2 Developments On Tuesday That Show Further Strength In Ultra-Deepwater Drilling

Includes: PACD, VTG
by: Power Hedge

Two developments occurred on Tuesday, January 22 that show the continuing strength of the market for offshore drilling rigs, particularly in the ultra-deepwater sector. I have discussed this strength a few times over the past month, most notably here.

The first of these developments is an announcement by Vantage Drilling (NYSEMKT:VTG) that it has received a conditional letter of award for its newbuild drillship Tungsten Explorer. This two-year contract will commence in mid-2014 and end in mid-2016. The customer will also have four options to extend the contract for a period of six months per option. Thus, the rig would be under contract from mid-2014 until mid-2018 if all four of these options are exercised.

The Tungsten Explorer is a 2013-built ultra-deepwater drillship that is capable of drilling wells up to 40,000 feet deep in up to 12,000 feet of water. This makes the rig one of the most capable ultra-deepwater drillships in the world today.

Source: Vantage Drilling

Vantage Drilling stated that it expects total revenue from this contract to be approximately $468 million, including the mobilization fee. This works out to approximately $641,000 per day but, once again, that includes the mobilization fee. Therefore, the rig's dayrate is not $641,000. Vantage Drilling did not state what the mobilization fee actually is so we cannot calculate the actual contractual dayrate. However, based upon mobilization fees for similar contracts, we can assume that the contractual dayrate is around $600,000, the midrange of a span of possible dayrates that extends from the upper $500s to $620,000. The biggest factor here is whether or not there are any customer-requested modifications to the rig. If there are no such modifications then the dayrate will likely be at the high end of this range, around $620,000 per day or so. The company will amortize its mobilization fee over the life of the contract so ultimately Vantage Drilling will realize revenues of $641,000 per day over the two- year contract term. However, it is important for investors to realize that the mobilization fee is only intended to reimburse Vantage for the costs that it incurs in getting the rig into position and ready for its assignment. The dayrate is where the contractor really makes its profit and so it would be nice to have a definite value for this.

This contract does not begin until mid-2014, however the rig will be delivered this year, in 2013. That leaves a period of time where the rig will be idled without a contract. This means that the rig will generate no revenues and Vantage Drilling's revenues and profits will be lower than if the rig were operational during this time. Vantage Drilling addressed this in its contract announcement and stated that the company would try to secure additional work for the rig sooner, to avoid idling. According to Paul A. Bragg, Chairman and CEO of Vantage Drilling,

"The announced project is an attractive cornerstone for us. Since the Tungsten Explorer is scheduled for delivery in May 2013, we expect to obtain additional work for the unit to commence upon delivery from the shipyard. We are currently discussing drilling requirements for the second half of 2013 and early 2014 with both affiliates of the counterparty to this contract as well as several other customers. We expect that we will conclude another contract, thereby increasing Tungsten's contracted backlog, inclusive of options, to be approximately five years from commencement."

Given the current state of the market, Vantage is unlikely to have much difficulty finding near-term work for the Tungsten Explorer, although most oil companies prefer long-term contracts in the current environment and the current contract precludes that possibility. However, short-term contracts also carry much higher dayrates than long-term ones so Vantage would benefit from the higher dayrate should it secure such a contract. Mr. Bragg's statement that the company is already in talks to secure a contract for the second half of this year and early next year do provide optimism regarding the company's changes of securing an additional contract.

Also on Tuesday, Pacific Drilling (NYSE:PACD) announced that it has exercised an option to construct an eighth ultra-deepwater drillship with Samsung Heavy Industries. This drillship will be one of the most advanced ultra-deepwater rigs in the world. The rig uses the same design that many of Pacific Drilling's other rigs use. This includes Pacific Drilling's state-of-the art dual-gradient drilling capability. I discussed the advantages of dual-gradient drilling in an article published earlier this year.

Pacific Drilling's CEO, Chris Beckett, specifically stated that the strong market for deepwater drilling is one of the reasons why the company ordered the new rig. This is evident by looking at the Deepwater Floating Rig Day Rate Index compiled by IHS Petrodata. This index, compiled every third Friday of the month, tracks the movement of competitive deepwater and ultra-deepwater rig dayrates and utilization. This index reached its highest level ever in December.

Source: IHS Petrodata

In its presentation at the Dahlman Rose & Co. Ultimate Oil Services and E&P Conference, Pacific Drilling provided a similar chart that tracks the historical dayrates of all fifth generation and later ultra-deepwater floaters. I included this chart in my earlier article that is linked above:

Source: Pacific Drilling

Dayrates are the primary source of revenues and profits for offshore drilling contractors. Therefore, for obvious reasons, rising dayrates are a very good thing for companies in the industry and their respective investors. However, the companies cannot immediately increase profits just because market dayrates go up. This is because each driller only has a limited number of rigs and these rigs are contractually limited to a specified dayrate for a specified period, usually at least a few years. Therefore, if dayrates increase after a rig is contracted out then the offshore drilling company will not benefit from the higher day rates (unless the company has another rig to contract out).

Pacific Drilling is looking to take advantage of this market strength through the addition of an eighth rig to its fleet. The rig will not be ready until 2015 but the company may be able to contract the rig out sooner than that and so lock in a dayrate in the strong market. Of course, it may pay to wait since there are indications that the current strength in the market will continue into 2015. Pacific Drilling's move to build another rig indicates that its management agrees as it would make no sense to have a new rig delivered into a weak market. This will allow Pacific Drilling to contract out the rig into a strong market and thus capture high dayrates. It will also stimulate the company's growth as the new rig will provide an additional source of revenue and profit in addition to the seven rigs that it has now.

Disclosure: I am long 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.