Why Investors Should Avoid Transocean, and 2 Better Alternatives

In this overheated stock market (now in its sixth year of a bull run), value investors are struggling to find places to invest new money. Luckily, the energy sector is one that still has many good values to choose from, and right now the offshore drilling space is one of the most undervalued. This is largely because of recent negative press from Barron's magazine (predicting a long-term decline in oil prices of 25%), as well as negative reports from Barclay's (predicting potential share price declines of 40%), Citigroup, and Morgan Stanley. 

The reasons for these concerns? Short-term weakness in offshore drilling day rates for industry leaders such as Transocean (NYSE: RIG  ) . This weakness is a result of two things: a slew of new UDW (ultra-deepwater) rigs being delivered in the next two years and energy companies announcing a pullback on their E&P (exploration and production) budgets over the next few years. 

However, the long-term outlook for the offshore industry is stronger than ever, due to several key factors:

  • Global oil demand is expected to increase by 13%-26% through 2035.
  • Oil prices are expected to gradually increase to $125-$150/barrel during this time.
  • Conventional, land-based oil production is expected to grow by just 1% CAGR through 2030.
  • UDW offshore production is expected to increase by 19% CAGR.
  • Global E&P budgets total $650 billion annually and have grown at 15% CAGR over the last 11 years.
  • By 2020 a total of 165 more UDW rigs will be needed to meet demand than exist now or are scheduled to be built. 
However, just because there is long-term wealth to be made in this industry doesn't mean that investors shouldn't be careful about where they put their money. As I'm about to explain, industry giant Transocean is a far inferior long-term investment to younger, smaller, and UDW pure-plays Pacific Drilling (NYSE: PACD  ) and Ocean Rig UDW Inc (NASDAQ: ORIG  ) .
 
What's wrong with Transocean?
During its latest earnings call management revealed that its turnaround plan was working, albeit slowly (utilization rate up 3% to 78% and cost cutting of 13%), but Transocean is facing a gigantic obstacle in the coming two years. Twenty of its UDW contracts are expiring, and its UDW fleet, at 23-years-old, is the second oldest in the industry. 
Most of Transocean's UDW fleet is 4th generation rigs, while competitors such as Seadrill and Ocean Rig have mainly 6th and 7th generation rigs.
With its contract backlog shrinking by 12% in the last year (from $29.7 billion at beginning of 2013 to $26.1 billion today) management is placing a lot of its faith in a turnaround in a new entity called "Caledonia offshore." This is the company's effort to sell off its older, obsolete rigs, specifically eight North Atlantic harsh environment rigs that are an average of 30 years old. 
After the BP Deepwater Horizon oil spill, these obsolete rigs are likely to fetch very little, and the company has yet to deal with the fact that only 51% of its fleet is contracted through 2015. 
 
Why pure-play UDW is a better choice
The investment thesis for Pacific Drilling and Ocean Rig is simple: growth and dividends.
 
At just 1.9 years old for Pacific Drilling and 3.1 years old for Ocean Rig, they have two of the most advanced UDW fleets in the world. 
This industry-leading technology is why the the company can command fleet average day rates of $563,000 and $575,000 respectively. It's also why they command backlogs of $3.3 billion (for Pacific Drilling, three year backlog growth rate 30% CAGR) and $5 billion (for Ocean Rig, three year backlog growth rate 41%). 
 
The second part of the investment thesis is the fact that both companies have announced plans to become high-yielding income stocks. Pacific Drilling's board is recommending a dividend, beginning Q1 of 2015, representing a 7% yield. 
Meanwhile Ocean Rig just announced its first dividend, representing a 4.2% yield. 
 
With strong growth expected going forward -- Pacific Drilling is guiding for EBITDA growth of 52% CAGR through 2015 -- both companies can be expected to enrich long-term investors, both in terms of income and capital gains. 
 
Foolish takeaway
Transocean may be the largest offshore driller in the world, but its legacy assets of aging, obsolete rigs along with its shrinking backlog and huge number of expiring contracts leaves it massively vulnerable to the coming short-term industry weakness. On the other hand, UDW pure-plays Pacific Drilling and Ocean Rig have the two youngest, most up-to-date, and highly sought after fleets in the industry, and their small size means years of tremendous growth ahead. The fact that these two are planning on (or already have instituted) generous dividends points to management's confidence in their ability to execute on their growth plans and just adds one more reason for income investors to take a look at these two rock stars of the offshore drilling industry. 

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