Offshore Drilling Industry Continues To Weaken - Contractor Cash Flows Threatened

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Includes: ESV, NADL, PACD, RDC, SDRL
by: Power Hedge

Summary

IHS Petrodata publishes a monthly report showing utilization and new contract dayrate trends for the offshore drilling industry.

The latest report shows that the oversupply of drilling rigs continues to increase among all types of rig, putting pressure on dayrates.

All types of offshore rig are now having a hard time securing new contracts that generate positive cash flow.

Barring a reversal in oil prices, this will likely result in declining cash flows among industry participants, even when compared to today's depressed levels.

It is no secret among energy investors that the offshore drilling industry has been very weak since the fourth quarter of 2013 and this weakness was exacerbated when oil prices plummeted to their current levels a year later. This has led to widespread concerns that several major players, most notably Seadrill (NYSE:SDRL), are likely to go bankrupt in the near future. Few of these reports discuss what the actual conditions in the industry are, however. This report, the latest in a long running series, will seek to rectify that.

One of the best sources of information showing the supply and demand fundamentals in the offshore drilling industry is the Offshore Rig Day Rate Trends report that is published monthly by leading industry analytics and consulting firm IHS Petrodata. In this report, IHS Petrodata discusses the utilization and new contract dayrate trends for four different types of rig that the firm believes serve as adequate proxies for the same fundamentals for the industry as a whole. Overall, these proxies due serve as very effective ones, as will be discussed in this article.

Ultra-Deepwater Drillships

The first type of offshore drilling rig whose utilization and new contract dayrate trends are tracked by the IHS Petrodata report are ultra-deepwater drillships. For our purposes here, an ultra-deepwater drillship is defined as an independently-mobile drilling platform that is capable of operating in at least 7,500 ft. of water. Due at least in part to their independent mobility, most ultra-deepwater drilling rigs that have been constructed since the end of the last recession have been drillships. As a result, most current generation ultra-deepwater drilling units would be accounted for by this chart. Therefore, here are the dayrate and utilization trends for ultra-deepwater drillships:

Source: IHS Petrodata

As this chart shows, contrary to popular belief, all of the ultra-deepwater drillships in the world were being used until well into the middle of 2014, or several months after the offshore drilling industry began to weaken. Since that time though, the overall trend in utilization has been decidedly negative. In fact, in all but a few months, the utilization rate for ultra-deepwater drillships declined from the previous month. There are two main reasons for this. The first is that offshore contractors around the world began construction on ultra-deepwater drillships en masse during the previous industry upcycle that ended in 2013. Due to the lengthy construction time of these rigs (at least two years), many of them are only now leaving the shipyard and joining the worldwide fleet. While some contractors have managed to delay the date that their newbuild rig(s) leaves the shipyard, others have been unable to do this. Furthermore, while other contractors have been scrapping old rigs, thus far this has not been at the level needed to counteract the effects of the new rigs coming online. Furthermore, the rigs being scrapped are older, less capable units, and so would not be reflected in this chart at all.

The second reason for the declining utilization rate is the weakness in oil prices. This is the reason that most industry bears cite as the reason for their concerns. This is certainly a valid concern as it is quite difficult to make most ultra-deepwater projects economically viable with oil prices at today's levels. As a result of this and the constrained cash flows at most exploration and production companies, contractors have been experiencing great difficulty securing contracts for their ultra-deepwater drilling units. The one thing that has been helping to support this segment of the industry throughout the current downturn has been the historical length of the contracts for ultra-deepwater rigs. During the recent industry upcycle, exploration and production companies typically contracted an ultra-deepwater drillship for at least three years and in some cases for five or more years. As a result, many of these rigs were still under contract when the industry downturn began and were therefore still fully utilized and still generating revenue for their owners. However, the downturn has now persisted for a long enough period of time that these rigs, even those with lengthy contracts, have begun to come off contract. As the number of new contracts being awarded in the marketplace is fairly limited for reasons that have already been discussed, these newly available rigs have been having difficulty getting new contracts and this naturally has a negative effect on the utilization rate.

In addition to the utilization rate, the new contract dayrate for ultra-deepwater semisubmersibles has also been steadily declining along with utilization rates but the decline has been far from steady. For example, as the chart above shows, there were several months in which the new contract dayrate remained steady or even increased since the downturn began. The overall trend has been decidedly negative however, and the new contract dayrate now currently rests at a level that is below the cash flow breakeven point for one of these rigs. Thus, a contractor is no longer able to make a profit or indeed even cover its expenses should it manage to secure a contract for an ultra-deepwater drillship. This is most certainly a distressing situation for every company in the industry, especially those companies that have a large proportion of uncontracted rigs like Pacific Drilling (NYSE:PACD).

