Description

Transocean (RIG) is the world's largest provider of offshore drilling services. The company owns a fleet of drilling rigs which it contracts out for exploration and production activity.

Summary thesis

Transocean's ability to deliver strong operating results depends heavily on the ability of deepwater rigs to command day rates similar to those prevailing over the past few years. The market seems to think that this is unlikely, but we believe that the opposite is true.

Rates for deepwater rigs will hold up better than the market expects because supply and demand will remain tight for the foreseeable future. Four key points underlie our faith in demand. First, the recent rise, fall, and recovery in oil price did not have a material negative impact on the capital expenditures funding deepwater projects. Second, daily rig rate pricing is better protected than many might think, because of its relatively small size within the cost structure of a deepwater project and the perceptions of procurement planners. Third, the increase in demand for deepwater rigs in recent years was not the result of higher oil prices, but of an ongoing shift in spending towards deepwater due to improved technology and understanding of the deepwater reserve potential. And fourth, this elevated demand is no "pig in the python." Because of the extent and timing of drilling requirements, the current roster of active projects will create growing demand for several years before plateauing for many years beyond.

The supply story is simpler. Supply is tight today, and unexpected growth is unlikely. At over $500 million, building a deepwater rig is a major expenditure for even the largest of companies, and is especially difficult in today's financing environment. Furthermore, building a rig takes three to five years. In short, incremental supply is unlikely to arise without specific incremental demand, and even in that case, would only materialize beyond a five year horizon. 

Valuation

Buying Transocean is fundamentally a valuation play. There is not a high probability of significant improvement in operating results, but there is a high probability of revaluation when the market starts to believe in deepwater rig rates. As summarized above, there are powerful reasons to suggest that rig rates will remain at or around current levels. However, RIG's valuation implies that the market believes the opposite.

Current valuation is undemanding on operating metrics, on replacement value, and in comparison to other oilfield service companies. P/E is around 5.7x for 2009 and 2010. EV/EBITDA is slightly over 5x for 2009 and 2010. EV stands at 90% of estimated replication cost.

Perhaps most surprising is RIG's valuation in comparison to the diversified oil service companies (SLB, HAL, BHI, WFT, SII). This group trades at an average P/E of over 18x for 2009 and 2010, and at an average EV/EBITDA of over 8x for 2009 and 2010. Meanwhile, the diversifieds' revenues and earnings are at much greater risk over the near to medium term. Pricing for services is more volatile than that for rig contracting. Additionally, even the largest service companies have more exposure than RIG to less creditworthy E&Ps whose spending is volatile.

Furthermore, RIG's relatively high indebtedness (net debt of ~1.5x 2009 EBITDA) creates the possibility of a powerful de-leveraging over the next few years: assuming free cash is used to pay down debt, and based on today's market cap, year end 2011 enterprise value would be only 3.0x EBITDA. While the sheer size of the debt load (~$13 billion) may have deterred the fearful equity investors of recent quarters, the leverage is manageable and will sharpen share price reactions to changing market sentiment.

To value Transocean, we estimate normalized earnings power based on day rates corresponding to what was seen in the 2005-2006 time frame. Applying a low teens earnings multiple, we arrive at an implied share price of ~$110, or ~50% premium to the current price. Should enthusiasm for the industry return (due to notable increase in offshore drilling, further supply constraints, higher oil prices, etc.), it is not hard to see one's way to a $140 share price, which was roughly where the stock traded during the commodity bull market of last summer. For downside protection, we would point to estimates of replacement value, which implies a share price of just under $90.

Deepwater Supply and Demand

Drop in oil price didn't matter, or at least not as much as people might think

In general, economics of deepwater deals have not moved outside the original return parameters as a result of oil price fluctuation. The deepwater market is heavily skewed towards the largest E&P operations: the international supermajors (IOCs), and the national oil companies (NOCs). This group also tends to be the most risk-averse and exhibit the most stable capital spending trends. One of our contacts emphasized Exxon's intransigence in its insistence on achieving breakeven economics at "normalized" oil price levels and strongly hinted that nearly all Exxon projects would work at $40 oil. Even when oil ranged over $100 per barrel, Exxon maintained its conservatism - often to the great frustration of project planners, who noted the possibility of hedging sufficient production to safeguard projects in the event of a fall in oil price (any reliance on hedging was unacceptable to Exxon's management). From the point of view of a supermajor like Exxon, the oil spike might as well have never happened, and the proof is in the numbers: their capex budget continues to grow. Exxon clearly takes conservatism to the extreme; however, our conversations would suggest that the approach of their counterparts is not so different. Of the supermajors, ConocoPhillips appears to have been the only one overly emboldened by the oil price spike. Petrobras, the most important constituent of deepwater demand (operating 22% of 2008 deepwater production), has been increasing its capex budget steadily: they plan to spend nearly $29bn this year vs. $23bn last year. Additionally, Petrobras's 2009 5-year E&P spending plan increased by 61% over the previously released plan. These spending trends would suggest that their reports of deepwater pre-salt projects being economic at under $40/bbl are not just idle talk.   

