oversupply which crashes prices to scarcity which skyrockets them. The long development cycles compared to other industries probably create too much uncertainty among industry participants about the state of future supply which in turn results in poor planning. The same logic extends to the OFS segment. Constructing a drilling rig is a multi-year process. When making the decision to commission the rig from a shipyard, the driller is making a bet on the supply-demand balance for drilling services several years down the road. Conversely, when there is an oversupply of rigs, it isn’t that easy to reduce them because the fixed costs are sunk. These forces explain why both oil as the underlying commodity and the services industry developed around oil are bound to see some mean reversion as they swing between the extremes.

The S&P 500 Energy Index (XLE) was the top sector performer for 2021 with a 47% gain, which suggests that energy may have already seen its “mean reversion.” However, if we look beneath the hood, we can see that 2021 was probably more a tale of two cities. The recovery was concentrated on E&P companies with direct exposure to oil and gas prices while the oilfield services (or OFS) segment hasn’t really lifted off yet. A big part of the story is likely the different nature of the current oil and gas recovery compared to past bull cycles. After several years of underperformance, E&P companies’ new focus on “capital discipline” and balance sheet health, combined perhaps with long-term concerns over ESG mandates, has severely limited the investment in new capacity. This is pressuring up oil prices (CL1:COM) and E&P’s producing from developed reserves are greatly benefiting, but the OFS players are still lagging behind because they will only get more revenues when E&Ps start spending on capex.

This situation cannot go on forever and OFS should eventually catch up. Given the recovery in demand post-COVID and the natural decline in supply, if capex doesn’t pick up any time soon, oil prices will rise even further until it does. This is simply the market’s invisible hand at work and government interventions such as the recent release from the U.S. Strategic Reserve probably won’t have a meaningful impact even just due to the sheer size of energy supply and demand. Therefore, from a macro perspective, it makes a lot of sense to look into OFS right now before the segment gets on the E&P trajectory from last year. I have previously looked into Schlumberger (SLB) as a broad OFS idea given the company’s scale and diversified oilfield services profile. However, within OFS, drillers have fared even worse, so it is not unreasonable to expect a stronger mean-reversion “push” precisely in this segment.

Industry forecasts

The key phrase in industry forecasts over the last several years has been “rig attrition.” Back in 2014 when oil prices crashed, the drilling industry found itself with an excess of rigs which brought down dayrates as E&P operators could basically pay rig owners their variable costs given the abundance of idle rigs which couldn’t find work. Naturally, the industry response has been the retirement of older and less economical rigs which has improved the supply-demand balance, but this process has been slow and frustrating for the investors awaiting a recovery. Nonetheless, the overall environment for offshore drilling has been steadily improving in the last years. Many offshore projects were delayed because of COVID, but now it seems that the recovery in the sector is back on track.

In the good years prior to 2014, floater dayrates were north of $400k. After oil prices crashed in 2014 and capex budgets were slashed, dayrates collapsed below $200,000 and many rigs had to be stacked due to the lack of work, effectively earning zero. More recently, Transocean has started seeing dayrate fixtures above $300,000, specifically in the Gulf of Mexico:

Transocean; drilling rigs; floater dayrates; US GOM fixtures; Transocean investor presentation

Source: Investor Presentation

Transocean’s CEO Jeremy Thigpen said during the latest earnings call:

And finally, rounding out the Gulf, based upon our knowledge of the responses to several recent tenders, we expect awards to be made in the near future at day rates of approximately $300,000 per day, reflecting as we’ve discussed the increasing tightening of this market.

The CEO also commented on the utilization rates:

At the same time, we continue to see a tightening of the offshore market unfolding across multiple regions. Marketed utilization of the global floating rig fleet is nearing 80% to 85%, which has historically been the inflection point at which material increases in day rates are triggered. Notably active utilization in the Golden Triangle, which as you know consists of the U.S. Gulf of Mexico, South America and Africa, currently sits in the 90% range.

Globally, offshore rig count contract awards have been on the rise for four consecutive quarters and are beginning to exceed level seen before the pandemic. Average tender duration increased in the third quarter with a particular uptick in the length of option periods. This reinforces our belief that our customers see the signs of a rising market and are recognizing the importance of securing the highest specification asset for longer periods of time.

