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By Stephen Ellis

Nearly three years after the Macondo oil spill, the industry's eyes are focused on the Gulf of Mexico again. The Bureau of Safety and Environmental Enforcement has issued a notice to operators in the Gulf regarding a failed bolt that was part of General Electric's (NYSE:GE) H-4 connector, which connects the blowout preventer to the wellhead. The BSEE has directed operators to pull up every BOP in the Gulf to inspect it and replace any faulty bolts with newly certified ones, which has created headaches for the offshore drilling industry. We expect operators are now asking their drilling contractors to inspect BOPs worldwide, given the zero-tolerance environment around well control post-Macondo.

We see no immediate threat to valuations for the offshore firms we cover. The impact on the offshore drillers could very well be muted, depending on the outcomes of specific negotiations on a rig-by-rig basis and whether the bolts can be replaced as part of an already-planned maintenance program. Outside the Gulf of Mexico, operators very well may be more lenient without the specific regulatory action that we've seen in the Gulf.

Not Just a GE Problem

The BSEE issued a safety notice to operators in the Gulf of Mexico regarding BOPs that may contain faulty bolts. The discovery of the faulty bolts was made after a leak of drilling fluid was detected due to stress corrosion cracking. GE Oil and Gas issued a safety notice on Jan. 29 about the bolts used as part of its H-4 connector, which connects the BOP to the wellhead. These bolts are provided by a third-party manufacturer and thus do not appear specific to GE's BOPs. As a result, we believe the bolt failure has larger implications beyond the initial obvious candidate, GE, and could affect the offshore drillers we cover, such as Transocean (NYSE:RIG) and Diamond Offshore (NYSE:DO), as well as other BOP manufacturers, such as Cameron (NYSE:CAM) and National Oilwell Varco (NYSE:NOV).

The BSEE noted that the bolt failure has occurred on three rigs in the Gulf of Mexico, and it has ordered all operators in the Gulf to inspect their BOPs. The operators must direct the drilling contractors to pull the BOP to the surface and then suspend operations until an independent third party can certify that the existing bolts are sound, or if replacement bolts need to be installed and certified. GE said 24 of the 83 rigs drilling in the Gulf of Mexico are immediately affected, and several have already been cleared to return to drilling operations. In an environment of zero tolerance for issues around well control, we expect operators worldwide will be ordering drilling contractors to pull their BOPs as well. Shell (NYSE:RDS.A) and Statoil (NYSE:STO) are already assessing their operations in the Gulf as well as worldwide.

Offshore Drillers May See Additional Downtime in 2013

For offshore drillers, this development may be a headwind throughout 2013. It will take about one to two days to pull each BOP up from the seafloor, but potentially longer to find replacement bolts, install them, and have them certified. In a best-case scenario where the existing bolts are fine, we envision perhaps four to seven days of downtime for a driller per rig, which entails four to six days of pulling and reinstalling the BOP and one day for a successful inspection. Depending on the well depth, however, it could take as long as two weeks to pull the BOP -- deeper wells require more time.

If the bolts need to be replaced, then it could take several weeks to acquire new ones, as the equipment suppliers are generally supply-constrained across the industry. For example, Diamond Offshore has said it will replace the bolts on 30 of its rigs worldwide, including two in the Gulf of Mexico, and expects the replacements to be completed within six weeks. On the other side of the coin, Ensco (NYSE:ESV) indicated that its jackup fleet and its 8,500 series of rigs were not affected, and it has already replaced the bolts for other floaters in its fleet. For the remaining floaters in its fleet, Ensco has scheduled its bolts for evaluation, and where appropriate, they will also be replaced. The company has spare bolts on hand; it can requalify other bolts from available stock and has also secured new bolts to augment its inventory.

Any downtime will probably result in a negative impact for the contract drillers because they are unlikely to be able to recover the lost day rates (anywhere from $500,000 to $600,000-plus) for the out-of-service days. However, some rigs may be able to replace the bolts as part of planned maintenance programs, which could reduce any negative impact. Also, each rig situation is quite specific, as there are likely to be negotiations between the driller and the operator about who pays for the downtime, similar to what we saw during the Gulf moratorium after Macondo. The drillers have already been seeking improved contract terms to cover themselves in these types of situations post-Macondo.

Mixed Implications for Equipment Suppliers

The implications for the major BOP manufacturers (National Oilwell Varco, Cameron, and GE) are mixed. The BSEE also requested that operators review the quality assurance/quality control programs for all equipment vendors, both contracted and subcontracted, which will place them under some tougher scrutiny. Despite the fact that GE did not make the failed bolt, we think the company will have to weather some negative media coverage for a little while, which may damage its reputation in the eyes of the drillers.

The bigger problem is that the equipment suppliers all appear to rely on a single third party for a single piece of equipment, which means that the failure has cascading effects across the industry. We think the event speaks to the need for suppliers to qualify more than one third-party manufacturer for key pieces of equipment to prevent this type of event from recurring. However, as the industry is supply-constrained, particularly around well-control efforts, we suspect finding additional first-tier suppliers may be a challenge.

We think events like these serve to reinforce the existing competitive advantages of the major BOP players, because smaller suppliers will not be able to procure replacement parts fast enough from third parties, or meet the more stringent quality-control standards set by the major offshore oil and gas operators. We consider this type of event a good litmus test for the quality and reputation of an equipment supplier to the offshore oil and gas industry, and it is likely to be a reminder that the major oil and gas firms are well served by sticking with the largest equipment suppliers with the best reputations for reliability.

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Source: Faulty Bolts Create Headaches For Offshore Industry