Transocean Will Ultimately Pay The Price For Reckless Ocean Rig Acquisition – Transocean Ltd. (NYSE:RIG)

Back in 2018, Transocean (RIG) announced that it was going to buy fellow driller Ocean Rig. At that time, Ocean Rig had two harsh-environment semi-subs, nine modern drillships and two drillships under construction. I did not like the deal from the very beginning as it looked very similar to Ensco’s (now Valaris (VAL)) purchase of Atwood Oceanics – a stockpiling of workless rigs. Not all Ocean Rig’s rigs lived to see this day: one semi-sub and one drillship were scrapped, while two newbuild drillships were abandoned. The fate of the eight drillships that stay in the fleet is not that bright since four remain cold-stacked and one is warm-stacked without a job. Only three former Ocean Rig drillships and one semi-sub have contracts today.

The price that Transocean had to pay for its excessive optimism was significant. On February 15, 2018, Transocean had 459 million of shares outstanding. Two years later, on February 12, 2020, the number of shares outstanding increased to 612.5 million. Meanwhile, the company’s debt increased from $7.4 billion at the end of 2017 to $9.3 billion at the end of 2019 (the company also sold $750 million of notes at the beginning of 2020). Transocean has always relied on its industry-leading backlog, which stood at $10.2 billion in the latest fleet status report, to shield it from the slow pace of the recovery. However, the coronavirus (WHO has just declared that Covid-19 outbreak is a pandemic) and Russia’s recent move to exit the OPEC deal (I wrote about it here) created a new reality in which the company will have to operate. The stock price has already reflected the new risks:

Here’s what the new situation in the world oil markets means for Transocean:

1. Cold-stacked rigs are not coming back to the market anytime soon if ever. I think that we can safely write off the less capable drillships Deepwater Champion, Discoverer Luanda, Discoverer Americas and Discoverer Clear Leader. The cold-stacked drillships acquired in the Ocean Rig transaction – Ocean Rig Apollo, Deepwater Athena, Deepwater Mylos, Deepwater Olympia – are also under question. The more a rig spends in the cold-stacked state, the more the company will have to invest to bring it back to the active fleet. Currently, all of the above-mentioned rigs face a prospect of many more months of cold-stacking as their reactivation will demand much higher day rates (current day rates are expected to be about $225,000 for modern drillships; I believe that oil below $40 has stopped the day rate upside).
2. No actual scrapping will happen even if Transocean determines that a certain rig will never work again due to the accounting consequences of such a move. Last year, a decision to scrap three drillships built at the very beginning of this century led to an impairment charge of $583 million. Certainly, scrapping drillships built in 2009 or later will lead to a devastating impairment.
3. Fortunately for Transocean, its active, benign ultra-deepwater fleet is mostly contracted for 2020. Drillship Deepwater Orion remains without a job since October 2019. Contracts of drillships Deepwater Asgard, Discoverer Inspiration, Discoverer India, Dhirubhai Deepwater KG and semi-subs GSF Development Driller I and Deepwater Nautilus end in 2020, but their contracts end in the second half of the year. The company is currently not forced to find jobs for these rigs when everyone has likely frozen investment decisions to give the coronavirus situation some time to evolve.
4. The balance sheet, which was weakened after the Ocean Rig deal, will attract a lot of investor attention during the upcoming earnings reports. This year, the company’s management deserves credit for using the window of opportunity provided by increased U.S.–Iran tensions at the beginning of this year and selling $750 million of senior unsecured notes due 2027. This was a very timely move that will facilitate Transocean’s life this year. In my view, the capital markets are now shut for drillers, so they’ll have to survive with the liquidity they have – no near-term help is coming.

While I’ve always been skeptical about Transocean’s ability to reactivate its stacked drillships, I’m now sure that the acquisition of Ocean Rig will ultimately lead to mass scrapping of drillships – legacy Transocean rigs will fall victim of cannibalization (they were substituted by more modern active Ocean Rig drillships), while Ocean Rig’s stacked drillships will see their reactivation costs skyrocket due to too many years of stacking. A double blow from the coronavirus and Russia’s decision to abandon the OPEC deal is most likely a fatal blow for the majority of Transocean’s stacked rigs. Even if the company survives with the current capital structure, Ocean Rig acquisition has already dealt material unrepairable damage to the company which will ultimately have to scrap and write down many modern rigs. At this point, Transocean is a trader’s stock – expect plenty of volatility to come in the following days and weeks.

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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.

Additional disclosure: I may trade any of the above-mentioned stocks.