Ultra-Deepwater Semisubmersibles

In some ways, an ultra-deepwater semisubmersible is similar to an ultra-deepwater drillship. In particular, both are capable of drilling wells in at least 7500 ft. of water. Where the two types of rig differ, however, is in mobility. As already mentioned, a drillship is independently-mobile, meaning that it can reach the drilling site under its own power. A semisubmersible rig, in contrast, is not independently-mobile and requires a support ship such as a tugboat to move it into position. Due at least somewhat to this fact, these rigs have been much less commonly constructed in recent years than drillships. Therefore, most ultra-deepwater semisubmersible rigs are older units and as I have pointed out in numerous past articles, older rigs are in lesser demand by oil and gas companies and have been for quite some time. This is clearly reflected in the utilization and leading market dayrate figures. Here they are:

Source: IHS Petrodata

As this chart shows, the utilization rate for ultra-deepwater semisubmersibles began to decline in early 2014, almost around the same time that the industry downturn began. This decline then accelerated in early 2015, immediately following the approximately 50% decline in oil prices that occurred in December 2014. As with the utilization rate for ultra-deepwater drillships, this decline has not been steady and, in fact, it did increase slightly in the latter stages of last year but the overall trend cannot be denied. Currently, approximately half of the ultra-deepwater semisubmersibles in the world are sitting idle.

The leading new contract dayrate for ultra-deepwater semisubmersibles, meanwhile, has followed a markedly different path than the utilization rate, but the overall trend has been negative since 2013 as well. This is clearly shown in the chart above. As shown, the leading new contract dayrate bottomed out in October of 2015 before beginning to increase in the final two months of last year and the early months of this year. It then decreased once again before rising. Today, it currently rests at just under $300,000 per day, which is a higher level than it had during the spring months. However, this is still not a high enough dayrate for a contractor to achieve cash flow breakeven on a rig that is still financed but it may be sufficient for an older rig that has already been paid off. Very few ultra-deepwater semisubmersibles in existence have been fully paid off, however, so most rigs whose numbers would be included in this chart are operating at a loss.

Harsh-Environment Standard Jackups

The third type of rig whose dayrate and utilization trends are tracked by the IHS Petrodata report is harsh environment-capable standard jackups. As the name implies, these are shallow-water drilling rigs that have been specially equipped and reinforced in order to operate in some of the most difficult environments on Earth, such as the Norwegian Continental Shelf and the Arctic regions. Unlike the other types of rig profiled in the IHS Petrodata report, these are standard jackup rigs and therefore these figures do not consider the utilization or dayrates being achieved by more capable and modern harsh-environment jackup rigs such as those operated by North Atlantic Drilling (NYSE:NADL). In general, a standard jackup is one that is only capable of operating in less than 350 ft. of water, but IHS Petrodata does not specifically define what it considers to be a standard harsh-environment jackup for the purposes of this report. Regardless, the vast majority of shallow-water harsh environment-capable rigs would be included in the category as I just defined it so this does appear to be a good proxy for the harsh-environment subsegment of the industry as a whole. Also, please note than unlike the charts for both types of ultra-deepwater rig, this chart only considers the dayrate and utilization trends for those rigs operating in Northwest Europe. This is not necessarily a problem as Northwestern Europe has historically been the location where these rigs have been found and although they have since begun to operate in other areas, it is still the area where the significant majority of harsh-environment rigs operate and so can provide us with a good overall picture of the broader market. Therefore, here is the utilization and new contract dayrate trends chart for this classification of offshore drilling rig:

Source: IHS Petrodata

This chart is somewhat interesting considering that the offshore drilling industry began to weaken in late 2013. As this chart shows, every harsh-environment shallow-water drilling rig in existence was under contract until early 2015, or well over a year after the industry slowdown began and more than six months after oil prices began to decline. One reason for this is that, like ultra-deepwater rigs, harsh-environment rigs tend to have long-term contracts that last for three years or more. This provided some support for both utilization rates and new contract dayrates as oil and gas companies were very excited by the potential for Arctic oil discoveries even into mid-2014 and were aggressively contracting any rig that became available through this time. This changed when oil prices began to decline, but not immediately. Unfortunately for owners of harsh-environment rigs though, once demand did start to decline, it declined dramatically. This is shown clearly in the chart above. The primary reason for the decline is the same as for the ultra-deepwater rigs: it is very difficult to make Arctic drilling economically viable with oil prices at today's levels and exploration and production companies are very cash constrained and are therefore desperate to preserve their cash flow. Therefore, they have largely postponed the execution of their Arctic exploration programs until oil prices return to a more favorable level. With that said, it is still economically viable to produce oil in other harsh-environment areas such as on the Norwegian Continental Shelf but oil companies have greatly cut back on all exploration, which also impacts this area. As a result, those rigs that have been coming off of their existing long-term contracts over the past eighteen months have been largely unable to get new contracts for work and this is reflected in the plunging utilization rate seen since then.

