Why Transocean $RIG is better than Valaris $VAL or Noble $NE.
Just kidding, there is money enough for everyone all around. Why can’t we be friends?
Transocean, RIG, is the market leader and technology leader in offshore oil and gas services. Just think of the Deepwater Horizon in the Gulf of Mexico, or better yet, don’t think about the Deepwater Horizon. You can find a recap on the offshore thesis at the end of this post.
Usually there is a tradeoff between the market leader, who likely will fetch a higher multiple as generalists enter the space at the top of the cycle and only want to buy the best name, or the laggard who has the most torque to a thesis but may never fetch the same high multiple. In this rare case, the market leader has the most financial leverage and operating leverage and is trading at a discount to its smaller competitors.
RIG has the most financial leverage because almost all of their competitors went through bankruptcy during the oil bear market starting in 2014. Most of their competitors have squeaky clean balance sheets, RIG does not. But that also means that a bankruptcy judge didn’t force them to scrap their idle equipment.
This discount compared to their competitors is not due to management quality, in my humble opinion. Transocean’s management deserves nothing but praise for surviving the oil price downturn from 2014 without zeroing out their shareholders. They have consistently been disciplined in every action that I have been competent enough to measure.
Those that prefer Valaris or Noble do so because they are already profitable at current day rates and are engaging in share buybacks. Transocean will need a few years to work on its balance sheet before they can return capital to shareholders. RIG is already cash flow positive, with a lot of equipment to depreciate, but of course, cashflow is not profits. At this valuation, however, I would even be happy if I was just paid cashflow in dividends.
Valaris in particular has been prioritizing full equipment utilization over trying to hold out for higher rates. Transocean has been trying to hold the line on higher rates, but this has given RIG more whitespace than Valaris. Which approach is better? Normally I would say Valaris’, however, Transocean with 28 out of 70, give or take, ultra deepwater drillships might be big enough to move the market in their favor. I’m not sure which approach is best.
Transocean has a better fleet by quality than their competitors, without getting too into the weeds, they have more modern ultra deepwater drillships, and they have harsh environment drillships. Harsh environment semi submersible drillships can operate around Norway, Northern Canada, and the new discoveries off the coast of Namibia, and while all drillships are in short supply, experts in the offshore space predict that harsh environment ships are in even shorter supply. Transocean has 6 out of 11, give or take, Norway-capable harsh-environment semisubmersibles. Another 4 out of 11 belong to Odfjell, the only other company in the space to avoid bankruptcy. Valaris and Noble have none, so ship for ship, RIG is likely to fetch higher day rates for their equipment than their two largest competitors. I am a generalist so if you want to know more, check out Tommy Deepwater.
Transocean also has six cold-stacked rigs that can be reactivated and brought online in a world where very little new equipment can be obtained. There may be one or two orphaned, uncompleted drill ships in a shipyard somewhere in Asia. But other than that, Transocean’s six cold-stacked rigs is the majority of new equipment supply that could come online before 2030. And 2030 isn’t an exaggeration for the soonest that we could see any new drillships delivered. For that to happen, day rates would have to rise high enough for an operator to pony up a 40% or more down payment on a $1.2 billion or more ship so that a shipyard could finish the ship they are working on currently and then start to build a new drillship to be delivered two and a half to three years later.
An analyst that I highly respect who has announced his Valaris position has speculated that the cold-stacked ships are rusted out and will never be brought back online. I have to chalk this opinion up to commitment bias. Transocean management believes that they can reactivate a maximum of two cold-stacked ships per year, but that they will not reactivate out of pocket, the reactivation cost has to be able to come from the ship’s first contract. This would require a relatively long multi-year contract at a pretty high day rate.
Day rates have just broken the $500,000 per day threshold, and on previous conference calls, RIG’s management mentioned that contract negotiations are underway for longer term contracts. In a period of rising prices, operators want to lock in current prices for longer terms. Those longer contracts take significantly longer to negotiate as the oil majors need to work the contracts through their bureaucracy. This process has been ongoing, again according to Transocean’s management’s claims on conference calls, for the last six months or so. It is healthy to be extremely skeptical of management claims, but I am inclined to give RIG’s management team a bit of leeway here, as they have been extremely conservative in the past.
I am a deep value junkie, when I first bought Transocean, it was at $2.36 a share, and it was around 5% of replacement cost. Today it still trades somewhere around 10% of replacement cost. At prices that low, the only real question is are they obsolete, or is that equipment going to be rented out and fetch a market clearing rent. I would happily add more to my Transocean position if it were not already 13% of my portfolio. At that concentration, as much as I want to, I can’t buy any more, but I would still be a buyer here otherwise.
In the last cycle, RIG’s stock hit 2x tangible book value. If that were to happen again, it would be a $25 stock. If that process takes three years and there is a little debt paydown, that would be a $35 stock. Book value is probably less useful with inflation roaring, and I am not sure if the multiples from the last cycle will hold again as ESG seems to be putting a serious lid on the multiples that any fossil fuel stock can achieve. However, ESG is also making new investment in the space more difficult, so if that delays the new building of drillships by as little as two years, the day rates and the cash flow from these ships should make a sailor blush. Either way, at prices this unbelievably low, predictions just have to be directionally mostly right, which brings me to the recap on the offshore oil thesis.
Quick recap on the thesis:
Oil is not going away anytime within the next 30 years.
Shale oil is light, but a certain amount of heavy oil is useful for making diesel.
The only places to bring a new supply of heavy oil online is through offshore drilling or Canadian tar sands, and Trudeau has his boot on Canada’s oil development and Biden nixed the keystone pipeline.
The marginal cost for a new barrel of shale oil by some estimates is $65 a barrel, offshore oil has become more efficient and the marginal barrel of oil offshore is around $45.
Shale oil is becoming more gassy as longer lateral drilling increases the natural gas yield more than the oil yield.
Mergers and Acquisitions in the shale patch result in decreased output as the supermajors prefer a longer inventory life over barrels per day.
Environmental policy prohibiting flaring is going to add costs to shale oil.
Shale drillers worked through their oiliest inventory first and are left with gassier rock formations.
Low oil prices since 2014 has prevented the exploration and capex necessary to prove and develop new reserves.
ESG policy is starving the oil and gas industry of capital, so operators are reluctant to spend on proving and developing new reserves.
Operators have found capital allocation discipline and just do buybacks now.
Consumer demand growth for energy as India grows their economy at 7% per year.
Global commodity supercycle.
Counterargument:
Shale continues to benefit from innovation at a rapid pace such as horseshoe wells, predictive maintenance analytics, and artificial intelligence applications.
Electric pump trucks instead of diesel could reduce the cost of newly fracked wells.
Refiners can spend capex to put in place systems to get more diesel out of light shale oil.
New LNG export facilities are coming online and the price of natural gas in the US could normalize making shale more profitable.
Oil companies have so much cashflow they don’t need external financing to grow supply.
A salient accident such as the Deepwater Horizon could sour sentiment on the sector for years.