Analysis Of The Offshore Floater Market

|
Includes: ATW, DO, DW, NE, ORIG, PACD, RIG, SDRL
by: Karl Francis

Summary

The outlook for the offshore floater market follows oil price expectations, based on oil market supply and demand trends.

The odds of reaching a balanced oil market in the 2nd half of 2016 are increasing, moving into tight supply in 2017.

A recovery of offshore floater contract spending to 75%-80% of the 2014 level is assumed for 2018, while the total number of floaters could be 20% lower at that time.

The spending recovery, together with shifts within the floater market, is likely to result in a high utilization rate for class 6 floaters by the end of 2018.

Companies concerned: Atwood (NYSE:ATW), Diamond Offshore (NYSE:DO), Ensco (ESW), Noble (NYSE:NE), Ocean Rig (NASDAQ:ORIG), Pacific Drilling (NYSE:PACD), Transocean (NYSE:RIG), Seadrill (NYSE:SDRL)

The data in the tables below have been derived from the InfieldRigs database a few days ago. It's assumed that half the floaters in acceptance testing, maintenance, inspection and repair are contracted.

Ships

Class 5

Class 6

Total

Operating

8

67

75

Acceptance testing

0

1

1

En route

0

0

0

Inspection/Repair

1

4

5

Under modification

1

0

1

Ready stacked

9

15

24

Cold stacked

11

1

12

Total

30

88

118

Contracted

8.5

69.5

78

Utilization ratio (on the market)

46%

83%

76%

Utilization ratio (total)

28%

79%

66%

Under construction ex Brazil

3

19

22

Click to enlarge

Semi-subs

Build

until 1990

1990 to 2006

after 2006

Total

Operating

40

16

39

95

Acceptance testing

0

0

0

En route

0

3

3

Inspection/Repair

3

3

1

7

Under modification

0

1

1

Ready stacked

34

4

8

46

Cold stacked

24

3

6

33

Total

101

26

58

185

Contracted

41.5

17.5

42.5

101.5

Utilization ratio (on the market)

55%

81%

89%

70%

Utilization ratio (total)

41%

67%

73%

55%

Under construction ex Brazil

16

16

Click to enlarge

Global offshore oil production is around 30 Mb/d. In the past years, decreasing shelf production has been compensated by increasing Deep Water (NYSE:DW) and Ultra Deep Water (UDW) production, now estimated around 12 Mb/d. To keep offshore production from falling, DW+UDW production has to increase further in coming years.

Floaters - comparison with 2014

The situation in 2014 was quite volatile: A very high utilization rate at the beginning, more than 20 new floaters added and a decline in demand in the last quarter of the year, with old floaters starting to get scrapped.

Currently, the nominal total amount of floaters is near 300, down from 330 to 340 in 2014. The number of floaters on the market is close to 250, down from 300 in 2014. The number of contracted floaters is 180, down from the 260 average in 2014.

According to Morgan Stanley, $39B was spent on floater contracts in 2014. From that number, an average day rate of $430k (at 95% efficiency) can be calculated. The average covers a span from $200+k/d to $700+k/d. Using the same average day rate to calculate spending in 2016, and assuming an annual average of 165 contracted floaters, contract spending would be down by 37% to $24B. Average 2016 day rates are not necessarily lower than 2014 rates, as a relative high proportion of old floaters with below average day rates has left the market.

In 2013 and most of 2014, supply in the offshore floater market was considered tight, resulting in very good day rates for last gen floaters. The overall utilization rate of floaters on the market oscillated between 85 and 90% in these years. For the total market, 90% seems to be near the realistic top. Morgan Stanley estimates the average utilization rate in 2014 at 88% (relative to floaters on the market). Relative to the total number of existing floaters, the utilization rate was 78%.

The last 15 years show that day rates are very sensitive to the utilization rate of floaters on the market. At 80%, they are 1/3 or more below the top. One or two percent above 85%, they start to surge.

The current situation is an anomaly resulting from the unpredictable behavior of OPEC which, after more than 30 years, had suddenly abandoned managed supply and had unexpectedly even added to supply in an already oversupplied market. That not only has crashed oil prices beyond expectations but also made them less predictable, leading to an unprecedented postponement of projects and a near total absence of new offshore contracts resulting in floater day rates for new contracts way below the historic range.

