Offshore Drilling Facing Soft Market Conditions

Five-year credit default swaps (CDS) for offshore drilling companies in North America have widened 46% over the past month and 20% over the last week, underperforming other sectors in the region, according to Fitch Solutions.

New York-based rating agency Fitch Ratings said that CDS have likely widened partly in response to the recent Noble Corporation contract for a sixth generation semisubmersible rig valued at $317,000, which is below market day rate expectations.

“This may suggest softer market conditions that could pressure cash flows resulting in weaker than anticipated credit metrics,” Fitch explained.

Geopolitical conflict and supply concerns, as well as consistent global demand growth for crude oil, continue to support high crude prices. Fitch believes that this will continue to be the case in second-half 2014.

However, unlike historical supportive pricing environments, offshore drilling demand has moderated as international oil companies focus on cash flows and shareholder returns, while national oil companies delay drilling programs further depressing market conditions.

Fitch expects medium-term demand to expand, mainly due to declines in existing offshore reserve bases. On the supply side, newbuilds equal to roughly one-third of the working worldwide fleet are scheduled to be delivered through 2018. This will materially increase the supply of offshore rigs and raise the average worldwide fleet quality.

Transocean Inc., Noble Corporation and Diamond Offshore Drilling, Inc. have been at the forefront of widening with respective spreads 51%, 47% and 40% wider over the past month. Transocean CDS widened 31% last week alone to price at the widest levels observed since January 2012. Meanwhile, the cost of credit protection on Diamond Offshore Drilling’s debt is at the highest level since September 2011.

“Since few contracts have been entered into during the currently soft offshore market, spreads may have widened materially as the market recalibrates day rate forecasts to be more conservative in light of the recent Noble Corporation contract,” Fitch said.

Fitch continues to believe day rates for existing, lower specification rigs will remain under pressure in the near term. Further, the rate of absorption could heighten downmarket competition, leading to some lower specification rig displacement and, potentially, stacking and/or attrition.

According to Fitch, offshore drillers with weakening contract coverage and limited financial flexibility will likely experience heightened leverage metrics over the next few years.

Fitch affirmed Transocean’s Issuer Default Rating at ‘BBB-‘ with a Stable Outlook on Aug. 27.

“The rating reflects Transocean’s market position as the largest global offshore driller, strong backlog ($25 billion as of July 16, 2014), favorable rig fleet high grading and margin improvement efforts, and additional financial flexibility that provides headroom to absorb some additional market weakness. Nevertheless, negative rating actions remain a possibility and will be closely linked to management’s ability to manage its balance sheet through the current cycle,” the rating agency said.

Fitch views 2016 as Transocean’s likely inflection point, with a large proportion of its legacy backlog having rolled off and the majority of competitive new builds reaching the market. However, a prolonged aversion by the market to fleet attrition and/or a sustained period of depressed demand could push back the inflection point.

The debt market seems to have discounted Transocean’s commitment to its investment-grade rating and, in Fitch’s opinion, questions its financial flexibility. Fitch expects Transocean to fund its cash flow shortfall principally with cash on hand and asset sale proceeds, but recognizes the company may also delay capital spending and possibly cut or suspend the dividend.

Transocean Partners and, if successfully divested, Caledonia are substantial sources of liquidity. Further, Fitch views the year-to-date 30%-plus share price decline and approximately 9% dividend yield as a signal that equity markets do not fully believe the current dividend will remain in place, providing an opportunity to revisit in the coming months.