How Profitable Is Ultra-Deepwater Drilling? Very

Includes: ORIG, PACD, SDRL
by: Power Hedge

Contracting out offshore drilling rigs can be an incredibly profitable activity during the right market conditions. Those favorable market conditions are those such as the ones that we see today. But, just how profitable is this business? That is what this article will endeavor to answer.

One of the biggest factors determining the profitability of an offshore rig contractor is dayrates. The dayrate is the daily rate that an oil field operator (typically an E&P firm or a major oil company) pays to the rig owner for the use of the rig. The dayrate is only partially in the control of the individual rig owner since it is influenced by other factors including the availability of and demand for rigs. For example, if several contractors each have several rigs available to work on a given project then a rig's dayrate will not be particularly high. The reverse is also true. If only one rig in the region or world is available to work and several operators want to hire it then the dayrate will be higher due to the operators bidding against each other. This latter scenario is much closer to the dynamics of the market today than the former scenario.

The dayrate that a rig earns must be sufficient to cover all of the rig contractor's operating costs in order for the contractor to generate a positive cash flow from the rig. In general, this is not a problem as operating expenses for a rig are quite small relative to dayrates. For example, Pacific Drilling (NYSE:PACD) states in a recent presentation that it has total operating expenses of $180,000 per day on each of its rigs. This compares to dayrates that are currently in excess of $600,000. As you can see, the rates that operators are currently paying for rigs are more than sufficient to cover the contractors' costs of operating the rig.

This $180,000 per day figure seems to hold true for most offshore drilling companies. A notable exception to this is Ocean Rig (NASDAQ:ORIG) which has much higher costs. Ocean Rig provided this chart in a recent presentation which shows that the company has total daily operating expenses of $235,000.

Source: Ocean Rig

This chart also shows that we can calculate a rig's cash flow and its contribution to EBITDA by subtracting the rig's daily operating expenses from its dayrate. In the case of Ocean Rig, the company states that it expects to generate $371,250 per day from a floater rig after covering all expenses. This figure will vary depending on the rig's dayrate but even using these numbers we get an EBITDA margin of 59.4%. Other offshore drilling contractors that have lower expenses will achieve even higher EBITDA and cash flow margins from their floater rigs.

Another factor that is important to consider when evaluating the profitability of the offshore drilling industry is to look at the cost of building the rigs. This is where the big expenses are. Ocean Rig stated in its presentation chart above that it costs the company approximately $675 million to build a new ultra-deepwater rig. This is a bit on the high side. Seadrill (NYSE:SDRL) provided this chart in one of its recent presentations which provides a much lower figure for the cost of constructing an ultra-deepwater rig:

Source: Seadrill

According to Seadrill, it costs approximately $600 million to construct an ultra-deepwater floater rig. Pacific Drilling's cost to build an ultra-deepwater rig is in between these two companies. On January 22 of this year, Pacific Drilling announced that started construction on an eighth ultra-deepwater drillship. The company's total cost of constructing this rig is approximately $620 million. Thus, we can safely assume that the costs of constructing an ultra-deepwater rig are in the range of $600-$675 million. So, as you can see, generating these large cash flow margins requires an enormous upfront investment.

One important factor to consider here is the payback period which tells us how long it takes for the cash flows from an asset to repay the upfront cost incurred in acquiring that asset. In general, the shorter the term, the better, as this means that the asset or project is more profitable. As Seadrill points out above, it takes approximately five years for an ultra-deepwater rig to pay for itself. It should be noted that this five year payback period is based on rig dayrates of $550,000. As dayrates today are closer to $600,000, we should expect this payback period to be shorter. And, indeed, that is the case. At a dayrate of $600,000 and daily operating expenses of $180,000, we get pre-tax cash flow of $420,000 per day from a rig. Assuming a 4.0% tax rate, as Seadrill does, we get total after tax cash flow of $403,200 per day from the rig. Thus, the rig would require 1,489 days to generate sufficient cash flow to pay for itself. This is 4.08 years.

Ocean Rig has a significantly longer payback period due to its higher costs. The company states above that it takes 5.7 years for a rig earning $625,000 per day to pay for itself. In other words, it takes much longer for one of Ocean Rig's units to pay for itself compared to one of Seadrill's even assuming that its rigs are earning more money. The impact of higher costs is truly visible here. At a $625,000 dayrate, Seadrill's rigs would be generating $427,200 per day of after tax cash flow. This would result in a payback period of 1,405 days or 3.85 years. Pacific Drilling is likely in between these two extremes (but much closer to Seadrill's side) due to its higher construction costs. Other offshore drilling companies are similarly profitable.

Disclosure: I am long SDRL, PACD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.