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Transocean Ltd. Looks Like a High-Risk, High-Reward Bet on Oil Prices


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For drilling stocks like Transocean Ltd (NYSE: RIG ), the past few years have shown just how risky the sector can be. RIG stock has dropped 72% in the past five years - and 91% in the last ten.

And Transocean isn't alone in struggling. Seadrill Limited (NYSE: SDRL ) filed for bankruptcy last year, and shareholders were nearly (though not totally) wiped out. Peers Noble Corporation PLC (NYSE: NE ), Ensco PLC (NYSE: ESV ), and Diamond Offshore Drilling Inc (NYSE: DO ) are also having a tough time.

It's not hard to see why. Offshore drilling demand has weakened, while industry participants still deal with an oversupply of rigs built years ago. For Transocean, revenue fell by two-thirds between 2014 and 2017. Even with the industry continuing to "cold-stack" or outright retire equipment, utilization rates linger around 50%.

But as crude oil prices have risen, the sector is starting to bounce back. RIG stock, for instance, has gained 81% from August 2017 lows. And it sets up an interesting bull case for RIG - and the industry as a whole. Contract drillers still have a long way to go, and a lot of pitfalls to dodge, but if current trends hold, RIG could be a multi-bagger.

The Oil Price Tailwind

Oil prices obviously are key to demand for Transocean's semi-submersibles and UDW (ultra deepwater) drillships. At sub-$50 Brent crude prices - as seen last year - many offshore drilling projects simply aren't economical. Once rig leases expire, customers like BP plc (ADR) (NYSE: BP ) and Royal Dutch Shell plc (ADR) ADR (NYSE: RDS.A , RDS.B ) move on. And Transocean is left with very expensive assets creating zero revenue ( and accumulating storage costs).

The rise in oil prices hasn't yet had much of an effect on Transocean's operations. First-quarter revenue was down year over year - and the company's net loss widened . 2017 results were weak as well, leading James Brumley to argue on this site that there was simply too much risk in RIG stock.

But taking a long-term view, there's finally some hope for a turnaround in the sector - and for Transocean. Brent crude sits at $77. The Trump Administration is trying to expand drilling offshore. And while that doesn't necessarily mean that RIG revenue will return to the $9 billion-plus reached as recently as 2014 (which would be more than triple current top-line levels), a reversal in demand can have a big impact on RIG stock.

And if demand returns, Transocean should see revenues rise - and profits rise even faster. Overall utilization was just 48% in 2017. It's relatively inexpensive to put rigs back to work and growth in that count could be a huge benefit for Transocean.

Patience Will Be Required

All that said, this is a situation that will require significant patience from investors. Operators aren't rushing toward new projects; it will likely take sustained strength in crude (particularly Brent crude) to materially inflect demand from E&P customers.

Meanwhile, on the supply side, it's true that Transocean has a large number of unutilized rigs. But so do all of its peers. That in turn pressures day rates, as contractors can undercut one another on price. And that problem isn't likely to change until the industry starts retiring, instead of mothballing, more of its rigs.

That process is slowly underway: Transocean itself announced last month that it would retire four rigs . But on both the demand and the supply side, it will take some time for the current multi-year imbalance to correct. Until then, earnings, margins and prices in the industry are likely to remain relatively muted.

Is RIG Stock the Best Play?

For investors who see a multi-year cycle of $70+ crude and increasing offshore development, the drilling sector is an intriguing choice. But there's also the question as to whether RIG is the best play on that thesis.

In the space, RIG looks like one of the best plays. As a recent investor presentation pointed out, the company has by far the largest backlog in the industry. The acquisition of Songa Offshore still has benefits to come in terms of growth and cost-cutting benefits. Its fleet tilts heavily toward more profitable UDW rigs. Bernstein argued this week that Noble Energy was the better choice , but Transocean, at worst, seems to be a close second.

But investors also can make a high-risk bet on oil through domestic services providers like Halliburton Company (NYSE: HAL ). Producers have similar leverage. Those stocks already have gained, and the thesis there probably is a bit more near-term. But upside remains if crude prices hold - and production both domestically and worldwide follows.

Still, RIG and its peers probably have the most upside, even if they require the most time for their bull cases to play out. And RIG stock, in particular, does look attractive - as long as investors understand what they're getting into.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.

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The post Transocean Ltd. Looks Like a High-Risk, High-Reward Bet on Oil Prices appeared first on InvestorPlace .



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.



This article appears in: Investing , Stocks
Referenced Symbols: RIG , NE , DO , SDRL , ESV


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