- Transocean is on the rebound after a long down-cycle.
- Shares are underpriced relative to market conditions.
- We rate the company a buy for investors with a high-risk tolerance.
Introduction
Transocean$Transocean(RIG)$ killed it the other day relatively speaking when earnings were released. The stock popped about 15% before sagging back toward the $4.00 mark. We think conditions are ripe for that dynamic to become more sustainable.
The company has been a favorite of mine in this space for about a year now. Primarily because in that time I have become more and more convinced that there would be a rebound in offshore deepwater drilling activity that the company has positioned themselves to serve. I wrote a detailed thesis for the company in September, and that article should be read as a companion to this one. While I am pumping my old material, you should also read this one. In it I put some strategic thoughts about oil supplies in the coming years. I am more convinced that I am on the right track, now than then, and it relates to our topic today.
Reading through the Q-3 call convinces me that RIG is in turnaround mode. I am not going to recap the material I covered in the prior article, but I will discuss the central thesis as to why this will occur.
RIG is a top pick for growth in the coming offshore investment environment. In this article we will present a couple of positive theses for RIG to outperform competitors.
The deepwater thesis
Two events caused the seven year depression in offshore drilling that we are just coming through. The first was the Saudi war on U.S. shale where they attempted to reassert their traditional role as the price maker for oil, and opened the taps. This was initially successful as burgeoning supplies made shale plays uneconomic as breakevens were very high, and drilling plunged. Shale drillers responded by improving practices and rethinking their approach to completions, and costs in the shale patch declined. Shale drilling began a ramp in 2016 that didn't end until early 2020.
In a parallel circumstance related to low prices, offshore drilling shrank by as much as 80% from 2014 levels, as operators wrote down acreage and revamped their exploration budgets toward short-cycle-shale drilling. Most of the offshore drilling contractors, one by one, went bankrupt, or were acquired by larger companies thinking a rebound was just around the corner, and then went bankrupt again. The main exception has been RIG, who has dodged debt bomb after debt bomb over the years trying to avoid the asset liquidation that probably would have followed a trip to the court house.
The second event that killed offshore drilling was the rise of the ESG 'oil is bad' movement that has only recently crested. From 2015-2021 the prevailing sentiment was that petroleum must be quickly abandoned to save the planet. Countries and companies followed the edicts of the Paris convention of 2016, and shifted their focus to renewables. Nowhere was this more evident than in the EU as most bad ideas begin in large bureaucracies, and the EU is the epitome of bureaucracy. Corporate giants, investment bankers, state actors, and even oil companies quickly followed suit on this side of the Atlantic, and pledged to freeze out new investment in oil and gas supplies. As we have discussed in prior articles about 3/4 of a trillion dollars has been deferred from exploration and development since 2015.
Last year a "chill wind" blew through the notion that petroleum would be very quickly phased out in favor of renewables, when... the wind in the North Sea didn't blow. Making the plethora of offshore wind farms a useless bunch of maritime and avian navigation hazards. Interest in acquiring new sources of petroleum and in particular supplies of natural gas surged and show no signs of abating.
Wrapping this up as we are not covering new material but establishing the thesis for a revival of offshore drilling and by extension RIG, the need to replenish declining offshore inventory is now incumbent upon the world. There is no choice but to begin a ramp in E&P activity in this sector. With the possible exception of Exxon Mobil $Exxon Mobil(XOM)$, the Super Major IOCs all have production declines that must be addressed if oil supplies are to be maintained going forward.
These companies need to find "Elephants." Archaic terminology for giant oil fields of a billion barrels or more. Increasingly these fields are found in offshore, deepwater environments, and few were elephants in 2021. That means more drilling will be required to maintain supplies.
This pivot to long cycle, deepwater activity comes at a good time. Companies are reporting record profits amid calls from governmental bodies to increase output, hopefully in their view to reduce prices.
I know, I know. That is the one of the dumbest ideas you've ever heard. Spending money to drive the price of the commodity you're producing... lower. I can just see presenting that to a board of directors! Tell this to a farmer. Grow more corn to purposely drive prices down so people don't have to spend so much money to eat. Pigs will fly! The point is oil companies treasure chests are overflowing and there is money to spend on exploratory drilling.
The thesis for RIG
Through a series of acquisitions, that brought praise and criticism - among them the Songa deal (that nearly bankrupted the company), RIG has rebuilt itself to be a pure play on deepwater drilling. It's debatable if that alone brings the perception of value in clients minds, but what's undeniable is they have the largest fleet of high spec 6-7th generation rigs that will command premium pricing. They are distributed around the world, in areas where they are likely to pickup contracts.
Offshore drilling units are a story of BOP rating, hookload capacity, pumping capacity, deck space, pit capacity, station keeping, and working pressure limitations. Add in modern robotics on the rig floor, safety improvements, and Managed Pressure Drilling-MPD capabilities, and the selection of these rigs over older, less capable 4th-5th gen rigs becomes a no-brainer for efficiency. One way operators have pared millions of dollars of cost out of deepwater projects is cutting the time for drilling and completing a well. This is done with the modern rigs and highly trained crews that RIG provides.