Industry sources have also been bullish lately on offshore drilling:

Source: Offshore magazine

According to the Offshore magazine article above which is based on insights from Evercore:

The firm said that over the past year, the industry has retired, scrapped, or converted to non-drilling purposes 34 jackups and 19 floaters, bringing the total to 159 jackups and 177 floaters since the offshore downturn commenced in 2014. This brings a net reduction in global supply of nearly 40% for floaters and 5% for jackups. Another 13 floaters and 52 jackups have been cold stacked for more than two years and are candidates for retirement, the report commented.

Meanwhile, the firm noted that demand “appears to be strengthening” with 28 contracts announced in October (flat year-over-year) and 23 thus far in November (up from nine as of mid-November 2020).

“We expect the industry to beat relatively easy November and December comparables to end the year with more than 400 contracts announced for about 380 rig years, up 33% and 20% respectively,” the report said. “While jackups continue to dominate, accounting for nearly 55% of all rig contracts (+18% year-over-year) and two-thirds of all rig years (+3% year-over-year), floaters have rebounded with contracting activity up 57% (9% short of 2019 levels) for an 80% jump in rig years (14% higher than the recent 2019 peak and 13% short of 2014 levels).

A recent analysis from Westwood’s RigLogix published in the Drilling Contractor also highlighted improving utilizations although in their view dayrates may lag behind a little longer:

Source: Drilling Contractor

Quoting from the Westwood analysis:

The global offshore rig market has experienced somewhat of a recovery – at least in utilization – in many regions. The price of Brent crude seems to have risen and stabilized at more than $70 over the past several months. Additionally, oil companies and rig owners have mostly managed to navigate through many of the logistical hurdles posed by the COVID-19 pandemic. Drilling programs that had been postponed have now begun or are back on schedule.

As a result, the number of contracted rigs has rebounded, and fleet utilization (jackups, semisubmersibles and drillships) is nearing March 2020 pre-pandemic levels. Dayrates for some rig types in certain regions, such as for U.S. Gulf of Mexico drillships, have risen dramatically. Conversely, dayrates for rigs in other regions have remained stagnant or only risen modestly, as is the case for Southeast Asia jackups.

The U.S. Gulf of Mexico improvement in dayrates will definitely be supportive of Transocean given a significant number of its rigs are located there. The Westwood analysis further explains:

The current floating rig fleet comprises 106 semisubmersibles (85 marketed) and 95 drillships (73 marketed). Marketed fleet utilization as of September was around 71%, with 112 of 158 units working or under contract. Drillship utilization was substantially higher than semis, at 75% versus 67%. Figure 2 shows that drillship utilization fell to 61% in July 2020, but the 14% increase since then represents the largest gain of any rig type.

The 85 floating rig fixtures this year have totaled 67 rig years of contract backlog. That number is below the 2020 total of 84.4 backlog years, but it took 116 contract fixtures to reach that. In fact, there have been 26 new deals (39% of the total) for one year or longer signed in 2021. There was the same number for all of 2020 (22% of the total), evidence of the more long-term nature of the market this year.

At present, drillship dayrates for new fixtures in a few regions have increased significantly versus 2020. One of the better-performing regions in 2021 has been the US Gulf of Mexico, especially for drillships. Currently only one of the 18 total units is available, and there are rumors that it will have a long-term contract in place shortly. There are two rigs that will exit the region in the coming months, and there likely will not be any spare inventory to speak of until the first half of 2022.

The range of new dayrates has increased substantially versus 2020. Last year, fixtures ranged from $178,000-$240,000, with just one fixture over $200,000. However, for the first eight months of 2021, the range has been $190,000-$335,000 (excluding 20K BOP fixtures). Outside of one sub-$200,000 and one rate over $300,000, rates were in the $215,000 to $285,000 range.

The main theme is that fleet attrition combined with stronger demand is leading to improved utilizations and longer contracts, both signs of a stronger market.

Source: Drilling Contractor/Westwood

For 2022, Westwood expects:

As a result, we believe demand in 2022 will see an average base case increase of 10-15 contracted units, while the best case scenario would see the contracted number go up by 20-25 units. This would result in an increased demand of 122-137 units. That will be offset some by a five- to eight-rig increase in marketed supply. All these numbers combined would result in 2022 marketed utilization ranging from as low as 76% to as high as 85%, the latter representing quite a jump from the current 71%.

As noted in our regional analysis, we believe the areas to watch for drillships will be the Golden Triangle, that being the US Gulf of Mexico, South America and Africa (including south and east coasts). For semisubmersibles, demand in South America will continue, as it will in the North Sea, Southeast Asia and Australia.

