Earnings of Transocean LTD (NYSE:RIG) may hurt in the short-term due to the ongoing over-supply of rigs. Slowing rig demand will continue for all of 2014.
Transocean is the world's largest offshore drilling contractor, with leading market shares in the deepwater and harsh environment drilling segments. The company owns and operates a fleet of high-specification floaters (composed of ultra-deepwater, deepwater, and harsh environment semisubmersibles and drillships), midwater floaters, and high-specification jackups.
Transocean operates in the midst of near to intermediate term weak outlook for the offshore drilling markets (midwater, deepwater and ultra-deepwater). The rig demand has slowed and that a number of rigs could see lower utilization levels as well as lower dayrates.
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The company has the most exposure to contract renewals in 2014, a risk to earnings. Approximately 42 percent (23 rigs) of Transocean fleet is up for contract renewal in 2014.
UBS analyst Angie Sedita believes a number of these rigs will experience lower dayrates and likely some idle periods between contracts. Several of the midwater and deepwater rigs could become idle and remain idle for an extended period.
Surprisingly, Transocean has announced the construction of two new ultra-deepwater rigs at the Sembcorp's Marine's Jurong shipyard in Singapore. The two drillships are expected to be delivered from the shipyard in the second quarter of 2017 and the first quarter of 2018, respectively, and will cost approximately $620 million each.
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Additionally, RIG has options to build three additional drillships with similar designs on similar payment terms. Transocean has historically been unwilling to build on speculation; thus, the announcement of two rigs and three options is a radical change from the past.
Sedita said the company can contract the rigs at economically viable dayrates; however, additional rigs into an already over-supplied market will be challenging.
Meanwhile, Transocean chose an unlikely shipyard in Jurong, Singapore. The majority of the drillships this cycle have been ordered from the well-established Korean shipyards. Traditionally, the Singapore yards have been most known for their jackup construction, and a few semisubmersibles, not drillships.
RIG noted that Jurong is building its second or third drillship today; however, after touring the yard the company felt comfortable that Jurong could deliver. The factor driving the decision may be the total price and the appealing financing terms of 5 percent down and 95 percent upon delivery.
Given the prototype design the delivery schedule for the prototype is longer than seen from the Korean yards. Sedita believes this is a risk to Transocean to build a newly designed rig from a yard with limited experience.
Meanwhile, offshore markets may take a "pause" near-term with rates and utilization under pressure. There have been a number of indications of slowing contract demand in the market. Transocean discussed yet another example with its disappearing contract opportunities for four high caliber rigs.
The company announced that it had Letter of Intent's (LOI) for four deepwater rigs to work in West Africa and the U.S. Gulf of Mexico that disappeared or ultimately canceled due to the operators postponing drilling programs to 2015. These rigs included the Sedco Energy (currently idle), and the Development Driller I and II (both available in Feb-14). The slowed E&P spending levels is the primary driver.
The economics of the wells are highly viable; however, E&P spending levels have slowed and major projects postponed. The question is when it will return.
Sedita said the industry has moved beyond a market in equilibrium to market of over-supply in UDW for the next 12, potentially 18 months. The industry is now expected to deliver 28 new-build UDW floaters in 2014, of which 12 remain un-contracted. At about this time last year, the industry was delivering 22 rigs of which 6 were un-contracted, and each rig was under advanced negotiations for a contract.
It will be difficult for all of these rigs to find contracts, and some may have to take short-term versus term work. Additionally, some of the smaller contractors could panic and take a less than market rate to employ the rig, thereby lowering the bar for future contract renewals across the industry.
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In addition, a number of floaters which are up for renewal in 2014 will experience idle time and lower dayrates. On top of the 28 rigs to be delivered in 2014, there are nearly 60 floaters up for contract renewal.
As such, midwater and deepwater rates likely to fall more meaningfully, and expect more idling of older rigs. As dayrates for new-build UDW rigs begin to fall, this will have a downward effect on all rigs of lower capabilities (midwater and deepwater).
Sedita noted that once the market reaches over-supply, the decline in dayrates for the lower capability rigs tend to be magnified as drilling contractors cut rates sharply to keep rigs employed. For a drilling contractor reducing a rate by 20-30 percent will often be preferable to idling the rig. Any margin is better than no margin.
In addition, given slowing E&P budgets, a number of the lower specification floaters which had been working steadily over the past five years will become idle either indefinitely or for extended periods between shorter term contracts.
As a result, new offshore rig construction must end (or at least meaningfully slow), until the existing rigs under construction absorbed, and demand to rebuild before the market will right-size itself. As of now, the trend doesn't bode well for Transocean, at least in the near-term.
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