Investors Are Betting Big Against Transocean Ltd -- Are They Right?

Image source: Getty Images. 

Transocean's (RIG -3.89%) stock price has done nothing but sink for the past few years. It's down nearly 40% over the past year and is now a stunning 94% off its all-time high. Despite this deep plunge, short-sellers believe the stock still has further to fall.

In fact, according to the most recent data, short-sellers sold a whopping 97.7 million shares of Transocean's stock short. That's 30.1% of its public float, making it one of the most heavily shorted stocks in the offshore drilling sector:

Data source: Yahoo! Finance. 

Further, shorts have been increasing their position against the company, with traders selling another 3.3 million shares short in recent weeks, boosting the bet by 3.5%. Given Transocean's troubles and the outlook for the offshore drilling sector, this is a gamble that could continue to pay off.

The sinking fleet

Transocean's problems started well before oil prices collapsed. In late 2013, the company reported that demand for offshore drilling rigs by oil companies was weaker than expected. Because of that, a third of its rigs were looking for work in 2014. Conditions only grew worse when oil prices began collapsing in mid-2014, causing rig demand to continue falling. 

As a result, the company needed to retire 28 of its older rigs, bringing its fleet down to 58. While it has another 10 rigs under construction, most of those will replace older rigs given that the company plans to retire another six to 12 rigs by 2020. Because Transocean's fleet is contracting instead of expanding, the company will continue to see its financial results sink. 

A sea of rigs looking for work

Despite the rig retirements from Transocean and others, there's still not enough work to go around. That's because oil prices are so low that producers are not incentivized to boost investments in offshore drilling. Most are instead cutting spending, which is leading them to cancel contracts or seek new terms. For example, India's Reliance Industries recently canceled a contract with Transocean five years early. Meanwhile, Diamond Offshore is one of the many contractors using blend-and-extend contracts, with it extending the contract on its Ocean Courage, for example, by 875 days while at the same time agreeing to reduce the day rate from $455,000 to $380,000 per day.

Unfortunately, this situation is not expected to get better anytime soon. According to analysts at RBC, the rig "supply overhang will take years to overcome." That's why RBC said: 

Drillers will need to continue the current pace of rig retirements and retire an additional ~110 rigs by 2020 to balance the market, in our view. The floater market still needs rig retirements to balance supply/demand. We would expect to see an additional ~70 over the next four years, bringing the total since the peak to >120. The jackup supply picture is equally challenging. With ~120 newbuild jackups still in the pipeline, we estimate that the jackup market will need ~40 additional retirements over the next four years to reach mid-cycle equilibrium by 2020.

The view that the market will not rebalance until 2020 is forcing rig contractors to take what they can get for new contracts. Atwood Oceanics, for example, recently announced a new contract for its Osprey rig at $190,000 per day starting in 2018 and going through 2019. That rate was well below the $450,000 it's earning under its current contract. Meanwhile, Transocean recently won a new contract for a currently idled rig. The 15-month contract does not start until the third quarter of next year and is for $260,000 per day, which is about $200,000 less per day than similar rigs in its fleet currently fetch.

Given the glut of rigs and falling dayrates, analysts expect offshore earnings to decline over the next few years. That is why RBC recently cut its price target on Transocean from $14 to $11, while also slashing the price targets of rivals Diamond Offshore Drilling, Atwood Oceanics, Rowan, and Noble.

Investor takeaway

The offshore drilling sector appears to be several years away from returning to normal. Because of this, there very well could be more downside on the horizon for Transocean. That is why shorts continue to bet against the company as they seek to profit from its decline while the industry sorts through the current mess.