The fact that 85% utilization is now considered possible is quite important. Historically, the relationship between utilization and dayrates hasn’t been linear. Moving from low to mid utilization levels doesn’t necessarily increase the dayrates because new demand can be met by idled rigs which just need to cover their variable cost for the contract to make sense from the driller’s perspective. According to Westwood again:

The general rule of thumb is that utilization must hit 85% for substantial rate improvement to occur (this number used to be 90%).

The 85% level aligns to the CEO’s comments and hence the “inflection point” reference in this article’s title. When utilizations get close to 85%, the bargaining power shifts from the operators to the drillers and then the dayrates can increase dramatically as we last saw prior to 2014. The fleet attrition process during 2014-2021 has undoubtedly been very slow and frustrating for existing investors who would be deeply in the red by now. However, we finally seem to be nearing the critical utilization levels at which dayrates can break from the last years’ trend and rise more sharply. This could be a great opportunity for new investors opening positions at today’s share price levels.

Transocean’s competitors also share the positive outlook. Valaris sees a steady 6% YoY demand growth over the next several years while Noble Corporation (NE) also supports the $300,000 dayrate data point:

Source: Valaris Investor Presentation

Source: Noble Investor Presentation

It is probably good to point out as well that these forecasts refer to “marketed utilization” which excludes from the denominator stacked rigs which aren’t actively marketed. Total utilization which represents the proportion of working rigs from all rigs (including the stacked ones) could be 10% to 15% lower than the marketed utilization number. If the dayrates get very high, it is not inconceivable that some stacked rigs will also be activated to join the party, but the activation process would take some time during which the already marketed rigs can enjoy the exorbitant dayrates.

Bankruptcy risks

The main risks for investors to consider is the bankruptcy risk. Since Transocean didn’t restructure as Valaris and Noble did, the possibility is unfortunately still on the table if things don’t go well. Nevertheless, in some ways Transocean is in a better place now compared to 2019.

The debt maturity profile has been already stretched out:

Transocean; debt maturities; Transocean investor presentation

Source: Investor Presentation

Most importantly, the 2023 wall of debt which looked so menacing back in 2019 has slowly been transformed into a few smaller “walls” further back in time. Liquidity also appears good now:

Transocean; liquidity; Transocean investor presentation

Source: Investor Presentation

The bond markets also show significant improvement since 2020 although the current price for the 2025 notes probably suggests a 20% default probability:

Transocean; 2025 notes; bond price

Source: Markets Insider

Transocean earned a slight upgrade by S&P during the summer of 2021:

Swiss-based offshore drilling company Transocean Ltd has been upgraded by one notch to CCC from CCC- by S&P on steps taken to improve its liquidity. The issue-level ratings were also upgraded by one notch – secured debt rating raised to B-, unsecured guaranteed debt upgraded to CCC+ and unsecured debt upgraded to CCC, reflecting the potential that the company will undertake additional distressed transactions over the next year. The rating agency said that “Despite the recent run-up in oil prices, oil and gas exploration and production companies remain relatively disciplined and have not materially increased their spending.” and added that “As of Apr. 28, 2021, the company had a contract backlog of $7.4 billion, which provides it with significant revenue visibility over the next two years.” The rating action comes with a negative outlook due to high debt and significant capex. The company has $461mn of debt maturing over the next 12 months, $588mn in the 12 months following that, and ~$900mn the year after. It also has a newbuild capex spending of ~$50mn in December 2021 towards delivery of Deepwater Atlas and ~$350mn in May 2022 towards its Deepwater Titan. The funds from operations (FFO) to debt of the company is less than 5%. These factors could lead to the company to execute another distressed debt exchange or debt restructuring over the next 12 months.

On the positive side, S&P seems to feel relatively comfortable over 2022-2023 due to the backlog. The risk is certainly there, but with where we are with the broader energy supply-demand balance right now, if Transocean isn’t successful, that would in my view signal much bigger energy shortage and economic problems which would be very negative for equity markets in general.

