SeaDrill: Rig Rates Remain High Despite Oil's Fall

Oct.25.06 | About: Seadrill Ltd. (SDRLF)

Oil prices are continuing to show significant weakness, with yesterday's price so far maintaining the sub-$59 level. However, that doesn't seem to have softened demand for deepwater offshore drilling rigs.

Lack of Energy Alternatives = High Energy Costs
Whether you believe that oil is being manipulated down by the great Bush/Saudi conspiracy and will quickly bounce back after the election (which seems a bit far-fetched), or just that prices even at these levels are still quite high and profitable for the oil companies, I think in the long term, the trend for energy costs will be generally higher thanks to increased worldwide demand and slow-to-develop alternatives.

The oil companies are going to continue spending heavily to increase their reserves. Royal Dutch/Shell (NYSE:RDS.A), for one, has already stated that they can make their current exploration projects profitable at $20-40 oil, and prior comments I've heard from some drilling companies say they don't expect a significant reduction in demand for rigs unless oil dips well below $50 and stays there.

So although it is certainly tempting to jump on the cheap oil bandwagon and say that all the producers will cut and run from their E&P projects now, the way they did when oil ranged from $10 to $20 through the 1990s, I don't think that's terribly likely as long as prices stay at the historically high levels of $40 and up (that's just a guess number). I will get nervous, however, if they dip below $50.

Right now, though, I think the oil services pendulum in general has swung too far in the direction of pessimism -- demand for oil is certainly still strong, even if not as overwhelming as we thought it was a year ago, and there is very little true excess capacity in the world even if OPEC shuts off a small amount of their production. The easy oil has been found and burned, with the possible exception of the Saudi reservoirs, and with demand generally continuing to grow as the world motorizes and develops, the expensive oil will have to be produced, too.
Seadrill Drillship
Record Deal for SeaDrill
And the oil majors clearly realize these facts. With their reserves at pretty low levels and a large portion of the world's easily accessible oil politically embroiled, they're still signing deals for difficult fields and spending the money to develop those fields.

The latest I've seen on this is a new deal for a SeaDrill (OTC:SDRLF) drillship, scheduled to come out of the yard in mid-2008. They just announced a letter of agreement for three years with a "major oil company" at $570 million, which translates to a day rate of roughly $520,000.

I don't know if that's a record for a deepwater drillship, but it's a record for a SeaDrill contract. Current drillships with this general capacity (water depth of more than 4,000 feet is the broad category, though this ship can handle depths of 10,000 feet) are currently going for a bit over $200,000 a day according to RigZone data, and SeaDrill has signed contracts for comparable semisubmersibles (not drillships, but with the same depth capacities) of between $400-480,000 a day going out to 2012.

Their most recent deal was for a semisubmersible with roughly the same capabilities and starting rate of $473,000 a day in the Gulf of Mexico. For the most part, SeaDrill is succeeding in its goal of getting contract rates for new rigs that allow them to pay for themselves over the first 3-5 years of their working life. They're also still investing where they can to get the best equipment, including taking over Eastern Drilling and their two under-construction best-of-breed deepwater rigs.

There may well be a glut in the smaller, cheaper jack-up rigs that's driving prices a little lower -- but for the rigs that can drill in extremely deep water or in difficult conditions it's still a seller's market where many rigs coming out of the yards in the next two years are already booked through 2012. SeaDrill has a large portion of it's fleet positioned well to sign contracts at these high rates, but I think all the drillers who focus on deep water should do well despite the pessimism over oil prices.

I could certainly be wrong on this -- Phil Davis does a good job of arguing against energy investments in the current climate, and I'd agree that it doesn't make sense to buy big integrated oils or oil royalty trusts right now. The fact that oil prices have fallen 25% is going to have some significant impact on the sector, even though prices remain well above where they were pre-Katrina.

But it seems unlikely to me that we'll see energy prices fall enough that it ceases to be important to find and drill new wells, and I think that's good news for the companies that own the most advanced drilling equipment.

SDRLF.PK 1-yr chart:

Full disclosure: SeaDrill is my largest individual stock holding.