What happened
Shares of oil services company Transocean (RIG 2.16%) were plunging today, down 7.8% as of 1:17 p.m. ET.
Transocean's financial results are dependent on sales of offshore drilling rigs, which is dependent on new drilling, which is dependent on oil prices. While oil prices are affected by a variety of factors, today saw rising U.S. bond rates, which tend to strengthen the dollar against other currencies. Since oil is priced in dollars, oil prices were falling today in response.
Additionally, oil traders may be worried about the broader economy ahead of tomorrow's Federal Reserve interest rate decision. A potential recession would also be bad for oil prices.
So what
Today, the 10-year Treasury bond broke out over its previous June highs. In fact, the 10-year hit a yield of 3.6% before retreating slightly on the day, going well above the previous June high of near 3.48%.
Why does this matter for oil prices? Because higher government bond rates in the U.S. versus the rest of the world tends to strengthen the dollar against other currencies. The dollar has appreciated a lot this year, as the U.S. economy has been relatively stronger than that of war-ravaged Europe, as well as the problematic Chinese economy.
Since oil is priced in dollars, a stronger dollar would mean oil is worth fewer dollars, all else being equal. In addition, other investors may be nervous that the Federal Reserve's interest rate hikes could lead to an economic slowdown or even recession, which generally means less oil demand.
Transocean is usually even more volatile than the typical oil stock, which is also quite volatile. That's because unlike most exploration and production (E&P) companies, Transocean is actually still unprofitable, thanks to high interest costs from its otherwise high debt load. As of last quarter, Transocean had about $7.2 billion in debt and little cash.
In fact, Transocean recently exchanged some of its existing high-yield debt for exchangeable bonds that both yield 4.25% and come with warrants that will dilute shareholders further. While Transocean did announce it would retire some higher-yielding secured debt with the proceeds, the exchange seems to indicate the company won't be profitable enough to make a dent in its debt load anytime soon.
Now what
Given Transocean's high debt load and the fact that it not only needs higher oil prices, but also the industry to invest in growth, it's a risky name to own, especially compared with explorers and producers.
If oil prices continue to go down, E&P companies will likely hold off on large capital expenditures in order to protect their dividends and shareholders returns. The new post-pandemic paradigm has been one of industry discipline, which is leading to a bifurcated oil sector. For drillers, it's great news, as it seems large consolidated producers are controlling supply and minting high profits.
However, more disciplined supply growth is bad news for service and rig companies like Transocean. That's why many big oil producers have been able to pay down their debt over the past year, while oil field service companies have continued to face difficult times.
If we see another supply shock and an oil price rally, it's possible the more beaten-down service stocks like Transocean will rally harder than the explorers. However, given the vast differences in risk, that risk doesn't seem worth taking relative to the solid dividend-paying producer stocks.
