It’s no secret that oil and gas prices are surging. As they do so, investors are rushing to bolster their allocations to the energy industry. It’s important to realize that there is a great difference in potential risk and reward of various oil stocks. Large integrated oil companies tend to be safe but have lower upside. Refiners are cyclical and tied to end market demand. And so on. The offshore oil drilling segment is a boom-bust portion of the energy market. And, even within that group, Transocean (NYSE:RIG) has more risk than many of its peers. Throw in sizable short interest, and RIG stock is one of the most controversial and levered ways to play a bet on rising oil prices.
The issue with deepwater drilling is that it takes a ton of upfront investment. Oil companies have shied away from the category recently. Due to ESG and climate concerns, there was much discussion of oil being a “stranded asset.” That is to say that oil companies would have to leave oil in the ground as folks turned to renewables instead. Think back to 2020, and oil was selling for $40/barrel. It seemed plausible that high-cost offshore oil reserves would never end up being tapped.
Now, sharply higher oil prices may change that. Still, it hasn’t been an overnight revival for the offshore industry. Given its huge upfront costs to get to new production as compared to something like shale, oil companies are understandably hesitant to greenlight new offshore exploration. A recent industry report found some recovery in the offshore market in terms of developing already existing prospects, but that new exploration work remains in a significant trough. In other words, activity is picking up a little bit but it’s far from boom times for offshore drilling owners, despite the high headline price of oil.
How does this all filter down to Transocean specifically? In February, Transocean released its latest quarterly fleet report. In it, there was surprisingly little in the way of contract extensions despite sharply higher oil prices. Transocean’s overall contractual backlog slipped once again to $6.5 billion from $7.1 billion the previous quarter. It was up at $10.2 billion just prior to the onset of the pandemic. Transocean’s future contract outlook continues to dim, and it’s not entirely clear when the tide may finally start to turn.
Adding to this uncertainty, Transocean has more than $6 billion of long-term debt. That’s a lot given Transocean’s uneven profitability metrics and declining contractual backlog. Transocean is also under additional pressure since industry rivals Valaris (NYSE:VAL) and Noble (NYSE:NE) went through bankruptcy reorganization and shed much of their debt in the process. This leaves Transocean in a disadvantaged competitive position compared to those two key peers with strong balance sheets.
To put all the pieces together, if the price of oil continues to soar and exploration and production companies race to put offshore fields to work, all three of these companies should benefit. RIG stock, with the most leverage (and a big short position to boot) would be primed for a major squeeze higher. However, if offshore activity continues to take a long time to ramp back up, RIG stock could be dead money for the time being as the company has to deal with its heightened debt load.
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On the date of publication, Ian Bezek did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.