Competitive position

Transocean obviously isn’t the only driller so reviewing the company’s standing relative to its peer group is also important. From a backlog perspective, RIG is clearly ahead even considering the Noble merger with Maersk Drilling (OTC:DDRLF):

Transocean; drilling rigs; backlog; Transocean investor presentation Source: Investor Presentation

When it comes to fleet age, Transocean is in the middle of the pack and Valaris and Seadrill lead:

Source: Valaris Investor Presentation

However, Valaris, Noble and Seadrill still own jackups whereas RIG has positioned itself exclusively in the technologically more challenging deepwater segment. Transocean touts itself as having the “only two fully sanctioned 20K drillships in the world”:

Source: Investor Presentation

In other words, there could be market situations in which RIG is a de facto monopolist with regard to the specific drilling requirements.

A look at Seeking Alpha’s ratings shows that SA contributors are bullish on RIG and NE while neutral on VAL:

Source: Seeking Alpha

SA’s valuation quant factor grade is much stronger for RIG than VAL too. Overall, I don’t find the meta-rankings conclusive here, but one factor that clearly differentiates RIG from its peers is the leverage. In a positive environment, I see it as a plus because equal gains in dayrates and cash flows for RIG and say VAL would result in disproportionately larger effect on RIG’s equity. Of course, you could theoretically go long VAL on margin to a achieve similar risk profile, but I don’t see most investors doing that. The leverage works the opposite way in a downside scenario, so VAL is a safer investment from that perspective. However, my view is that if you are looking for a “safe” investment it doesn’t make any sense to look at the drillers to begin with.

Finally, for all it is worth, RIG’s management survived (so far) the extremely challenging 2014-2021 period whereas the others didn’t. You could argue the bankruptcies pursued some strategic considerations, but you could also see it as a signal showing superior management skill and that should count for something too.

Valuation scenarios

I developed a few high-level valuation scenarios to show the potential upside for RIG. These are mostly meant to illustrate the disproportional impact on the equity value from relatively modest topline improvements:

Scenario 1 2 3
Fleet size 39 39 39
Total utilization 75% 80% 85%
Dayrate $300,000 $350,000 $400,000
Implied revenue $3.2 B $3.9 B $4.8 B
EBITDA margin 36% 36% 36%
EBITDA $1.15 B $1.43 B $1.74 B
EV/EBITDA 7.5x 8.0x 8.5x
Implied EV $8.6 B $11.4 B $14.8 B
Plus: Cash $900 M $900 M $900 M
Less: Debt $7.35 B $7.35 B $7.35 B
Implied equity value $2.1 B $5.0 B $8.3 B
Shares 650 M 650 M 650 M
Implied share value $3.38 $7.74 $12.86

Source: Seeking Alpha; Investor Presentation; author’s calculations

I based the EBITDA multiples on where RIG has traded lately, so I am not assuming material multiple expansion:

Chart
Data by YCharts

My minimum case for Transocean is that sometime later this year we are going to see again the $5 per share price from the July 2021 peak. I think we have seen through January 2022 that the oil shortage isn’t going away any time soon, so there is no reason we shouldn’t retest the $5 level. The high case is probably in the low double digits which would make the stock a potential “multibagger.”

Many smaller E&P stocks in mid-2020 had similar risk profile to what we can observe for RIG now. Some like Chesapeake Energy Corporation (CHK) didn’t make it, but others who avoided bankruptcy such as Centennial Resource Development, Inc. (CDEV) delivered multibagger returns to the equity holders who entered at the low price point. We may see a similar scenario in 2022 for some levered players in the OFS sector, but there is no denial that the high reward comes with high risk, so it isn’t a free lunch by any means.

Conclusion

I have laid out my bull case for Transocean:

  1. The energy sector recovery in 2021 has focused on the E&P sector due to capex-less nature of the recovery so OFS has been left behind; this means that for 2022 the mean reversion forces will be stronger in the OFS segment including drilling.
  2. Within the drilling space, RIG is highly levered, so if the segment recovers, RIG will offer new investors the greatest bang for the buck; operationally and technologically RIG is not worse either and is arguably better positioned than its peers.
  3. This is a high risk, high reward opportunity. My minimum case is that we’ll see again the $5 price point from last July which by itself is already a 50% to 60% upside and the high case is in the low double digits. Overall, I could be “very bullish” on RIG but on a risk-adjusted basis I feel the “bullish” rating is more appropriate.

I also acknowledge that anyone who has invested in the drilling space since 2014 would be likely very frustrated by now and some people are probably tired of repeatedly hearing that “dayrates are going up soon” over all these years. However, I personally do think that in 2022 we are finally close to the “inflection point” after what all that we saw happen in energy during 2021. I would be curious to hear your views in the comments.

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