The $1.7 Billion Liability Hiding on Transocean Ltd.'s Balance Sheet

By Markets Fool.com

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Image Source: Deepwater Horizon Response via flickr.com

One major criticism ofTransocean is that the offshore driller has many older rigs that are well beyond their economic lives. These rigs must be eliminated so that the company can focus on its fleet of newer, higher-specification rigs, according to some investors.

I'm guessing that Transocean's management would like to say this to these investors: "If you fork over the $1.7 billion it will take to get rid of these rigs, then we'll more than gladly do it"

Let's look at Transocean's fleet, what kind of life these older rigs have left, and why the company hanging on to some of them longer than it should.

Addition by subtraction

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Over the years, offshore drillers have operated at deeper and deeper depths. To adapt to the needs of the business, companies such as Transocean have expand their fleets with new rigs. While older, less-qualified rigs have not become completely obsolete, many of them are nearing the end of their economic lives. As shown in the table below, almost all of Transocean's legacy rigs in the deepwater and midwater classes are more than 30 years old and are coming close to the end of their current contracts.

Rig Classification Total Rigs in Class Avg Age of Rigs in Class Utilization Rate Average Contract Length Remaining Per Rig
Ultra-deepwater 28 (plus 7 under construction) 10.2 years 72% 26 months
Deepwater 7 36.8 years 75% 8 months
Midwater 15 32.9 years 86% 9 months
Harsh Environment 7 21.8 years 85% 22 months
Jackups 10 (plus 5 under construction) 11.8 years 100% 16 months

Source: Transocean Rig Status updates and reports.

Based on the age of these rigs, the glut in the rig market, and the places in the ocean where they can be used -- the majority of midwater rigs are used in the shallower North Sea, which is in decline -- it seems highly unlikely that Transocean will secure new contracts for all 22 of these rigs within the next year or so.More important, Transocean will focus its attention on ensuring its fleet of ultra-deepwater rigs get work since these are the company's top revenue generators and clearly its future.

What this likely means is that a large portion -- if not all -- of Transocean's deepwater and midwater fleet will be sent to the scrapyard sooner than later. While Transocean has not given a timeline for this to happen, it is clearly part of the company's long-term goal to transform its fleet.

Source: Transocean Investor Presentation.

While turning the company into a more focused fleet owner seems like a great idea, it will likely cost a large chunk of change. According to the company's most recent fleet status update, Transocean will spend somewhere between $300 million and $325 million to scrap four rigs --ones not included in the table above. Based on a quick calculation, it costs $75 million to $80 million to break down a rig and sell it for scrap parts. Using that number, it would cost somewhere in the range of $1.7 billion-$1.85 billion to scrap the company's older fleet.

Within the past year, the company has announced the retirement of 16 rigs. This doesn't include the 23 rigs in operation, so Transocean probably has a greater than $1 billion bill to take those rigs off the market already. When you add the amount needed for rig retirements to the $3 billion-$5 billion needed to complete its newbuild program, the company is looking at some pretty hefty costs over the next few years. These numbers help to explain management's decision to cut the company's dividend by 80%. Doing so frees up about $870 million annually in cash that can be dedicated to these costs. Still, Transocean will likely have to tap its credit facility or potentially the debt market to cover these costs.

No wonder the company isn't rushing to get these rigs off the market.

What a Fool believes
It's easy to armchair quarterback this situation and say Transocean should have unloaded or scrapped some of these older rigs much earlier to avoid its current glut. But what manager in his or her right mind would intentionally scrap a money-generating asset when the market for rigs was so promising less than a couple years ago? It's going to take a lot of money from cash flow -- and a lot of pain from investors -- before Transocean can transform its fleet to what it wants over the next few years, but it is making the right moves to rightsize the fleet over the long run. If it can scrap its massive fleet of aging rigs and bring online new rigs without breaking the bank, then Transocean cold be in good shape. Just don't expect it to do anything for you in the short term.

The article The $1.7 Billion Liability Hiding on Transocean Ltd.'s Balance Sheet originally appeared on Fool.com.

Tyler Crowe has no position in any stocks mentioned.You can follow him at Fool.com under the handle TMFDirtyBird, onGoogle +,or on Twitter,@TylerCroweFool.The Motley Fool has no position in any of the stocks mentioned. 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.