Floaters under construction

The InfieldRisk database still includes a sizeable number of Brazilian floaters under construction (23). That's pure fiction. Officially, the number of floaters under construction in Brazil had been reduced to less than 10 several months ago. Recent news indicates that nothing is happening any more. Investors have written off their investments, the whole financing to construction chain is insolvent and the Japanese partners have jumped ship. In the best case, it will take several years to see any of the few Brazilian floaters really under construction getting finished. In the table, the "Under construction" numbers therefore exclude Brazilian ships.

As to the retained floaters under construction, their delivery date is a moving target. A few, probably less than 10, could come to the market in 2017, the arrival of the others will be spread over the years 2018 to 2020.

Short term trends

Currently, 180 floaters are contracted. That's below the required number for maintaining production, according to Seadrill. Because barely any new contract is expected in 2016, the number of working floaters should continue to decline during the year with a potential low around 150 and an estimated annual contract average of 165 units.

Regarding the 30+ year old semi-sub segment: the number of contracts is expected to fall to around 20 by the end of 2016 and to around 10 by the end of 2017. Between 40 and 50 units have been scrapped since 2014 and the trend continues. With very little employment prospects in the first years of a market recovery and 20% of them facing potentially very costly five year inspections each year, a common view is that up to half of the currently existing number could have disappeared by the end of 2017. Some specialized floaters will continue to get contracts. A part of the other survivors could return to the market when day rates for class 6 floaters move above the $500k/d range again, as past observations indicate.

Segregation of the market

Ships and semi-subs will increasingly serve different geographic market segments. The ships are the preferred floaters in the Golden Triangle type of environment (the "ships area") while the semi-subs will be more and more reserved for less hospitable environments like the North Sea. The relative utilization outlooks depend on the respective investment volumes in these market segments. The areas suitable for ships probably comprise up to 80% of the total global floater demand.

In the ships area, an estimated 15% of the money is going to 30+ years old semi-subs in 2016. While total floater contract spending is expected to recover, the contract-money flow now going to these old floaters will be increasingly reallocated to younger floaters, mostly ships, adding to the total demand for these units.

The contract prospects for class 5 ships are poor. Most of these ships are UDW specified, but with inferior performance characteristics. Only 8 of a total of 30 class 5 ships are currently working, based on old contracts. Even in 2014, when class 6 ships still got contracts with near record high day rates, Transocean, owner of a major part of these ships, could not get new contracts for its class 5 ships and started to cold stack them.

The pecking order in the ships area clearly is: class 6 ships, followed by class 6 semi-subs followed by class 5 ships. Employment prospects for class 5 ships will only meaningfully improve when class 6 ships are near full employment with high day rates again.

In the semi-sub category, the distinction is less clear. The column for builds after 2007 in the table includes a meaningful number of non class 6 units, build for special purposes/areas with long term employment contracts. The non specialized class 6 semi-sub is second choice in the ships area and can also be at a disadvantage in the semi-sub area, compared to specialized units, having for example a harsh environment specification. The utilization rate difference between class 5 and class 6 semi-subs is relatively low.

Outlook

With the expected oil price recovery continuing through 2017 and the growing awareness of a tight supply situation developing in 2017 and beyond, resulting from the enormous upstream spending cuts in 2015 and 2016 (see below), a significant part of the $200B delayed offshore projects will probably get progressively launched, starting in 2017.

A minimum floater utilization recovery, moving the contract volume up to 200 floaters, necessary for DW and UDW oil supply stability, would require a 25% spending increase from the 2016 average. That might appear high but it only means annual spending recovering to $30B, still significantly below the 2014 level of $39B. A 25% spending recovery by 2018 should increase the number of floaters under contract by 35 units from the estimated 2016 average (or up by 20 units from today's contract volume).

On the supply side, estimating that 2/3 of the floaters under construction are getting delivered by the end of 2018, the total amount of class 6 ships would increase to 101 then from 88 now. The total amount of semi-subs build after 1990 would increase by 11 to 95.

Assuming that the number of floaters built before 1990 falls by 50 units and that 25 new floaters currently under construction are added by the end of 2018, the total supply of floaters would be around 275 units, with 225 on the market by the end of that year. Taking into account normal attrition rates of old floaters, total supply could further increase by 5 to 10 floaters after 2018, while the number on the market could increase to the 250 level under condition of a significant day rate recovery. That would still be 50 units below the 2014 situation.

If the increase in contract volume resulting from the partial spending recovery and the contract shift from old floaters (15 floaters) is fully allocated to class 6 ships and class5+6 semi-subs, their combined utilization rate would be above 90% at the end of 2018 (based on total supply, including new supply), with the ship's utilization rate higher - probably closer to 95%.

