How Much Lower Can Transocean Go?

Offshore drillers have been one of the market's worst performing sectors during the first three months of this year, significantly underperforming the market, even after the inclusion of dividends. Seadrill (SDRL +0.00%) for example is down 16.4% year to date, Diamond Offshore (DO +0.00%) is down 18.2%, and Transocean (RIG +2.11%) has slumped 18.6%; the S&P 500 gained 1.3% over the same period.

Sadly, it would appear as if the market is not yet done punishing these companies. According to Finviz.com 9.3% of Transocean's shares are sold short, 11% of Diamond's shares are on loan for shorting and Seadrill has 4% of its shares out on loan, which according to the Financial Times, is the highest short interest for the company at any point during the last three years.

But are the shorts right? With Transocean and Diamond both pushing multi-year lows, how much further can the share prices of these drillers drop?

Deteriorating environment
The biggest concern for offshore drillers over the next year will be the excess capacity currently plaguing the market. Indeed, with international oil and gas majors cutting back their exploration spending, the industry is likely to become a more competitive environment as multiple companies chase after one contract.

Further, it is widely believed by many industry analysts, that the offshore drilling industry is about to enter a cyclical downturn At present analysts are currently predicting that the day rates for ultra-deepwater, or UDW, drilling units will drop by around 16%, to an average of $475,000 per day over the next few years, as a result of a 12 to 18 month industry slowdown.

Of more concern however is the fact that according to Riglogix, the average offshore driller has only contracted out 63% of available deepwater rigs for 2015, leaving many companies struggling to find customers in a slack market. Diamond in particular only has 50% of its older, refurbished rigs contracted out for 2015, although Seadrill, with its younger, more diversified fleet, is in a stronger position with 70% of available capacity contracted.

Here come the downgrades
Unfortunately, with analysts taking a negative view on the offshore drilling sector, these drillers have been hit with a slew of earnings downgrades. This means that all three companies, Diamond, Seadrill, and Transocean, look to be priced about right considering their declining earnings. What's more, there is also the possibility that the fortunes of these drillers could deteriorate further throughout the next year or two , leading to yet more downgrades.

Source: 4-traders.com. Figures in $US.

How much further can Transocean fall?
So, with earnings set to fall for Transocean during the next few years, the company's outlook is not good, but how much further can the company's shares fall? Well realistically, Transocean's and Diamond's shares could fall much further as trends in the rig market play out. In particular, according to analysts at Credit Suisse:

"With 9 floaters currently idle, ([Transocean] 5, [Diamond Offshore] 3, and [Ensco] 1), another 18 rigs [will] rolling off contract through Q2, and another 13 floaters rolling off contract in Q3 we see the potential for multiple floaters to be stacked [taken out of service] (we expect 10-15 over the next two years).

The cost of ... stacking a rig drops the daily OPEX [operating cost] ... However, the decision to cold stack is a long-term decision – recrewing a rig is challenging and reactivating costs can be in the $50-100M+ range."

So, it would appear that during the next few years, Transocean's earnings power is going fall as the company has to take rigs out of service to cut operating costs. With cost to restart these rigs being in the region of $50 million to $100 million, it could work out easier for the company to scrap rather than restart rigs. Indeed, the average age of Transocean's fleet is two decades, and the company is unlikely to find any buyers for its older stacked units. Not only will this erode earnings power, but scrapping units will depress Transocean's book value per share, a key metric used to assess the company's underlying value.

Foolish summary
All in all, it would appear that unfortunately, Transocean's share price can drop much further as the offshore drilling market enters what analysts predict to be a two-year slowdown. Unfortunately, this slowdown is likely to result in a number of Transocean's rigs being taken out of service, never to return, and the company could see further earnings downgrades.