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Swiss Drilling contractor Transocean (NYSE:NYSE:RIG ) is a wolf in sheep's clothing despite rallying more than 500% in the last year from $0.63 to $3.90 a share. Once the market realizes the cash flow potential of Transocean's drilling fleet, the stock could more than double as investors begin correctly discounting future earnings.
The significant underinvestment in upstream oil development has likely reached a cyclical bottom. Transocean in particular has seen its share price drop 90% from its previous cyclical peak of $44 (2014) to around $3.90 today. After years of negative returns due to oversupply in both oil production and rig supply, the fundamentals for offshore drilling now look fantastic.
As dayrates increase so does Transocean's cash flow, and if management begin reactivating their stacked vessels due to greater contract demand, this would bring huge cash flow to the bottom line. If average dayrates hit above $400,000 while management reach 27 contacted vessels, EBTIDA is capable of reaching $1.58 billion, which is impressive for a company with a market cap of $2.51 billion. This could generate returns of 255% over the coming years. Below I will discuss the industry trends and data, along with conservative estimates, to determine Transocean's intrinsic value. This is an example of a company with strong fundamentals both from an industry and solo operations standpoint. Fundamentals can be strong without it immediately translating to earnings; however, I believe it's only a matter of time before Transocean returns to profit after years of negative earnings.
Over the last 10 months, some of the biggest offshore drilling contractors filed for chapter 11 bankruptcy. These include Noble (NYSE:NE) , Diamond Offshore, Valaris (NYSE:VAL) , Seadrill (OTCPK:SDRLF) and Pacific Drilling. After restructuring their debts, some of these companies re-emerged at a fraction of their previous size but with healthier balance sheets. With the exception of Pacific Drilling who was acquired by Noble. Clearly this was a result of contracts being revoked or renegotiated by producers as oil prices collapsed in 2020 leaving multi billion dollar fleets inactive.
Transocean avoided bankruptcy unlike most major players last year which was directly a result of better management. Transocean as the market leader has the biggest contract backlog of $7.4 billion, while the second largest backlog is for Valaris with less than $3 billion. At the start of 2020 (Feb) Transocean’s backlog was over $10 billion suggesting how many projects have been suspended. With low drilling demand, a contract driller's fleet quickly becomes an unsustainable cost burden, while simultaneously operating with a heavily levered balance sheet is the recipe for disaster.
However, when drilling demand is high with little or less-than-historical rig supply, these assets become incredible cash flow machines - particularly newer more advanced rigs that secure much higher dayrates.
This change in the competitive landscape has caused a massive number of offshore rigs (floaters/jack-ups) to be sold off, scrapped or cold stacked with no intention to recommission. As competitors shrink, it leaves more market share for Transocean as the industry regains traction.
Over the last few years Transocean has focused its fleet on Ultra-deep water drilling (UDW) and harsh environment (HE) drilling, possessing 37 floats of which 10 are specified for harsh environment drilling and 27 are for ultra-deep water drilling. Transocean currently have 2 additional drillships being built, Atlas and Titan. Both drillships have already secured contracts in the Gulf of Mexico and are the only vessels in the world capable of utilizing 20,000 PSI deepsea wells. Currently only 22 vessels are contacted out of the 37.
Since the oil price collapse in 2014, drilling services declined at a dramatic pace due to significant overproduction from both US Shale producers and OPEC. As offshore drilling demand weakened, the building of new drillships, semi-submersible and jack-up rigs continued in 2014/15 which quickly shattered the entire market.
At the start of 2014 Transocean had 14 ships under construction compared to only 2 today. Between 2013 and 2015, Transocean was spending over $2 billion annually on new builds. Likewise, this number has been shrinking and, in 2018, capital expenditures reached a low of $184m.
Furthermore, in 2015, Transocean possessed a fleet of 75 rigs (including new builds) whereas today that number is down to 39 (including new builds), and this trend is the same for every other offshore drilling contractor.