We did not investigate the capital spending habits of the NOCs as extensively, but logic would suggest that their spending trends should be even further insulated from the vagaries of price movements. Opaque and unaccountable to shareholders, their chief prerogative is generally maximizing production and reserves - return metrics are relatively less important. In an E&P operation where revenue maximization is encouraged at the expense of efficiency, it might be more likely to see a capex increase in the event of a fall in oil price. 

Summary of E&P capital expenditure, 2006-2009E

Rig rates are relatively protected in the broader cost structure of a deepwater project

            Newcomers to the oilfield services industry might be surprised to learn that the revenue to the rig contractor (Transocean, e.g.) represents only about 1/6^th of the total expense of a deepwater drilling project. Within today's typical deepwater project, roughly a third of costs is consumed by drilling. Of that third, roughly half goes to RIG, while the other half goes to the service company (HAL, SLB, BHI etc.) and other equipment providers. The remainder is filled out by subsea infrastructure (1/3^rd) and by the production/storage/offloading apparatus (an "FPSO," for instance) (1/3^rd).

Two common sentiments emerged from our discussions of drilling in the deepwater cost structure: one, initial cost planning is very conservative. Project requirements are always assumed to be contracted at prevailing rates with yearly inflation. Two, rig contracting is perceived to be the most inviolable of the expense buckets, given that it is generally contracted well in advance for a multi-year time horizon. This stands in stark contrast to descriptions of malleable oilfield service fees. When operators ask for price reductions they generally receive them because the oil service majors will compete for market share at the expense of margin.

This difference in pricing power between services and rig contracting demonstrates one of the key reasons for owning Transocean over the diversified service companies. Services are generally interchangeable between the major providers, and in many cases a major provider can be replaced by a smaller local operator, or a consortium of local operators. Deepwater rigs, on the other hand, are rarely replaceable. In most cases there would be only a handful of rigs with specifications appropriate to the project. Not only would the availability of those rigs be unlikely, but there would also be a high probability of those rigs being owned by the same company: RIG alone controls nearly 40% of current floating rigs rated for depths greater than seven thousand feet.   

Perhaps most importantly, procurement officers are not expecting any significant fall in deepwater rig day rates. If buyers are content with current prices, we are unlikely to see much downward pressure.

Rig rates increased due to a shift in capex focus, and this shift did not result from higher oil prices

The most important factor in the re-allocation of capex dollars towards deepwater was the relatively recent realization that deepwater is the only prospect for meaningful reserve replacement. The difficulty of organic reserve replacement has steadily increased due to several factors: consolidation ("law of large numbers"), NOC behavior (less locations to work with), and accelerating depletion ("peak oil" or whatever you want to call it). The challenge of replacement was further highlighted by the Shell reserve reporting scandal in 2004. Industry participants now acknowledge that the only viable option for "needle-moving" discovery and development work is deepwater. As one of our contacts put it, deepwater is to large oil companies what banks were to Willie Sutton: that's where the oil is.

Technology has also been critical in driving the shift towards deepwater. Improvements in technology and a concomitant decline in execution risk significantly reduced the expected costs of deepwater projects. One of the most critical technologies, "dynamic positioning," the ability of a ship/floater to self-regulate its position, wasn't perfected until after 2003. This technology and others improved deepwater economics by lowering and narrowing expected cost ranges.

Elevated demand for deepwater is here to stay: no "pig in the python"

Some might contend that the rapid increase of deepwater activity in the last two to three years was an unusual event stemming from exuberance in the oil industry, and should start to taper off in the near term. Fortunately for the deepwater industry, this is not the case. Capex cycles in the oil and gas industry are long, and for massive projects like deepwater exploration and development, the cycles are even longer. A typical deepwater project lasts at least five to ten years. Demand for drilling days typically increases through at least the first four years of a project before reaching a steady state. Keep in mind that most deepwater projects today are only two years old - Brazil's giant Tupi discovery was only announced in November 2007.

Additionally, unlike other potential sectors, there is a massive inventory of deepwater projects remaining to be exploited. The key limits on expansion of deepwater drilling are rig capacity and manpower - not geological opportunity.    

Further, most of these projects are, in the parlance of our times, "too big to fail." Once a deepwater project is fully underway, sunk costs are so large that it is very difficult to re-allocate capital away from the project without admission of a major miscalculation.

Supply is unlikely to change much over the next few years

            The case for steady and increasing demand has been supported in the preceding paragraphs. Fortunately for the price outlook, supply is also relatively stable.