With the pivot to deepwater development, RIG is in a better position to field these ultracapable rigs than their closest competitors, Noble Corp. $Noble Corp PLC(NE)$ and Valaris$Valaris Ltd(VAL)$. Make no mistake these other companies have restructured and have balance sheet advantages to RIG. That said the demand pull of market tightness, will make this a numbers game that RIG will feast upon.
Competitors VAL and NE trade at what I think of as dangerous EPS multiples. 179X and 26X respectively. RIG, with no earnings has no multiple, so either is a better choice than RIG using that metric. On an absolute basis RIG is $4.00 per share and I consider it derisked there, plus or minus a buck. Percentage-wise, big moves, in real money, sort of a "Meh."
As a final point in RIG's favor, it is worthwhile to note that it is the only OSD whose stock hasn't gone to zero in the last seven years. A fact likely stemming from the debt collateralized status of much of its fleet, as much as anything else. "No play if you don't pay," as the saying goes. Still long time RIG stockholders have not been completely wiped out as has been the case with the competitors mention. That should count for something. But, I am not sure what.
The general contracting environment
This was another quarter of incremental improvement in dayrates and the contracting environment in general. Jeremy Thigpen, CEO of RIG commented in this regard:
Looking forward, we expect the global recovery for the offshore drilling market to continue on a pace consistent with the past several quarters. The offshore CapEx budgets of the majors have increased for the second consecutive year, and we're seeing this reflected in tender and contracting activity.
Points of interest from the call
Drillship day rates have continued their upward trajectory and recently moved comfortably above the $400,000 per day mark. The day rate for this sort of fixture has more than doubled in the last two years.
RIG added an incremental $1.6 billion in backlog since the release of the July fleet status report, bringing their total backlog to $7.3 billion. This critical metric for RIG had been on the decline, falling from over $14 bn in 2017, to around $6.1 bn in the prior quarter. A 15% bump in one quarter changes the conversation directionally.
One of the core deepwater markets, the GoM, is 100% sold out and RIG notes 8 new programs and in particular a number of multiyear commitments being tendered.
The new 8th Gen rigs, the Atlas and the Titan are contracted for the next 2-5 years at acceptable rates. The Lower Tertiary play that these rigs were built to develop is just getting underway, which should provide ample contracting opportunities for these rigs at substantially higher day rates over the life of the play.
Brazil has a new leader, Lula. He was president when I lived there and is a big advocate for Petrobras (PBR). Thigpen noted that another 19-21 deepwater rigs could find work as a combination of PBR and IOC activity. Recent contracts have been above $400K per day and should increase as new work is awarded.
Norway is going through a soft patch with day rates in the $300s. That will change gradually as we move toward 2024 (15 months away now). Current demand supports around 15 floaters and is expected to increase as projects sanctioned under the tax incentives to come online. RIG anticipates the Norwegian market will not have enough rigs to fulfill customer requirements by 2024.
Q3 2022
RIG reported a net loss attributable to controlling interest of $28 million or $0.04 per diluted share. During the quarter, they generated adjusted EBITDA of $268 million and improved the adjusted EBITDA margin to approximately 37%. Cash flow from operations was approximately $230 million.
Adjusted contract drilling revenue was $730 million at an average day rate of $343,000. Revenues above guidance came from higher uptime rates and an early termination fee.
Operating and maintenance expense for the third quarter was $411 million. Costs came in below guidance due primarily to the timing of certain maintenance activities and other costs. RIG ended the third quarter with total liquidity of approximately $2.1 billion, including unrestricted cash and cash equivalents of approximately $154 million, approximately $387 million of restricted cash for debt service and $774 million from the undrawn revolving credit facility.
While not yet issuing firm guidance for 2023, they expect adjusted contract drilling revenue of approximately $600 million based upon an average fleet required revenue efficiency of 96.5%. The quarter-over-quarter decrease is attributable to somewhat lower activity in the fourth quarter.
Capital expenditures and capital additions for the fourth quarter, including capitalized interest, were forecast to be approximately $575 million. This includes approximately $540 million for the newbuild drillships and $35 million of maintenance CapEx. Cash taxes are approximately $9 million for the fourth quarter.
Recurring forecast for 2023 adjusted contract revenue to be between $2.9 billion and $3 billion. They expect full year 2023 O&M expense will be between $1.8 billion and $1.9 billion. With G&A costs to be around $200 million.
Expected liquidity in December 2023 is projected to be between $1 billion and $1.2 billion, reflecting their revenue and cost guidance and including the $600 million capacity of the revolving credit facility and restricted cash of approximately $300 million, which is reserved for at service as well as anticipated secured financing of our second eighth generation drillship with Deepwater Titan. This liquidity forecast includes the 2023 CapEx expectation of $260 million.
