Offshore Oil Drillers such as Transocean (RIG -2.29%), Seadrill (SDRL), Ensco (VAL), Noble (NEBLQ), and Diamond Offshore (DO) have faced a difficult year, with oil companies pushing back new drilling projects into 2015 and 2016. 

In Transocean's most recent conference call, CEO Steve Newman, Executive Vice President and Chief Financial Officer Esa Ikaheimonen, and Senior VP of Marketing Terry Bonno made several statements regarding the state of the company, as well as the industry, that investors in these companies should be aware of. 

Market conditions aren't improving 

"Since our last call, the ultra-deepwater market outlook is largely unchanged. ... [We're facing] very challenging market conditions. ... While we see a few opportunities on the horizon in the Golden Triangle, India, and Mexico, continuing delays in customer programs and a growing sublet market continue to put pressure on utilization." --Terry Bonno

This is a major concern for Transocean, which is facing a massive number of contract expirations in the years to come. 


Source: Transocean Investor Presentation, Pareto Offshore Energy Conference

As the above image illustrates, through 2016 Transocean has a vast majority of its ultra-deepwater (UDW) drillships coming off contract, which is a far larger percentage of its fleet than its competitors: 

  • 81% of Transocean's drillships coming off contract by the end of 2016
  • 74% of Diamond Offshore's drillships will be off contract 
  • 63% of Noble's drillships
  • 62% for Ensco
  • 38% for Seadrill
Market weakness may last longer than initially thought
"The large influx of uncontracted newbuilds will challenge the less capable units and we are likely to see pricing pressure in the future from the increasing competition." --Terry Bonno
 


Source: Transocean Investor Presentation, Pareto Offshore Drilling Conference

 
In my last article on Transocean, I cited Seadrill's management stating that they are confident that the market for offshore drilling will begin to improve in 2015 and 2016. However, as this graph with data from Feamley offshore indicates, the oversupply of rigs may last longer than many analysts (and offshore drillers) are anticipating -- through 2016. That could have a very detrimental effect on key industry variables, such as backlogs, dayrates, and contract lengths. Already we are seeing contract lengths shrink from last year's five year terms to just three years for newly announced contracts.
 
Transocean's contract backlog is in trouble
"Year-to-date we generated $1.4 billion of contract backlog, including securing contracts for the KG1, Jack Bates, and the Celtic Sea." --Terry Bonno
 
This quote highlights the fact that Transocean is currently running a $2.8 billion contract backlog rate, which, given the difficult market conditions cited above, indicates continued pressure on its shrinking backlog. 
 


Source: Transocean Investor Presentation, Pareto Offshore Drilling Conference

 
For example, the current rate of new contracts replaces just 74% of amount of this year's expiring backlog, and just 47% of next year's figure. In fact, 54% of Transocean's backlog will vanish through the end of 2016, the time period when a combination of new rig oversupply and decreased demand from oil companies is likely to put continued pressure on dayrates and contract lengths. 
 
Given the fact that Transocean currently pays a dividend yielding 7.6%, which costs the company $987 million per year, and that it's modernizing its fleet by building 12 new high specification rigs, the pressure on its backlog and cash flows might put the dividend in jeopardy should market weakness persist past 2016. 
 
The news isn't all bad
"The Deepwater Invictus, the most recent addition to our industry leading fleet of high-spec rigs has commenced its three year contract with BHP Billiton in the Gulf of Mexico at a dayrate of $595,000 a day. The Deepwater Asgard is expected to commence its three year contract at $600,000 per day any day now. As a reminder, five of the remaining seven ultra-deepwater newbuilds under construction are backed by attractive long-term contracts with key customers." --Steve Newman
As this quote shows, though the contract lengths might be shrinking, state of the art drillships can still command premium rates. As long as this holds true offshore drillers such as Ensco and Seadrill may be able to sustain their high dividend payouts of 5.9% and 11.1%, respectively.
 
In addition, certain kinds of rigs are facing less challenging market conditions. For example, according to Terry Bonno, "Utilization and dayrates for premium jackups remain stable due to demand in Angola, Mexico, India and Southeast Asia. We expect demands to remain high through 2014 and anticipate that the uncontracted new builds will be absorbed by the market through 2014."
 
Unfortunately for Transocean, the vast majority of its revenue (51%) comes from UDW drillships, with only 6% coming from high-spec jackups.
 


Source: Transocean Investor Presentation, Pareto Offshore Drilling Conference

 
Another problem for Transocean is that, though high-spec jackup rates are expected to hold up well through the rest of the year, management is only expecting dayrates of $160,000-$200,000/day, with dayrates for its most important segment (UDW rigs) falling to $300,000-$400,000/day.
 
This means that even strength in the premium jackup market may not be able to offset weakness in the company's critical UDW segment, resulting in continued pressure on the backlog, cash flows, and the dividend. 
 
The industry is turning to alternative financing to get through the downturn
"We completed a very successful initial public offering of Transocean Partners (NYSE: RIGP) contributing net proceeds of approximately $420 million to Transocean." --Esa Ikaheimonen 
The spinning off of Transocean Partners, which owns a 51% stake in three UDW rigs with two to five years remaining under contract, represents a form of alternative financing first started by Seadrill, which spun off two MLPs, North Atlantic Drilling (NYSE: NADL) and Seadrill Partners (SDLP). 
 
Noble recently followed suit with the spinoff of Paragon Offshore (NYSE: PGN), which now owns 100% of its (former) standard specification fleet of 42 vessels. 
 
The benefit of this form of financing, especially with MLPs, is that a company such as Transocean can sell its most profitable rigs to them, recouping a large part of their cost, and benefiting through fast growing incentive distribution right fees and distribution income. In this way Transocean can continue to pay down debt while growing cash flows when the market recovers. 
 
Foolish takeaway
Transocean's latest quarterly conference call highlights the cyclical nature of the offshore drilling industry and that this current market weakness may be longer-lived and more severe than initially thought. However, for long-term income investors this is the perfect opportunity to acquire high yielding shares of the industry's best companies, such as Ensco and Seadrill.