Looking at the chart below, you can see the number of active offshore rigs reached 275 before collapsing to 150 in the late 1990s.
T he price of oil started on a downtrend in 1997/1998, so you could anticipate a slowdown in demand for offshore drilling. However, as producers reduced their activity (all at the same time), this led to a supply shortage, which quickly drove the price higher in 1999. These events are identical to what we are going through now in 2021 albeit from a different circumstance.
Looking at 2021 on the chart, you can see the spread between the number of active offshore rigs and the price of crude p/b. If this chart was updated, it would show crude at $80+ p/b and the spread would be even larger. At some point, there needs to be a mean reversion as offshore drilling catches up, hence at the moment offshore drilling demand is at the bottom of the cycle. This macro environment for companies that benefit from a higher oil price (producers, drillers, tankers etc.) is likely going to experience a long profitable recovery.
Dayrates and utilization rates are the two most important metrics to follow in this market. The contracted dayrate refers to the price it costs a producer to hire a rig (including personnel) in an oil/gas field daily. The utilization rate refers to the percentage of a contractor's fleet that is contracted during the year.
At the last peak in 2014 offshore drillship utilization rate reached 95%, and if you were a drilling contractor back then, your first thought would be to build more drillships in order to meet this demand from producers. However, as everyone does the same and producers oversupply the market which weakens their margins, then the new rigs being built become negative ROI assets.
In 2014, dayrates for UDW floaters in Transocean’s fleet were as high as $700k and the average dayrate for the UDW fleet in 2014 was in the mid $500k region. Today Transocean's UDW fleet has average dayrates in the low $300k region, with some drillships on low 200k dayrate contracts. Some HE floaters are on sub 200K dayrates. A 10% increase in the average contractual dayrate for the entire fleet could add millions to the bottom line. Contractors are hyper sensitive to contractual dayrates, as small changes in price amplify their profits and losses due to leverage.
Average contractual dayrates based on Transocean’s backlog shows increasing dayrates over the next few years, further suggesting Transocean are going to see a strong and sustained recovery. Below you can see dayrates hitting $468,000 in 2024; however during 2024 these figures will be slightly lower as only newer/higher specification rigs tend to secure longer-term contracts. Hence older vessels will slightly lower the total fleet average over the coming years.
The graph below illustrates the global offshore rig attrition over the last 10 years.
This shows the vast amounts of rigs that have been deactivated over the last decade. So much of the global fleet has been reduced that it is impossible for producers to undergo new projects without paying significantly higher rates to drilling contractors. Due to the Biden administration keeping restrictions on US Shale, producers are more incentivised to seek projects offshore.
Extract from Q2 FY21 filing :
many of our customers are now shifting their focus to increase exploration and production activities, and many previously delayed projects are again active. Offshore drilling activity is increasing in almost every ultra-deepwater market, and due to attrition of the global offshore fleet over the last several years, there are significantly fewer available drilling units and, particularly, an increasing scarcity of the highest specification drilling units as customers look to secure the best equipment for their projects. In the North Sea harsh environment market, an accelerated level of recovery is anticipated in 2022 through 2023 as the effect of Norway tax incentive programs is realized by our customers.
Considerable uncertainty remains about the speed of the global economic recovery and the associated demand for and supply of hydrocarbons, particularly with respect to prospective actions of the Organization of the Petroleum Exporting Countries. We believe that the rapid decline in production activities due to the ongoing pandemic, combined with the lack of investment in exploration and production activities over the past several years will precipitate substantial supply constraints that are not easily reversed without significant new investment in drilling”
Global oil demand is historically inelastic year over year and the pandemic was a rare anomaly. This is why investors, researchers, traders etc. focus more on OPEC (supply) than economic indicators (demand) to forecast oil prices, because historically supply is the determining factor.