            Deepwater rig supply moves slowly. From industry conversations, we have learned that if one were to order a deepwater newbuild today, the earliest potential delivery would be in three years' time. However, this timeline would only be achievable if an existing design template were used. More typically, a rig buyer would need to commission additional design work to meet the individual specifications of his targeted client. To build a rig requiring any sort of customization, the wait time would stretch out to five years. The sluggishness of a potential supply response is the critical difference between the market for deepwater rigs and the market for jackups - jackups can be built in less than a year, so the potential for a glut based on near-term optimism is much higher.

            The high price tag of a deepwater rig also constrains supply. Given the financing environment, no one today is willing to put down large sums to build a deepwater rig (at least $500mm) without a guaranteed contract on the other side. In other words, the speculators are out of the market, and they will be for as long as the difficult credit environment persists. In all likelihood, any new rig will only be built to meet specific incremental demand.

Comparing supply to demand: tight and getting tighter

The current supply outlook does not allow for the increase in demand that we anticipate. Taking a broad definition of deepwater, including all rigs rated over 4,000 feet, and using conservative demand growth assumptions, ~12% of rig days are currently available in 2010, and ~30% are currently available in 2011. While this might appear concerning at first glance, remember that the demand side decision makers will not necessarily lock in pricing for all of their expected needs, even if they believe that rig rates will rise. For evidence of this, look back to the availability levels that were seen in March 2007. This was a time when oil price was rising, rig supply was constrained, and rig rates were rising with no signs of slowing down. Yet even then, a much headier time than now, the availability picture looked similar.

Availability of rig days rated greater than 4,000 ft:

*GS/ODS data

These minor changes in availability, when compared to the significant fall in Transocean's valuation multiples, suggest that the oil industry's outlook for rig rate pricing is far more sanguine than those of its investors:

*GS estimates

Because most deepwater projects are still in early stages, we believe it likely that "internal demand" for rigs, i.e., natural demand growth from existing projects underway, will easily take up any slack in supply. Modeling a 15% growth in "internal" demand for the next few years suggests a tight supply/demand situation. We think that our 15% assumption is conservative. To get a sense for the internal growth potential of existing projects, we spoke to various industry experts who said that demand for drilling tends to increase through the early years of a project, and development stage drilling activity can range anywhere from 2-10x exploration and appraisal activity levels. Of course, these sorts of growth rates will only apply to projects relatively early in their lifecycle, so they are not representative of aggregate demand. However, given these historic trajectories, and considering the proliferation of deepwater exploration and appraisal activity over the past couple of years, we think that the market is underestimating the scale of demand that will be generated by the transition of current projects to development stages.        

Beyond internal demand, and as discussed more extensively above, there is also a high likelihood that the number of projects will grow significantly as E&P budgets continue to shift towards deepwater, and as new provinces continue to expand: Brazil, India, Malaysia, Libya, West Africa, to name a few. 

Using the conservative demand estimates described above, and assuming five cancellations/delays, unmet demand for deepwater rigs as a percent of total fleet will remain in the high single digit range for the next four years. However, we think that this "conservative" demand case is less likely than one which would see demand far outstripping supply for the foreseeable future.

According to industry chatter, current tendering processes are demonstrating the supply tightness: supposedly there are four bidders in the hunt for a RIG semi-submersible that is coming available in Q1 2010.

            For more tangible evidence, consider a few of the day rates that have been contracted recently. On 3/19/09, DryShips contracted the Leiv Eriksson out to Petrobras for three years at $540,000 per day. On 6/1/09, Transocean's Dhirubhai Deepwater KG1 was fixed for four years to ONGC at $495,000 per day. These rates are well above the conservative day rates that we used in our "normalized" valuation.

Caveats

What could go wrong?

This investment offers an excellent risk/return profile based on current valuation and the strength of the underlying operations, but disruptive and deleterious exogenous events continue to be real possibilities.

Brazil accounts for a large portion of deepwater drilling demand, probably between 20% and 30%. A crisis in Brazil, or major change in Petrobras's current development plans, could have a material negative impact on industry demand that could result in lower day rates. For now, all indications are positive: appraisal and exploration well results continue to impress, and Petrobras's capex budget continues to grow. It is important not to lose sight of the broader view: offshore Brazil is an opportunity roughly the size of the US Gulf of Mexico and we are still in the earliest stages of its development.  

Government regulation is a perennial concern, and the new US administration has brought those concerns to the forefront. There are fears that another spike in oil prices would greatly heighten the chance of the US government imposing a "windfall" style tax regime that could impair the oil and gas industry.

Of course, the reverse, a significant drop in prices, would also be problematic. Our contacts generally seem to think that a reversal of this capex cycle would require not only a price collapse to the low $30s level, but also a belief in such prices for the longer term. Such a scenario would probably require a severe global depression, and further failure of OPEC to control its members' output.

Another threat is the possibility of a major environmental accident - deepwater drilling has an excellent track record thus far, but a blowout could be a significant boon to opponents of offshore activity.

Disclosure

We and our affiliates are long RIG.  We may buy or sell shares in the future.  This is not a recommendation to buy or sell shares. 

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