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The offshore drilling market has been negatively impacted by reduced spending by E&P companies.

This downturn has primarily been focused on ultra-deepwater.

Shallow-water still offers strong fundamentals, but there are some concerns about potential future oversupply.

Drilling in Arctic environments remains a good opportunity for Seadrill and North Atlantic Drilling.

Seadrill and North Atlantic Drilling have limited exposure to current market weakness.

In its fourth-quarter earnings report, Seadrill's (NYSE:SDRL) management discusses the current conditions in the offshore drilling industry in considerable amount of depth. These conditions have sparked fear into many investors in the industry, resulting in stocks such as Seadrill and North Atlantic Drilling (NYSE:NADL) offering double-digit yields to those with the fortitude to buy them. In the case of these two companies, though, fortitude may not be required, as neither company has significant exposure to the current market. This limited exposure will be discussed later in this article. First, I would like to start this piece by discussing the current state of the industry, as seen by Seadrill.

As I discussed in a recent article, the offshore drilling market over the past few years has been characterized by exploration and production companies demanding more offshore drilling rigs than were available at the time. This resulted in a sellers' market, in which day rates for rigs were surging and offshore drilling contractors had no difficulty securing contracts for their rigs. That situation changed in late 2013, as exploration and production companies began to encounter cash flow difficulties and have been forced to cut spending on their exploration programs. The offshore drilling industry, thus, no longer has a situation in which demand exceeds supply, but instead now has a situation in which supply is sufficient to meet demand. As a result, near-term day rates have begun to show weakness. Seadrill states, though, that it is seeing some signs that the weakness will only be short term. For example, it has been seeing a growing number of companies asking about contracting rigs beginning in 2015. Seadrill characterizes the increase as "a slight increase", however, and given that we are barely into 2014, it may be too early to draw conclusions from this.

It is not a good idea to make overly broad statements about the industry as a whole, however. This is because there are multiple types of offshore drilling rigs, each of which is designed to operate in a different environment. Each of these environments has different dynamics and fundamentals. Therefore, it is best to look at each of the rig types individually when evaluating the company's macro-environment. Seadrill's management appears to agree and, for this reason, the company has broken down its own market outlook by rig type. Seadrill operates ultra-deepwater drillships and semisubmersibles (collectively termed "floaters"), along with shallow-water high-specification jack-up units. If we include the rigs owned by the company's majority-owned subsidiaries, North Atlantic Drilling and Seadrill Partners (NYSE:SDLP), then the company also has tender rigs and harsh environment shallow-water and ultra-deepwater units that are capable of operating in the Arctic. For this reason, I will discuss the market environments of these different rig types in this article.

Ultra-deepwater Floaters

Ultra-deepwater floaters are those drillships and semisubmersible units that are capable of drilling wells in more than 7,500 ft. of water. Admittedly, this is a fluid term and I have seen multiple definitions of what constitutes an ultra-deepwater environment, but this is the definition that Seadrill uses and it is also the one that I will use. There is likely to be substantial production growth in the ultra-deepwater areas of the world going forward. Today, the total oil production in these regions stands at one million barrels per day. However, the world's ultra-deepwater regions are expected to produce nearly five million barrels by 2020. This represents a compound annual growth rate (CAGR) of approximately 30%. Achieving this sort of growth, though, will require the use of more rigs than the 130 that are employed currently, possibly substantially more.

The current bidding activity for the rigs that will drive this growth is lower than the levels set in 2012, however. This could jeopardize the growth potential of this market, should this trend not reverse itself. This is one reason why Seadrill expects that the market will strengthen after a lull that lasts until the end of 2015 at the latest.

Seadrill notes that the demand for ultra-deepwater units that does exist is almost exclusively for sixth- and seventh-generation rigs. This would roughly correspond to those rigs that were built in the last ten years. Most of the rigs in Seadrill's fleet would fall into this category. The reason why oil companies are specifically requesting rigs of this vintage is because of their superior performance and safety characteristics compared to older rigs. For example, these rigs are much more likely to have dual-blowout preventers, increased deck space, and high variable load capacity than older models. These newer rigs are also much more reliable in the high temperature and pressure conditions that characterize an increasing number of downhole environments today.

