Future Difficulties In Ultra-Deepwater Market Likely To Be Focused On Lower End

by: Power Hedge

Investors who follow the offshore drilling industry are by now no doubt aware of the recent deluge of articles in the financial media that suggest that the strength that the industry has enjoyed for the past few years may be coming to a close. For example, a recent article on The Motley Fool states that an abnormally high number of drilling rigs are coming off contract in 2014. Additionally, leading offshore contractor Seadrill (NYSE:SDRL) states in its third quarter 2013 earnings report that several oil companies are encountering cash flow difficulties and are being forced to re-examine their budgets. This may result in the oil companies that are the customers of the various offshore drilling companies postponing the development of several offshore fields. This will likely reduce the demand for offshore drilling rigs. This reduction of demand combined with the large number of rigs hitting the market next year could reverse the undersupplied market conditions that have been prevalent for the past few years. However, the actual situation is a bit more complicated than this and not all offshore drilling companies will be equally affected by these new market conditions.

The Motley Fool article that I linked to in the introduction states that Transocean (NYSE:RIG) alone has fourteen deepwater rigs coming off contract in 2014 and that there are a total of 39 rigs coming off contract industrywide next year. However, not all deepwater and ultra-deepwater rigs are created equal. In previous articles, I have discussed that the exploration and production companies that contract out offshore drilling rigs have displayed a marked preference for modern rigs. There are far fewer of these rigs than the industrywide numbers would appear to show. In a presentation at the Cowen and Company Third Annual Ultimate Energy Conference on December 4, Pacific Drilling (NYSE:PACD) stated that 48% of all existing floater rigs (which would include all deepwater and ultra-deepwater rigs) are more than ten years old.

Source: Pacific Drilling

It is these older rigs that will incur the brunt of the negative consequences from the reduction in spending by oil companies. Seadrill states in its earnings report that customers are increasingly only interested in drilling units that are equipped with dual BOPs, increased deck space, and high variable deck load capacity. These are features that are generally only available on rigs less than ten years old which partially explains why Seadrill says that customers are no longer interested in anything older than sixth generation. There are other reasons why oil companies are primarily interested only in modern rigs. These reasons are primarily due to the fact that offshore oil wells have much more demanding requirements than they did ten or twenty years ago. Modern rigs are better able to operate under the demanding conditions of modern wells than older ones.

Further evidence of this customer preference for modern rigs can be found by looking at the utilization of the worldwide floater fleet by build year.

Source: Pacific Drilling

As is immediately obvious from the chart above, every floating rig that was built in 2007 or later is currently being used to perform drilling operations. Older rigs have lower utilization, with the percentage of idle rigs increasing with rig age. Further evidence of this customer preference for modern rigs can be obtained by looking the contract status of rigs that are still under construction. According to Seadrill, there were ten rigs whose construction is scheduled to be completed in 2014 that did not have contracts or specific discussions for contracts at the end of the second quarter. That number had been reduced to seven by the end of September. Clearly, demand for new rigs is still present despite the reductions in exploration and development spending by customers.

Further evidence that demand for modern, high-specification rigs is still present can be obtained by looking at the dayrates awarded to such rigs in recent weeks. Long-time readers of my articles will likely recall that I have previously discussed the dayrate difference between modern and vintage rigs. That gap has increased in recent weeks.

Source: Pacific Drilling

So, what is this telling us? It appears that sufficient demand exists for modern, high-performing rigs to hold dayrates relatively steady, with new ultra-deepwater floaters commanding dayrates in the $550,000-$650,000 range. Additionally, oil companies continue to be willing to pay dayrates in this range for such rigs, even with the budgetary pressures that several of them are facing. However, the same cannot be said of older rigs at the lower end of the market. As the chart shows, dayrates for these rigs have been falling. Thus, it appears that the budgetary pressures being faced by the industry's customers have resulted in these companies becoming more selective about which rigs they contract. Thus, demand for these vintage rigs has fallen dramatically and dayrates have followed this falling demand.

Therefore, not all offshore drilling contractors will be affected equally by the industry's downturn. Those companies that operate older fleets such as Diamond Offshore (NYSE:DO), Fred Olsen Energy (FEOAF), and Transocean will likely bear much of the damage from any downturn. Those offshore contractors whose fleets consist of modern, high-specification rigs such as Seadrill, Pacific Drilling, and Ocean Rig (NASDAQ:ORIG) are likely to be much less affected.

However, the coming year is likely to be more difficult for offshore drilling contractors than the last few years have been, even for those companies operating modern rigs. This is because there will be an enormous number of new ultra-deepwater rigs leaving shipyards in 2014. This will result in a change in the market from the undersupplied conditions that were present in 2012 and 2013. By most indications, supply and demand will be fairly well-balanced in 2014. There is also the possibility that supply will exceed demand, resulting in some downward pressure on dayrates. However, this downward pressure will likely be most prevalent in the low end of the market. This could prompt rig owners to scrap their older rigs which would help keep supply in balance with demand during the year.

Source: Ocean Rig UDW

Another potential risk here can be seen in the chart above that shows the dayrate differences between modern and vintage rigs. Although the exploration and production companies that serve as the customers to the offshore drilling industry have thus far been willing to pay dayrates of $550,000-$650,000 for modern units, the dayrates awarded under new contracts over the past month or so have fallen off slightly from where they were earlier in the year. Should that decline prove to be more than a blip or accelerate then there could be some trouble ahead even for those companies that do operate rigs at the high end of the market. At least for now though, dayrates for these rigs have been stable and even though dayrates have been very slightly lower over the past month, the decrease is in no way comparable to the decline in dayrates that has been seen for vintage rigs over the same period.

The viewpoint that all these new rigs that are entering the market will not result in a supply glut is evident through the actions of the industry's customers. First, why would oil companies be willing to contract rigs at today's dayrates if they expected a supply glut in the near future to result in cheaper prices in the near-term? Second, nearly one-third of the new rigs that were available to be contracted out are now no longer available. Seadrill's management stated in the company's third quarter report that it expects the remaining seven new rigs to secure contracts but even if not all of them do, the supply of available high-specification rigs will likely not significantly exceed demand.

Disclosure: I am long SDRL, 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.