Last Friday, offshore contract oil and gas driller Transocean Ltd (RIG) announced that in its September quarter earnings statement it would be taking an impairment charge of close to $2.7 billion, or more than a quarter of the stock’s market capitalization. The reason: deterioration of its business prospects caused by the recent sharp decline in the world oil price.
Despite this bad news, the stock closed down less than a percent on the day …a trading session in which the S&P 500 ended basically unchanged.
Why the muted reaction?
Offshore contract drilling is a very capital-intensive business. It can easily cost over half a billion dollars to build a state-of-the-art semi-submersible rig. Contract drillers rent their rigs out under long-term contract to oil exploration and development companies at rates of tens of millions of dollars a year.
In good times, meaning when the oil price is rising, rental rates go up as well. Contract drillers tend to sink all their cash flow (often plus all they can borrow) into building new rigs. This, of course, keeps both financial and operating their leverage high and eventually leads to overcapacity (as is the case in any capital-intensive commodity business).
In bad times, i.e., when the price of oil is falling, demand from the big oil companies wanes and rental rates fall. Worse than that, customers seek to renegotiate down rental rates for rigs already under contract, or simply announce they don’t need the rigs any more and, contract or no, stop paying and return them. Ouch!
The key variable in all this is the oil price. Because of this, the stock market takes the spot price of oil as a leading indicator of the drillers’ future profits and trade on that rather than waiting for reported earnings. Again, this is common in other commodity-like industries, as well.
The message I take from Friday’s price action is that, for the moment at least, the market expects the oil price to stabilize around current levels. Monday’s earnings announcement and conference call by RIG (I’m writing this on Sunday night) will be a further indicator of whether my view is correct.