Evidence of this oil company's preference for modern rigs can be seen by looking at the utilization rates for such rigs, along with the contract announcements and availability status for ultra-deepwater rigs. The total number of available sixth- or seventh-generation rigs with any availability in 2014 among all drilling contractors which are not currently in contract negotiations was five units at the end of the fourth quarter. There were seven such units at the start of the quarter. This tells us that there still exists interest for these rigs, just perhaps not as much as there once was. We can extend the numbers outward as well. There were fourteen units available with the same qualifications in 2015. While this is clearly more than the number of 2014 units available, there are still less sixth- or seventh-generation rigs available than fifth-generation ones. At the end of the fourth quarter, there were twenty fifth-generation rigs with at least some availability in either 2014 or 2015. From this, we can conclude that an investor would be best served by sticking to investing in companies with modern fleets.

Premium Jack-Up Rigs

A high-specification jack-up rig is a shallow-water drilling rig with an independent leg cantilever design that is capable of operating in at least 350 ft. of water. All of Seadrill's jack-up units fall into this category, and most of the company's rigs are capable of operating in up to 400 ft. of water. The market for these rigs is currently much brighter than the market for ultra-deepwater units. According to Seadrill, many shallow-water offshore regions of the world are facing a severe shortage of capable rigs. This is because a high percentage of the worldwide jack-up fleet consists of old drilling rigs that are nearing the end of their useful life.

As with the ultra-deepwater rigs, exploration and production companies operating in this environment appear to prefer the performance and safety characteristics of the most modern high-specification jack-up units over those of the older units. We can see evidence of this by looking at the utilization rates for such rigs, along with the day rates for them. For five consecutive quarters, the day rates of those jack-up units that meet the specifications outlined in the previous paragraph has exceeded 95%. Considering that the average contract length for one of these rigs is approximately nine months, this is an impressive figure that shows us that offshore contractors are having no trouble securing new contracts for those rigs whose contracts expire.

Seadrill also notes that oil and gas companies continue to demand these modern, high-specification rigs, even as the day rates for such units continue to climb. The company states that it has seen an increase in the number of bids that exploration and production companies are issuing. It is also seeing some oil companies lengthen the amount of time that they put rigs under contract. This is an indicator that these oil and gas companies are seeing increasing demand for a limited number of rigs. These companies are clearly concerned that they will be unable to contract the rigs that they require for their development plans at some point in the future. For this reason, the oil companies are putting the rigs under longer contracts to ensure that they have it when they need it. Exploration and production companies would not do this unless they saw a very real risk of a supply shortage.

There is also upward pressure on day rates from the supply side of the equation. In 2012 and 2013, offshore drilling contractors scrapped more than thirty aging rigs. This is more rigs than what were scrapped in the prior ten years. This increasing rate of rig retirements has reduced the supply of these rigs at a time when the demand for these rigs is increasing, and this has heightened the fears of exploration and production companies being confronted with a rig shortage. However, there is a concern here. The order book for new high-specification jack-up rigs now stands at 140 units. This means that offshore drilling contractors have ordered 140 new jack-up rigs from shipyards. This is approximately 65% of the number of jack-up rigs that are thirty years of age or older. Therefore, unless the pace of rig retirements accelerates dramatically, the current condition of demand exceeding supply could be reversed.

Arctic/Harsh-Environment Rigs

The world's Arctic regions may be the final frontier in the world's search for oil. Approximately 13% of the world's undiscovered oil and 30% of the world's undiscovered gas is believed to lie in the Arctic. Because of this, the world's exploration and production companies have increased their spending in the region by 11% annually over the past decade. Analysts expect this spending to increase at an 8% rate going forward until 2018. This spending growth is likely to fuel the demand for rigs that are capable of operating in the area, but there are very few such rigs. Seadrill's majority-owned subsidiary, North Atlantic Drilling, is the largest operator in this region and the only drilling company that is focused exclusively on operating in this area.

Seadrill and North Atlantic Drilling's Limited Exposure

In the introduction to this article, I stated that Seadrill and North Atlantic Drilling have limited exposure to the current market. This is due to each company having a very limited number of expiring contracts this year. Therefore, neither company will need to find new contracts for many rigs this year. For example, North Atlantic Drilling has no rigs with expiring contracts this year. Seadrill has 98% of its total time for floating rigs in 2014 covered by existing contracts. The company thus has only five rig months out of a total of 280 months for which it needs to find floater contracts. This limited exposure reduces the risks of both companies significantly because they are essentially hedged against the downturn in the ultra-deepwater market.

Disclosure: I am long SDRL, NATDF. 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.

Additional disclosure: I am short call options on SDRL.