Jan. 9, 2022
I like to quickly review the article, and then write down some notes for me to work on more in detail.
My notes:
- 85% utilization has been the inflection point for dayrates and we are close to it now. <- what is 85% utilization meaning?
- Facts: dayrates are still low;
- The E&P sector saw outsized returns in 2021 but oilfield services and drilling lagged behind because the higher oil prices didn't spur more capex so far.
- As capex inevitably returns, the future multibagger opportunities will more likely be found in the still beaten down services segment.
- Rig utilization has steadily risen with fleet attrition but dayrates are still low; historically, 85% utilization has been the inflection point for dayrates and we are close to it now.
- When we reach the inflection point, the dayrate change will be quick and could surprise many; Transocean is very levered compared to its peers, so its equity value will rise relatively more when this happens.
- This is a high risk, high reward opportunity; bankruptcy is not fully out of the picture yet.
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:
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:
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.
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.
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).
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.
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.
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.
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