Transocean at the Top?

Transocean (NYSE: RIG  ) is the largest deepwater drilling company in the world. While not yet revealed in the fourth-quarter results announced yesterday, this is a company that will begin to show tremendous earnings power in the next few years.

Stripping out gains from the sale of equipment and tax benefits, Transocean earned $1.25 per share in the fourth quarter of 2006, compared with $0.45 per share a year earlier. For the full year, earnings were $2.94 per share (again removing the impact of equipment sales and tax benefits), compared with $1.55 from continuing operations for the full year of 2005.

Waiting for the big payday
The 90% earnings increase is rather subdued compared with Transocean's competitors. Last week, Diamond Offshore (NYSE: DO  ) reported an annual earnings per share gain of 171%. In January, Noble (NYSE: NE  ) reported a gain of 147%. GlobalSantaFe (NYSE: GSF  ) has not yet reported, but analysts estimate a gain of 116%.

This information does not suggest that Transocean is doing worse than the other drilling companies, but rather to emphasize a point that fellow Fool Stephen Simpson made last summer. He basically said that Diamond Offshore has signed up for a wild ride by signing shorter-term contracts -- essentially betting that dayrates (the industry term for pricing) will continue to rise.

On the other end of the spectrum, Transocean has more long-term contracts. A big reason for this is because the company increasingly focuses on deepwater drilling, for which drilling programs generally utilize longer-term contracts than in the shallow-water jack-up market. The other three companies have larger percentages of their fortunes tied to the more volatile market for shallow-water jack-up rigs. In 2004, Transocean spun off its Gulf of Mexico jack-up operations in the form of TODCO (NYSE: THE  ) , and it has been selling other rigs in order to focus on their core deepwater drilling business.

Because Transocean has much of its fleet signed up for three- to four-year contracts, many of its rigs operated through 2006 with dayrates established in 2003 or 2004. As an example of how big the difference is, take a look at the dayrate for the deepwater drilling rig Discoverer Enterprise. This rig is capable of drilling in 10,000 feet of water depth, which is the maximum within Transocean's active fleet. In 2004, this rig was signed onto a three-year contract at a dayrate of $191,000. When the current contract expires (December 2007), the new dayrate will become $520,000.

While the Discoverer Enterprise is an extreme example, similar scenarios hold true for several rigs within Transocean's fleet. During the earnings presentation, the company pointed out that contracted dayrates across the fleet will continue to rise at least through the second quarter of 2008 (the furthest point into the future for which the company provided data). The increase for high-specification floating rigs (such as the Discoverer Enterprise), other floating rigs, and Transocean's international jack-ups will be from 30% to 35% for all classes. Assuming Transocean can keep control over rising operating costs, these increased dayrates should result in very strong earnings in the coming years.

How long does the party last?
Drilling is a cyclical business. Some day, oil prices will fall -- perhaps we'll be drowning in ethanol. If oil goes below $30 a barrel, I doubt that companies like BP (NYSE: BP  ) and Chevron (NYSE: CVX  ) will be too excited about signing up for $500,000 dayrates. In the current reality, enthusiasm for deepwater projects continues, and Transocean has a large percentage of its deepwater fleet booked through 2009. Beyond that, Chevron thinks there's sufficient value in deepwater exploration that it has signed contracts with Transocean to build two new rigs. The new rigs will be capable of drilling in 12,000 feet of water depth and 40,000 feet of total drilling depth. The dayrates for these new rigs will be around $450,000 until the year 2015 (if Chevron selects the five-year contract option on the second rig). Could this indicate that Transocean is a stock to hold for a decade? Only time will tell.

Foolish final thoughts
For the patient investor who buys during the inevitable selloffs in this sector, I think Transocean is likely to deliver market-beating returns over the next several years. Current results don't really offer any shocking news, other than we will have to wait about one more year before the true earnings power begins to be revealed. The average analyst estimate is for Transocean to earn $7.49 per share in 2007. With most of its fleet contracted through the year, Transocean should end up somewhere within shouting range of that number. Contracts at very high dayrates are already in place well into the future, suggesting earnings could continue to rise for several more years. In the meantime, Transocean has been buying back shares but does not pay dividends, which has been Diamond Offshore's method of rewarding shareholders. Personally, I prefer the cash, but a declining share count is better than nothing.

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Fool contributor Robert Aronen owns shares of Diamond Offshore, Transocean, and TODCO, but no other company mentioned in this article. He also has them in his Motley Fool CAPS portfolio, where he is desperately trying to catch up to his arch-nemesis TMFBent.


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