A Deepwater Dilemma

For the last couple of years, the deepwater drillers have been telling us that a recovery in day rates that would provide meaningful support for their share price, was right around the corner. A recovery that was a couple of quarters away at the most, as they have proclaimed in flashy investor packets as seen here.

I have been a stalwart supporter of an eventual recovery in deepwater exploration that would provide this boost. It just makes sense. A significant portion of the world's oil supplies come from this compartment currently. For example, Rystad estimates that about 20 percent of U.S. daily production is produced from deepwater. Globally this figure rises to about 10 mm BOPD, according to Rystad estimates.

The slide above shows that even with the contributions of the massive Shell- Appomattox and Vicksburg Gulf of Mexico projects, U.S. daily oil production from deepwater will fall.

The ugly truth, however, is that day rates have not moved meaningfully from the low ebbs of 2016. Recent tenders have been disappointing. An example would be Seadrill LP's, (NYSE: SDLP), 1-year, $72 mm contract commitment for the West Polaris, commencing in Q-1, 2020. This works out to $180K/day for a state of the art UDW drillship just out of the shipyard in 2018. This does not inspire confidence in SDLP as an investment.

In a rational market, we would be seeing oil companies scrambling for rigs. Having seen the worst collapse in oil prices on record from mid-2014 to Feb-2016, they have adjusted their project scopes and installation techniques to be profitable on much lower oil prices. Most big operators claim break-evens for their new deepwater projects in the $30 a barrel range, so current pricing is not a deterrent to increased activity. The ocean should be churning with deepwater activity, but it isn't.

This lack of activity and associated weak floating rig day rates, calls into question the long thesis for the deepwater drillers, and in particular, Transocean, (NYSE: RIG). Day rates have not improved and there is no realistic expectation that they will in a reasonable time horizon. Deepwater rig utilization has been in the sub-50 percent range a couple of years now, a recovery from its low ebbs, but not enough to propel an increase in day rates.

It is a supply vs demand conundrum. There are simply too many quality rigs, chasing too little work, and any expectation that will change is delusional at this point.

What is the problem?

It is rare that we get a look at forward-looking analyses that don't come from one of the deepwater drillers themselves. Wood Mackenzie is a well-known energy consulting and analytical firm that recently held a Webinar on the coming deepwater business cycle. The following slides are taken from that exercise.

The first problem we can see in the slide above, is that although contracting is on the rise from the depths of 2015/16, the 2019 project size has been scaled down by more than 50 percent in dollar terms. A significant portion of those dollars are coming out of Transocean's and the other deepwater driller's pockets.

There are about 126 deepwater rigs actively working currently. Or about 40 percent of rigs currently available for work, have it. WoodMac forecasts about 57 rig retirements over the next three years. That will bring us into 2023 with a deepwater fleet of ~210 or so rigs when you add in the high 23 spec new builds that are coming. WoodMac forecasts single-digit percentage increases in rig utilization over this time period, so we are unlikely to see a market tightening that would propel day rates higher.

The graph on the left side of this slide reinforces the excess supply point. Extending this out to 2023 shows that under the best scenario utilization will not exceed the middle sixties percentile. Sub-60 percent utilization will not bring any relief to the deepwater drillers.

The graph to the right is a sobering view of the day rate forecast for various caliber rigs. The bulk of the fleet, midwater (water depths 1,500-4,500') will not see day rates above $200K (ever again likely), but not before 2023 at the earliest. Transocean's fleet is heavily weighted toward the Ultra-Deep Water (UDW- 8-12,000') sector, with 31 of its floaters bearing that designation.

If you follow the light blue line on that graph you see that day rates of only ~$350K per day are forecast by 2023. There are some exceptions to that. Chevron, (CVX) has contracted RIG to build a new drillship, the Deepwater Titan, for delivery in 2021.

As technically exciting to me as an "old oil dawg" as this modern drilling marvel is, as an investor, I cringe. Transocean is going to incur nearly a billion dollars' worth of capex to build this rig, before it ever sees a nickel in rent.

The news of this contract, worth as much as $830 mm over 5-years was pretty eye catching when it broke. The day rate for this deal works out to ~$455K per day. But, as always the devil is in the details. A requirement for this rig is a 20K BOP-Blow-Out Preventer, and one that adds about $120K/day to the base rental rate. If you compare it to the best rates they are getting for harsh environment rigs with 15K BOP's, this day rate is pretty run-of-the-mill.

What's worse, is that CVX has the right to cancel this contract up until April, of 2020, compensating RIG only for the cost (so far undisclosed) of the 20K BOP. I will take a guess that the BOP costs (there will be two of them), and other items in the rigs pressure containment systems, will run about $80-100 mm each. If I'm close here, then RIG will have about $900 mm tied up in a vessel without a contract. Now, in my view, there is no way CVX cancels this deal. They have several deepwater developments in various FID stages that will require a vessel with the Titan's capabilities. But, still the "right to cancel" is in the contract.

What this brings us to is, that even on this state of the art new build, RIG is unable to secure a contract that is reflective of the value of the rig to the operation. CVX has been waiting for technology like this to arrive so that they can develop prospects like Anchor. These wells cannot be drilled without the technology that the Titan brings.

If the Titan, can only bring a paltry $350K day contract, what does that say about the prospects for the rest of their fleet?

Exactly.

Debt

All of the deepwater drillers have considerable debt leftover from the last rig building craze. RIG has about $10 billion in long term debt currently. As they are not generating free cash, when these maturities hit, they will have to raise capital-issue new stock, reschedule the debt at potentially much higher rates, or..."restructure." Restructuring is code for filing a Chapter 11 bankruptcy. It allows companies to negotiate with lenders and creditors to reduce payments to a level it can afford. It also generally wipes out the capitalization of the company, reducing stock prices to zero.

So, here is the hump, some $2.5 billion they have to cough up by Jan, 2024. This seems like a long way off, but it's not. It is 3.5 years away, at a time they will not be generating the cash to cover these payments.

There are analogues for companies with too much debt. One that comes to mind is Weatherford, (NYSE: WFT), which filed Chapter 11, July the 2nd. With falling revenues, and no profits since 2014 rescheduling their $7.6 billion in debt became too high of a hill to climb. Creditors will take an 80 percent "haircut" on their bonds in exchange for 99 percent of the emerged company.

Chapter 11 is good for the company. It gets to reform and continue business without the impossible overhang of previous indebtedness. It's good for the employees, they get to keep their jobs. Sadly, the common stockholders are left holding the bag, and see their wealth disappear into the ether.

Your takeaway

The picture for deepwater drillers, and Transocean in particular, is grim. I do not see the current price as a buying opportunity. That said, I would not panic-sell to preserve capital. There will be some ups and downs along the way, and my recommendation is to be looking for an exit point above $6.00 share.

I am sorry to be the bearer of bad news if you are a "deepwater true-believer," but there comes a time to take your lumps and move on.

In my view, that time has come for the deepwater drillers, including the strongest of them with the most modern fleet, the biggest backlog, and the most rigs in the UDW sector-Transocean. In my view RIG and several others are headed for a cliff, I don't plan to be onboard the day they do.