Much has been said about Transocean Ltd. (NYSE: R.I.G.) indebtedness and the fact that the backlog of the company does not increase. However, this is already more than factored into the stock price, especially given the considerable short interest in stock. The offshore drilling sector is gradually recovering. The process might not be as quick as many investors would like. But since there is an energy crisis in the world and supply chains can take months or even years to rebuild, oil prices will remain high, which is very positive for RIG’s daily rates.
My colleague Henrik Alex wrote a detailed article on the company’s first quarter results. But in this article, I would like to focus on the long-term industry trends and the macroeconomic factors mentioned in the management presentation.
New and future Transocean contracts
Europe is going through an energy crisis due to the situation around Ukraine. The sanctions imposed have not only limited supplies of natural gas but also oil due to financial restrictions. In this situation, the EU desperately needs to find alternative sources for these products. Equinor (EQNR) is the most obvious choice. A significant part of its operation is located in the North Sea. However, despite this obvious demand, Norway is encountering difficulties regarding the supply of the necessary underwater equipment. But the CEO of Transocean expects the North Sea market to be fully sold out by 2024, which is also a sign of strong demand.
Nowadays, however, great opportunities for RIG have emerged in many areas. The most attractive are West Africa and Brazil. I was particularly pleased to learn that management sees 20 opportunities in West Africa and predicts that a minimum of 15 years of drilling could be awarded. Brazil also seems to be an interesting market – this year 5 platforms have already been booked. With the new tenders that have come out, Transocean management expects 16 additional platforms to be occupied in the remainder of 2022.
The Development Driller III was awarded an 80-day contract with Brazilian Petrobras (PBR) at a daily rate of $331,000. That’s a pretty good rate. But in the Gulf of Mexico, the Deepwater Invictus secured a 2-well extension with BHP Billiton (BHP) at a rate of $375,000 per day. This makes the Gulf of Mexico a particularly attractive opportunity, especially now that shale oil producers are unable to significantly increase their production levels.
However, as I already mentioned in my other article, developing regions seem to be more reliable for Transocean, given their more lenient environmental regulations. However, since we are facing an energy crisis, the governments of the EU and the United States could be in favor of additional oil drilling.
Offshore and onshore drilling
When I first wrote about Transocean, my fellow Seeking Alpha contributors and some readers argued that onshore drilling was more attractive to oil giants than offshore. Admittedly, onshore drilling does not require as much upfront investment and is therefore more flexible. In other words, it is theoretically easy to increase and decrease production. However, I’m sure many investors have been wondering for a while why US shale producers aren’t increasing production. The situation is more than favorable. Most coronavirus restrictions have ended in many countries, there is an energy crisis, and oil is trading at over $100 a barrel. If onshore drilling is so flexible and cheap, why wouldn’t the shale giants dramatically increase their production? This would greatly increase their income, it seems.
The situation is not as simple as it seems. U.S. shale oil producers suffer from a lack of high-quality acreage, poor logistics, a lack of human resources, and a long history of chronic underinvestment in field development. oil. Some constraints include an obvious shortage of drilled but unfinished wells, drilling equipment and even necessary materials. For example, cobalt is in high demand by industry, but due to the situation in Ukraine, there is a lack of cobalt supply, which has an impact on the oil industry. Additionally, during the oil price crash of 2020, many oil workers lost their jobs. Some of them have obviously returned to their place of work, but some have decided to change jobs. This explains why the US oil industry is also facing personnel shortages. Additionally, the ESG agenda has caused many bankers and investment funds to steer clear of oil and gas companies and instead direct their funds towards alternatives”green“Energy companies. This situation can take years to resolve and it appears that the market is undersupplied, which is very bullish for oil prices.
Although many oil companies are more focused on paying dividends to their shareholders and buying back their own shares, it now makes sense for oil majors to invest in new wells wherever they can, including offshore drilling, and not just on the ground. Obviously some onshore oil is cheap to drill. For example, in Saudi Arabia, the break-even cost of extracting this oil is around $10 a barrel. But terrestrial oil is not as profitable to extract.
Offshore breakeven costs, as management mentioned on the call, are in 80% of projects below $60 a barrel and in many cases below $40. Obviously, if oil prices stay near $100 a barrel, companies can make a lot of profit. New offshore wells are also quite economical to drill since they can be used for 30 years, which is clearly not the case with onshore oil. This is why long-term offshore projects can make perfect economic sense if commodity prices remain at current levels.
Many analysts fear that Fed tightening could lead to a recession. It is quite possible and it could be a downside for the oil market. However, in the 1970s there were several recessions and black gold prices were really high.
Please see the chart with historical inflation-adjusted oil prices below. Recession periods are marked in grey.
In fact, high inflation was partly due to high energy prices and prompted the Fed to raise interest rates. This, in turn, led to recessions and stagflation – high unemployment and high inflation. The situation may repeat itself now.
Valuation of shares
In my opinion, RIG’s stock is undervalued. There is significant short interest in the stock. Most marketers ignore it due to the indebtedness of the business. But management proved its competence in 2020 when it restructured its debt without taking its company through bankruptcy proceedings.
A good EV/EBITDA ratio is usually around 10 or less. The average EV/EBITDA ratio of the S&P 500 is generally between 11 and 16. Transocean meets this criterion since its ratio is around 10. If we look at the history of the EV/EBITDA ratio of RIG, we will see that it was sometimes much higher than it is now. This is why Transocean shares are not currently overvalued by this measure.
This reasonable valuation and even undervaluation is also the case with RIG’s price-to-sales (P/S) ratio. After the oil price collapse in 2020, the P/S remained below 0.30. It was extremely low, of course. Now it is significantly higher, close to 1 but well below the 2018 indicator of 2.
So, for the moment, the title is not overvalued.
I fully understand that some analysts consider Transocean to be a high risk stock. But let’s not forget that it is also a high yield security. It is quite undervalued as the offshore recovery begins to take hold. I particularly favor the Gulf of Mexico because of its high daily rates but West Africa and Brazil also seem attractive. The only downside risk is that of a probable recession. But even if that happens, we could find ourselves back in a 1970s situation where oil prices were high despite stagflation. RIG is a definite buy for me.
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