The leading market dayrate for harsh-environment jackups has plunged as well, from over $150,000 in early 2015 to approximately $60,000 today. As with the ultra-deepwater rigs, this is not a sufficient level to enable a rig contractor to generate a positive cash flow from one of these rigs. The reason why rig owners have bid the leading market dayrate down to these levels is that they are, in aggregate, desperate to secure some revenue from their existing contracts so that they can at the very least carry their liabilities. This does however put many of the companies in the industry in a rather precarious situation.

High-Specification Jackups

The final type of rig whose utilization and dayrate trends are tracked by the IHS Petrodata report are high-specification jackup rigs. In this context, this specifically refers to independent leg cantilever jackup rigs that are capable of operating in at least 350 ft. of water. As such, this refers to the highly capable and modern shallow-water rigs operated by companies such as Seadrill and Rowan (NYSE:RDC). Other companies such as Ensco (NYSE:ESV) do have a few rigs that would be considered high-specification jackups but many more that are not and are therefore not considered in this chart. In addition, for the purposes of producing this report, IHS Petrodata only examined the utilization and dayrate trends of those rigs operating in Southeast Asia. Historically, this was the primary operating area for shallow-water drilling rigs but over the past decade they have become commonplace in other regions, such as the Persian Gulf and both the U.S. and Mexican portions of the Gulf of Mexico. With that said though, the Southeast Asia region still represents a significant portion of the shallow-water rig market and so will serve as an adequate proxy. Here are the dayrate and utilization trends for these rigs:

Source: IHS Petrodata

Here, we see many of the same trends that we saw with the other classes of drilling rig in that both dayrates and utilization rates have been declining. In this case however, the decline in utilization rates started almost immediately after the offshore drilling industry began to weaken. This is partly due to the fact that benign-environment shallow-water rigs tend to have much shorter contracts than either their harsh-environment cousins or ultra-deepwater rigs. In fact, even during the greatest period of industry strength in the past decade, it was rare to see a benign-environment shallow-water rig be awarded a contract with a term greater than one year (yes, there were a few, but those were the exception). Thus, rigs came off their earlier contracts much sooner in the downturn than their peers and immediately encountered difficulties securing new contracts as exploration and production companies had already begun to cut costs.

The effect on the leading new contract dayrate was nowhere near as immediate, however. This is contrary to what would normally be expected. According to the economic law of supply and demand, when the demand for a good for service goes down and the supply remains either static or increases, as is the case here, then the market price will decline as suppliers bid against each other to supply their particular good to their customer(s). It seems likely that early on, when the number of idle jackups was fairly low that contractors were hesitant to lower the dayrate that they would accept for the use of a given rig in an effort to protect their margins. However, as the number of idle rigs continued to grow, contractors began to bid much more aggressively for those few contracts that were being awarded and thus began to drive dayrates down. Currently, the leading new contract dayrate is at one of its lowest levels ever, at approximately $60,000-$70,000. As with the other types of rig discussed in this article, this is a level that will challenge the ability of a rig to operate on a cash flow positive basis.

Conclusion

It is quite clear that the offshore drilling industry continues to weaken, even from its already greatly depressed levels. While we have begun to see an industry-wide increase in scrapping activity, the oversupply of drilling rigs, at least modern drilling rigs, continues to grow as evidenced by the declining utilization rates. Moreover, unless oil prices increase significantly in the near-term, which seems quite unlikely, then most offshore drilling contractors will see further pressure on their cash flows going forward. This is because most offshore drilling contractors still have at least some of their fleet operating under older contracts that have higher dayrates than what the same rig could get now. As these rigs come off their existing contracts, the new contracts that they would get, if they even manage to get a new contract, would have a lower dayrate. This would cause the rig to generate lower cash flow, which would obviously negatively impact the parent company.

Disclosure: I am/we are long SDRL, NADL, 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.

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