With demand for floaters increasing further after 2018, there should be no problem absorbing the remaining new gross supply of 13 units with the surviving old semi-subs and class 5 ships finally also seeing a demand recovery.

In a study last year, Rystad Energy projected that the demand for floaters would recover from the 2016 lows to 254 in 2018 (that's 25% more than in the hypothesis illustrated above) and to over 300 by 2020. The satisfaction of that demand looks impossible after 2018 with the estimated amount of floaters available in those years.

Background: Oil outlook - supply and demand

The recovery of the offshore floater market is tied to the development of oil supply-demand and - price expectations.

Net oil exporters are likely to conclude some kind of production freeze agreement in April 2016. In an evolution from the December OPEC meeting, the Saudis and other GCC members are adopting a more realistic attitude and seem to accept a recovery of Iran's production now. The freeze agreement is a form of return to managed supply that will decrease the risk of irrational behavior and future market share battles, notably between the Saudis and Iraq, providing more planning security for oil companies.

The equilibrium price of oil, where enough upstream investments are made to compensate for the natural decline of producing fields and increasing demand, is much closer to $100/b than many people tend to believe currently.

The idea that US shale oil costs have come down so much that the new global equilibrium oil price will be somewhere around $50/b to $60/b is a myth based on voodoo economics. A honest full cost calculation, based on real Bakken data, for example (see en.og24.com), reveals that only one third of the past annual new well volume is viable under condition of the typical required IRR of 15% at WTI prices between $65/b and $70/b, taking advantage of distress pricing of services and equipment. That's not enough to return to old production levels and only viable for a limited time because of increasing sweet spot saturation. The numbers I have seen for the Permian are not much better.

Short term, the question is when supply-demand will return into balance. Regarding short term trends, the statistical agencies tend to be behind the curve.

The EIA which is the authority for US data, continues to lower estimates for US production. A few months ago, it saw US production bottoming at 8.8 Mb/d in 2016-Q3 and a strongly recovering in 2016-Q4. In its March 2016 report, US production is expected to bottom at 8.2 Mb/d in 2016, with 2017 production lower than 2016 production.

There is also the question of the missing barrels - where are all the pretended ever growing oil surpluses piling up? As Andy Hall from Astenbeck Capital rightly remarks in his letter from early March 2016:

To believe the IEA and the EIA, global inventories built by 2 million bpd last year and will continue to build in the first quarter of this year by 1.4 million bpd. While inventory data is not available for every country in the world, it is available for virtually all the OECD countries, for China, India, Brazil and most other major non-OECD countries…Observed inventories in all of these places were, in the aggregate, unchanged during the final quarter of 2015…The IEA on the other hand asserts that global oil inventories built by 2.2 million bpd last quarter.

[in its March 2016 report, the IEA has reduced its 2015 Q4 oversupply estimate to 2 Mb/d]

So far, in the first quarter of 2016, the seasonal increase in OECD inventories is below the 5 year trend. The question again is: where is the supposed seasonally adjusted oversupply piling up?

News from many producing countries regarding their expected 2016 production decreases are not reflected in the agencies projections yet. All evidence suggests that total non OPEC supply will fall by at least 1 Mb/d in 2016, compared to 2015.

With regard to the longer term, Rystad Energy concludes that the balance between production declines from aging fields and new additions turns negative in 2016, reaching minus 1.2 Mb/d in 2017, with the cumulative deficit continuing to increase in later years. Even with a full recovery in upstream spending to pre 2015 levels, it will take several years to close the gap.

Other things being equal, the expected decline of OPEC spare capacity in the next 5 years to an average of 2Mb/d from 4 Mb/d in the last 5 years (IEA; OPEC, MS), could increase the oil price relative to marginal cost by 25%, according to a statistical analysis from Bernstein Research.

To conclude: the odds are high that crude supply-demand comes into balance later in 2016 and then turns into an increasing supply deficit in following years. If a 1.5% global production surplus can reduce the oil price by 60%, you should not be surprised by a similar upside reaction when a deficit develops.

Will high inventories limit a crude price recovery? Don't bet on it. US inventories are currently 150 Mb above the 5 year average. In early 2009, they were 180 Mb above the 5 year average. That didn't prevent prices from doubling in the following 12 months.

Disclosure: I am/we are long ORIG.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.