Transocean's (NYSE:RIG) most recent earnings did little to give hope to investors of offshore drillers, which have seen shares prices plunge all year in the face of rapidly declining oil prices. 

RIG Chart

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This article will examine five key quotes from Transocean's latest earnings conference call to highlight five vital facts that all investors in the company, and in offshore drilling in general, need to know. All quotes are from Transocean President and CEO Steven Newman.

Industry weakness is getting worse

The market pause we began discussing with you more than a year ago has evolved into a cyclical downturn. Although our customers take a decidedly long-term view in making investment decisions, the approximately 27% decline in oil prices observed over the last three months is likely to increase their challenge to improve short-term returns to their shareholders.

Currently, 21% of offshore rigs are without contracts, with another 68 rigs set for delivery in 2015. The combination of oil companies pulling back on capital expenditures, a short-term glut of new rigs, and plunging oil prices is likely to result in dayrates continuing to decline over the next few quarters. Seadrill CEO Rune Magnus Lundetrae recently told analysts at an industry conference that "The market is going to be bad this year; it is going to be worse next year. Then it will be stabilizing." 

Oil's recent plunge is likely short term

As you know, the most effective cure for a low oil price is a low oil price, and we maintain that our customers' obligation to replace reserves and grow production will inevitably drive a return to drilling. It is in this context that our long-term bullish view of offshore drilling remains intact, underpinned by our fundamental belief in the long-term growth of energy demand and the key role that offshore hydrocarbons will play in meeting that demand.

Already there are signs that oil's recent slide might be about to end, even as Brent crude hit $79 on news that Japan, the world's fourth-largest oil importer, is officially in a recession.Iran and Kuwait are openly discussing advocating for more aggressive action to be taken during OPEC's Nov. 27 meeting, potentially including production cuts that might stabilize and raise prices.

Given OPEC members' dependence on oil exports for revenue, the cartel will likely have to act sooner rather than later. For example, according to the International Monetary Fund, Saudi Arabia, which derives 80% of its government's funding from oil, requires a price of $91 per barrel to remain solvent. 

Older rigs are causing utilization rates to decline

While we made very good progress in our operating performance during the first half of the year with 95.4% revenue efficiency, the third quarter was disappointing at 92.6%. The challenges we experienced during July and August were associated primarily with the drawworks incident on the Deepwater Nautilus and well-control and station-keeping incidence on other rigs.

Revenue efficiency measures what proportion of a contract's potential revenue is actually obtained. Older rigs require more maintenance and break more often, resulting in lower revenue efficiency. Transocean's management is confident that its plan to modernize the fleet will result in this important metric rising over time.

Older rigs will be retired at increasingly faster rates

With respect to our noncore floater fleet, we intend to scrap certain cold stacked rigs, recognizing their limited potential to reenter the market. The company will continue to assess the competitiveness of noncore assets on a case-by-case basis, and we are likely to retire additional rigs. 

Much of Transocean's $2.79 billion impairment charge this quarter was the result of writing down the value of aging rigs. Not only do such rigs require more maintenance and thus hurt revenue efficiency, but they typically see lower demand that results in plunging dayrates, decreasing fleet utilization rates, and weaker operating cash flows.

Floater Utilization Rates
Source: Pacific Drilling May 2014 investor presentation.

Udw Rig Ages

Source: Seadrill 42nd Annual Howard Weil Energy Conference presentation

Investors in older drillers such as Transocean, Noble, and Diamond Offshore should expect more rig retirements and possibly more impairment charges in the coming quarters. While this could result in lots of short-term pain when it comes to declining cash flow and negative earnings, in the long term it will strengthen these companies and make them better long-term investments. Which brings me to my final fact.

Transocean's balance sheet strong enough to weather the storm

The strength of our balance sheet reflected in our investment grade credit rating will enable us to act on opportunities which typically materialize in industry downturns. We will also continue to pursue our asset strategy, recognizing that high-spec floaters and premium jackups are much more resilient in stress markets.

In a capital-intensive industry such as offshore oil drilling, and especially during an industry downturn, owning shares in a company with enough cash and operating cash flow to cover its debts is vital. 

Company Cash ($Billion) Debt ($Billion) Operating Cash Flow ($Billion) Liquidity Ratio
Transocean 2.87 10.36 2.43 1.8
Seadrill 1.48 13.58 1.90 0.78
Ensco 1.22 5.96 2.07 2.68
Noble 0.068 4.74 1.93 1.57
Diamond Offshore 1.07 2.24 0.89 2.03
Industry Average       1.6

Source: Yahoo Finance

Company Interest Expense as % of EBITDA Interest Expense as % of Operating Cash Flow Interest+Dividend as % of EBITDA Interest+Dividend as % of Cash Flow
Transocean 13.12% 20.52% 40.36% 63.11%
Seadrill 8.71% 11.09% 88.55% 112.78%
Ensco 9.29% 11.26% 37.53% 45.51%
Noble 4.73% 5.61% 21.19% 25.14%
Diamond Offshore 5.23% 6.58% 11.30% 14.22%

Sources: Morningstar.com, Yahoo! Finance, company 10-Ks, 10-Qs, author calculations.

As these tables show, nearly all of these companies (with the exception of Seadrill) have no problem covering short-term expenses with their current cash flows and earnings. In fact, the liquidity ratio, (aka current ratio) for the industry as a whole should give long-term investors confidence in these companies' abilities to survive this cyclical downturn and to preserve their generous dividends. 

Seadrill is the one exception owing to its industry-leading dividend expense, which currently consumes 102% of its operational cash flow. The market is increasingly concerned that this payout, which now has a 19.2% yield, is unsustainable and unhealthy for the company.

Takeaway: Drillers will survive, but more pain is on the way

Investors in Transocean or its competitors need not fear an imminent dividend cut, but the worst does not appear over yet for the industry. The longer the cyclical downturn continues, the greater the probability that at least some of these companies will cut their dividends in the face of continued pressure on dayrates, earnings, and cash flows. At current valuations, offshore drillers like Transocean and Seadrill represent attractive, but increasingly speculative, income investments -- at least in the short-to-medium term. 

 

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.