In conclusion, rig day rates are now above levels necessary to generate cash flows that help support deleveraging their balance sheet. Meaning the proverbial "light at the end of the tunnel," may not be a train for the first time in a long time.
The 5-handle - The catalyst that will move the stock
The long awaited and much needed 4-handle on day rates have arrived and been surpassed. Stocks of the offshore drillers-OSDs have barely budged from the range they've been in for most of this year. Now how about that 5-handle that will signify the return of real profitability to the OSD sector?
Thigpen comments here:
Dayrates have improved 113% for ultra-deepwater drillships. And so we expect that trend to continue. Our customers feel it. They know it's coming. And so I'm not going to give you a date by when we would see a 5 handle, but we're definitely moving in that direction.
There is now a real expectation that sometime in the next year a contract will be signed at a day rate above $500K per day. That is getting within reach of the mid-6-handles top rigs were fetching in the last boom. Les bon temps roulez!
Risks and Accelerants to our thesis
Risks - The inherent debt risk in RIG can't be overstated. They still owe ~$6.5 bn in debt with ~$2 bn of this coming due over the next three years. Then the big ones start to hit. $1.6 bn in 2026, $1.9 bn in 2027, and $1.4 bn in 2028. The only way this debt gets paid when due, or more likely rescheduled, is if the supportive pricing environment that now is in place for oil, persists for much longer.
One risk that's sort of off the table is the shareholder dilution courtesy of opportunistic share sales by the company through the ATM facility. CFO Mark Mey comments in this regard:
Absent any material increase in the trading price of our shares, we do not plan to utilize our ATM equity sales program in the near future. We reiterate the creating value for our shareholders and we manage our priority, and we will assess all feature actions through this lens.
My view, let's take that will a grain of salt. If shares rose sharply the urge to sell another 10-15 mm shares would be irresistible. 2% dilution is a real possibility, but not the end of the world.
Accelerants - I have mapped out a fairly extended thesis for day rates to gradually increase over the next 1-2 years as rig utilization tightens. That is one possible future. Another is what happens when/if shortages of petroleum wreak a true dislocation on society? It hasn't happened yet, but we could be on the cusp of one.
As I noted in the "Hard Truths" article there is just such a dislocation coming, it's just a matter when people begin to realize it. As an example, the EU is on the verge of de-industrialization. It is just now materializing, but soon the effects will be felt in output, employment, and GDP. An article carried in Reuters notes:
Europe needs its industrial companies to save energy amid soaring costs and shrinking supplies, and they are delivering - demand for natural gas and electricity both fell in the past quarter. It is far too early to rejoice, though. The drop is not just because industrial companies are turning down thermostats, they are also shutting down plants that may never reopen.
And while lower energy use helps Europe weather the crisis sparked by Russia's war in Ukraine and Moscow's supply cuts, executives, economists and industry groups warn its industrial base may end up severely weakened if high energy costs persist.
The larger point here is we are in uncharted waters. Prior to the advent of the ESG movement that demonized the production of oil gas the focus on energy was making sure we had enough of it, and it was as cheap as possible.
I am going to predict that if a true dislocation of energy occurs in the Western World, it will have a profound effect on attitudes about drilling for oil and gas. As I have noted in the past, the Iron Law of Electricity will kick in, and that will ring the cash register at RIG. In that event the 5-handle will be a blip as it races toward the 6-handle. Is there a 7-handle out there?
Suppose E&P companies are faced with bidding contests for a badly needed drilling fixture? Suppose countries commandeer drilling fixtures to keep them in a particular location? I am letting my imagination run a little wild here, but as I said we are in uncharted waters. My suppositions are pretty far-fetched, I will admit.
But suppose they aren't? Sometimes long shots win. Two folks recently beat odds of 292,000,000:1 winning the $1.3 bn Powerball lottery. Don't say it can't happen.
Your takeaway
What makes RIG a top pick is the potential for improved EBITDA multiple expansion as day rates increase. Using 30,000 foot math, the company is on track to turn in $1.2-$1.3 bn in EBITDA over the next year and is trading at ~7X that figure. If the average day rate truly hits the $401K/day they list in the FSR, it would correspond to EBITDA in the $2.0 bn area, and drop that multiple toward a 4X. To maintain a 7X shares would need to rerate toward $8.00. EBITDA of $2.5 bn, not out of the question in the next 18 months, would drive a $10-12 share price. Isn't playing with numbers fun?
The analysts (at least one does) see this as a possibility. The 14 professional analysts covering the stock rate it a hold, with range between $4-$8. I am an optimist and think that $8 is reasonable target in the market I see developing.
In the case of my accelerated, "Dislocation" thesis the potential exists for a significant multiple expansion. A 10X would drive a share price in the middle $20s. It's been there before, it could happen again.
I think the stock can be bought for growth sub-$4.00, while acknowledging there is a diminishing opportunity to buy it at those levels in this cycle. If you're an investor with a high risk tolerance, "Smoke 'em if you got 'em," we're burning daylight.
https://seekingalpha.com/article/4554030-transocean-iron-law-of-electricity
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