Here is an extract from the above report.
sharp spending cuts and project delays are already constraining supply growth across the globe, with world oil production capacity now set to increase by 5 mb/d by 2026. In the absence of stronger policy action, global oil production would need to rise 10.2 mb/d by 2026 to meet the expected rebound in demand”
Furthermore, a report from Moody’s in late September highlighted that so much supply had been bought offline, the industry need to spend $542 billion in oil production to avoid a supply crisis. It’s obvious at some point capital expenditure needs to come back online and the longer producers wait the more favourable it is for offshore drilling contractors.
Looking at the balance sheet, it's easy to see why investors class offshore drilling stocks as risky. Excessive debt has been the only way to survive the last few years; however, the debt for Transocean did not increase during the pandemic surprisingly. The company was able to survive as a result of maintaining more contracts (through better cancellation terms) which kept cash flow coming in during 2020. However, its cash/equivalents has gone from $1.9 billion pre-pandemic to $988 million today. Furthermore, debt remains elevated at $7.52 billion with net debt/EBITDA (trailing 12 months) at 6.05x. Management have communicated their commitment to de-lever the balance sheet; however, a key prerequisite to this is a favorable market where dayrates and utilization rates continue to increase.
If it wasn't for large CapEx spending in FY21 and FY22 for Atlas and Titan, Transocean would report positive FCF numbers. Due to FCF numbers being hard to estimate in the following years (FY23/24), it’s not appropriate to build a discounted cash flow model at this point. Instead I will build 3 case tables using various assumptions to calculate equity value.
Based on the most recent fleet status report from July and recent company news, going into 2022, of the 39 floats, only 21 have contracts in 2022 so far. Although by the time we reach December I believe all of the active fleet will remain active in 2022 meaning a contracted fleet of 24 (excluding Titan which goes into service in Q1 2023). Therefore, I anticipate 24 active floaters in 2022 and 25-27 active floaters in 2023.
The previous cycle saw average dayrates in the mid-500k region, hence in my bull case I am being very conservative only using $375k. It's worth mentioning almost all sub 200k contracts are expiring in 2022 as they are short-term agreements. So the average day rate for the entire fleet can move quickly as these contracts expire. Furthermore, the new builds (Atlas/Titan) should help increase the average contractual dayrates going into 2023.
The chart below demonstrates how profit margins expand and contract for a cyclical company.
At the peaks, Transocean's EBITDA margins were breaking above 50%. I will use a 45% EBITDA margin in my illustration in order to remain conservative. The table below illustrates the possible scenarios with EV/EBITDA ranging from 7-9x over the next 2 years.
I believe the intrinsic value lies anywhere between the medium and bull case, therefore based on these assumptions, the intrinsic value per share is between $7.59-$13.85. From $3.90 a share, this represents a return of 94%-255% if these assumptions play out. This does not account for 'at the market' equity raise - therefore the model assumes 651m shares outstanding. Including the new builds, Transocean has a fleet of 39 floaters. However, I am anticipating 27 active floaters in 2023 in the bull case.
Management have guided that it takes anywhere between $60m and $100m to reactivate a vessel hence undergoing speculative reactivation without a contract lined up is not financially smart. Instead management will only reactivate a rig if they can make their money back on the first contract (after reactivation) plus a small return (5%-15%). As the market continues to tighten, we could possibly see a situation where Transocean is operating with 30 active floaters in the next 3 years.
Although the market is heading in the right direction and tightening continues, we have not reached a point where it's economical for stacked rigs to be reactivated. However I imagine this is inevitable due to very strong fundamentals either in 22/23 or by early 2024, a t which point I am expecting a much higher valuation. This is also subject to OPEC actions and a potential panic U-turn from the Biden administration. However, I trust parties to act in their own interest therefore they would be shooting themselves in the foot if they made unexpected changes to their current policies.
