Economics Of Rig Scrapping

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Includes: ATW, DO, NE, ORIG, PACD, RDC, RIG, SDRL, VAL
by: Artyom Zakaryan, CFA
Summary

Offshore rig industry began a process of scrapping rigs during the second half of 2014.

The vast majority of scrapped rigs are second and third generation floaters.

The process of rig retirement will gather pace in 2015 and help in alleviating supply/demand imbalance.

Capital spending necessary to keep older floaters operational no longer passes hurdle tests, thus scrapping becomes the only alternative.

The current downcycle in offshore drillers has been brutal in a sense that a large portion of their fleet has become economically obsolete. A ferocious investment cycle over the past four-five years has resulted in an unprecedented amount of newbuild drillships and floaters hitting the marketplace. Unlike in previous cycles, a significant number of newbuilds were ordered on speculation, i.e. without a long-term contract to back up the construction of the rig. Industry was faced with an oversupply problem in early 2014, but the oil prices were still high and most offshore drillers felt there would be an increased demand in the number of floating units necessary for oil operators. However, as oil price began its steep descent in June of 2014, drilling companies were hit with a double whammy - more supply and less demand.

During previous downturns, companies reacted to cyclical downturns by cold stacking rigs in hopes of finding them work once the cycle turned around. This time around the cycle is taking place in post-Macondo reality, where regulatory demands necessitate companies to put a significant amount of new capital into upgrading older floaters. Obviously, companies have IRR and NPV hurdles on allocated capital and this article will examine the financial framework of decision to scrap rigs.

Noble Corporation (NYSE:NE) provided very valuable numbers during its latest conference call with regards to its decision to scrap three floaters. The company mentioned each rig would have required over $100 million for upgrades to pass the class regulatory survey. This number was circulated earlier by Seadrill (NYSE:SDRL) as the company was touting its new fleet, which does not have to face such costly upgrades. Dolphin Drilling actually spent $210 million to upgrade its Blackford semisub in June, while Borgland Dolphin's upgrade had a cost of $160 million in Q3.

I wanted to run a calculation of what type of dayrate a rig needs to earn to justify an upgrade costing $100 million. In order to understand this several assumptions must be made:

1) Operating expenses of a midwater semisub are $110k/day

2) Operating expenses of a deepwater/HE semisub are $150k/day

3) G&A and support costs associated with the rigs are 5% of revenue

4) Salvage value after five years prior to the next class survey is $10 million

5) Revenue efficiency - 95%

6) Utilization over a five-year period - 80% (fully operational four out of five years)

7) Interest expenses at 60/40 equity/debt (varies for different companies) are 5% of revenue.

8) Tax rate - 3% of revenue

9) Discount rate - 12%

Incorporating above assumptions and solving for a dayrate I get the following breakeven dayrates:

Midwater dayrate - $275k/day

Deepwater/HE dayrate - $330k/day

Breakeven dayrates are not outrageously high; however, assumption on 80% utilization does not pass the test of current oversupply. These lower-spec floaters are being crowded out by a wave of newbuilds, which in some cases are accepting dayrates in high 300k region. For an operator, it's a no-brainer decision to hire a newbuild with almost 40% higher efficiency at a 20% higher rate. Assuming that the current oversupply lasts well into 2016, I calculated breakeven rates using a 60% utilization (i.e. three fully operational years over the next five years).

Midwater dayrate - $360k/day

Deepwater/HE dayrate - $440k/day

As you can see these older floaters would need to obtain rather high dayrates to justify $100 million of capital allocation for upgrades. It becomes quite obvious that scrapping is justified on the basis of capital returns if drillers do not believe they can ensure at least 80% utilization for their older fleet over the next five years. However, even if economics are marginally acceptable, keeping these older floaters in the fleet increases overall supply and acts as a drag on dayrates for newer more sophisticated rigs. Scrapping is thus justified even in these circumstances, since it ultimately decreases available rigs in the market and pushes dayrates higher for the remaining assets.

In conclusion, current offshore rig market oversupply coupled with dramatic cuts in exploration capex has set the stage for massive scrapping of second and third generation floaters. Economics of capital upgrades necessary to pass class regulatory surveys no longer justify keeping rigs in the fleet. Scrapping rigs during the cyclical downturn will make the industry much leaner and ensure a swift recovery in dayrates once the commodity prices stabilize. I expect more scrapping announcements as 2015 goes along, which will ultimately cure current supply/demand imbalance.

Disclosure: The author is long RIG, NE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.