Long-term debt and equity raise
Although Transocean was one of the only industry survivors from the pandemic, they still have over $7.5 billion in debt, significantly more than other restructured competitors. Source: Company's SEC Filings
This debt makes it harder to take on additional funding and prevents Transocean from building a strong cash position, and this is why I am keeping cash the same in my model for both years. Management have communicated their desire to de-lever the balance sheet; however, it's hard to imagine a significant debt reduction over the next few years. For example in 2023, Transocean has $800m in principal to be repaid, this money could be used to reactivate more than 8 vessels. Although this isn't actually a good idea, it shows the lack of flexibility that comes with such a heavy debt pile.
To put this in perspective from an asset valuation standpoint (in a bankruptcy case), Transocean has net PP&E on the balance sheet of $17.33 billion while the market cap is at $2.51 billion and the Enterprise Value at $9.05 billion. Transocean has a tangible book value of just over $11 billion. If we say in the case of bankruptcy net PP&E is sold off for $0.60 on the dollar ($10.40 billion instead of $17.33 billion), meaning tangible book value of $3.3 billion, even in this scenario the tangible book value per share owed to shareholders is $5.07 per share, which is 30% higher than the current share price of $3.90. Hence downside risk is incredibly low and if there was a bankruptcy (depending on the sale of assets), investors should still make a small profit.
However, these are very basic figures for tangible book value per share, the reality could easily be +/- another 10% as asset value (net PP&E) can change from what is on the balance sheet because yearly D&A of these physical assets does not account for industry trends which would lower their sellable value. For example, Transocean has incurred impairment losses of over $3 billion since 2018 as they reduced their fleet. Nevertheless, as there is such a large cushion in the case of bankruptcy (at these current prices), investors are more than protected and should likely make a small profit in a worst case scenario should the industry fail to recover.
Currently Transocean have ample liquidity and are capable of meeting debt maturities while also paying for Atlas/Titan this year and in 2022. The graph below highlights their project liquidity till the end of FY22.
Source: Barclays CEO Energy-Power Conference
Transocean has over $1.5 billion in principal to be paid back in 2026. Additionally, it has 6 bonds all maturing early in 2027. This suggests it is impractical for the company to undergo a total debt wipe long-term and by the time of these maturities, new debt will already be issued.
Also Transocean has an 'at the market' agreement to issue equity in the region of $400m. So far net proceeds of $66m have been raised through the issuance of 15.2 million shares.
The ATM agreement has capacity to raise a further $334m which would increase shares outstanding by roughly 86m at current prices (not accounting for transaction costs). This could represent further shareholder dilution of 13.22% if fully utilized.
If utilization and dayrates continue to increase due to a smaller number of rigs being available in comparison to the previous cycle, then Transocean stock should provide substantial returns. The cash flow Transocean’s fleet is capable of producing is very attractive compared to the current trading value of the company. Hence as Transocean’s contracts roll over (renewed/replaced), its anticipated much higher dayrates and utilization rates would bring the company back into profit with impressive FCF numbers. I also believe the next few quarters will see analysts revising their estimates to the upside, and I find it fascinating that there are zero buy recommendations currently for RIG.
Transocean is in their quiet period leading up to a much anticipated earnings release on 1 November. It is already apparent that the fundamentals are improving and there will be a positive outcome; however, the single biggest question is what Transocean will do with their stacked UDW floaters.
Is the market now tight enough to begin recommissioning stacked drillships or to begin recommissioning in 2022? From what I can see ideally Ocean Rig Apollo, Athena, and Mylos are key contenders for reactivation. I would also like to see further guidance on debt reduction and a focus on improving the balance sheet. Ideally I want to see net debt / EBITDA lower than 4x in the next 24 months. I also want to see backlog begin to trend higher above $7.3 billion over the coming quarters.
Despite the risks (heavy debt / further dilution), the fundamentals of the industry are obvious. Fundamentals can be strong without it immediately translating to earnings, therefore it's more important to keep track of dayrates and total fleet utilization -- p articularly the UDW fleet, as there are 10 stacked vessels and at least some of these (younger vessels) could be reactivated.
If Transocean achieves $400,000+ average dayrates with 27 or more active floaters, then the RIG stock should provide significant upside over the next few years.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.