Going Deep: Oil Service Providers Should Benefit From Boom In Deepwater Drilling

by: Elliott Gue

The Big Four's fourth-quarter results and related conference calls revealed that the boom in deepwater drilling has accelerated much more rapidly than most industry observers had expected three to six months ago. Well complexity and service intensity go hand in hand; an upsurge in deepwater drilling could be a boon for oil service providers.

Management teams from Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB) cited a series of pre-salt discoveries offshore Angola as a catalyst for the upsurge in deepwater activity.

On Dec. 20, 2011, Cobalt International Energy (NYSE: CIE) announced an oil discovery at its Cameia-1 well in Block 21 offshore Angola. The company is preparing the well for a production test that will provide further insight into the well's potential. With an active drilling program in each of its three Angolan pre-salt blocks, expect Cobalt International Energy to issue more press releases about potential finds. All of these discoveries will require deepwater drilling rigs to be delineated and produced.

In early January 2012, A.P. Moller Maersk's (Copenhagen: MAERSK B) oil unit announced that its 17,500-foot Azul-1 exploration well encountered crude oil in Block 23 of the Kwanza basin. Initial assessments indicate that the well has the potential to flow more than 3,000 barrels of oil per day. A.P. Moller Maersk will need to do additional appraisal work to learn more about the field and the potential resources therein.

These announcements come on the heels of sizable deepwater discoveries by Anadarko Petroleum Corp (NYSE: APC), Kosmos Energy (NYSE: KOS) Tullow Oil (LSE: TLW) off the coasts of Ghana and Sierra Leone.

Statoil (NYSE: STO) announced a pair of major oil discoveries - Skrugard and Havis - over the past year that may hold the equivalent of 600 million barrels of crude oil. With an ambitious plan to expand its oil production 32 percent by 2020, Norway's state-run oil company will be active in the deepwater.

Investors also shouldn't overlook the deepwater Gulf of Mexico. Drilling activity in the Gulf cratered because of the Macondo oil spill and subsequent moratorium on new deepwater drilling. Well permitting also slowed to a crawl after the ban was lifted.

But drilling activity in the Gulf of Mexico continues to recover. During Schlumberger's conference call to discuss fourth-quarter earnings, CEO Paal Kibsgaard told analysts that the rig count in the region could return to pre-Macondo levels by the end of 2012:

Analyst: So you'd mentioned that your outlook for North American rig count's flat this year, and you also said in your release that, basically, revenue was in line with the rig count, so it would seem to me that the upside here for you guys is really going to be in the Gulf of Mexico. And I was just wondering, if we strip out the strength of the seismic side, I'm curious as to where you are in your deepwater operations in the Gulf.

Are you back to the pre-Macondo levels? Are costs now fully absorbed in that market? And I guess I'm just wondering, are your margins now in the Gulf higher than in your U.S. land business?

Paal Kibsgaard: Yes, the simple answer to that is yes. This quarter, I think, was the first quarter where our Gulf of Mexico margins were accretive to North America. So, obviously, there's been a lot of focus in on the multi-client sales for Q4, which was quite strong, but I think it's also important to point out the strength we have on the deepwater side for well operations, both wireline and on the drilling segment. So we are quite optimistic in terms of the outlook for the Gulf of Mexico; firstly, in terms of our market share position, and in addition to how well we can leverage our high-end technology and operational performance in this type of market. So we see steady growth in deepwater drilling rig counts during 2012, roughly about a rig a month. So we would be at pre-Macondo levels for drilling rigs in the deepwater by the latter part of 2012.

Schlumberger traditionally has been one of the leading services company in the Gulf of Mexico. If the rig count in the region recovers to pre-Macondo levels by the end of 2012, that would be a huge boon for Schlumberger.

These major discoveries, coupled with a recovery in the Gulf of Mexico and Brazil's ongoing investments in offshore production, have tightened the supply-demand balance for deepwater drilling rigs, especially the ultra-deepwater units. Last month, several contract drillers announced impressive fixtures.

  1. Royal Dutch Shell (NYSE: RDS.A) hired Noble Corp's (NYSE: NE) Jim Day, a semisubmersible drilling rig capable of operating in water up to 12,000 feet deep, to work in the Gulf of Mexico from January 2012 to January 2016. The international oil company will pay $530,000 per day. The contract also includes a 15 percent bonus if the rig meets certain performance goals, which brings the potential day rate to $610,000. The rig's current contract features a day rate of $485,000.
  2. On Jan. 19, 2012, SeaDrill (NYSE: SDRL) announced that Royal Dutch Shell had extended its contract for the deepwater drill ship West Navigator by 18 months. The new deal is worth about $320 million, which amounts to slightly less than $600,000 per day.
  3. On Jan. 31, 2012, Ensco (NYSE: ESV) announced that a customer had booked one of its newly built deepwater rigs under a two-and-a-half-year contract in the deepwater Gulf of Mexico. The day rate on this contract is $530,000.
  4. Rumors are swirling that SeaDrill rejected an offer from Total (NYSE: TOT) to book the West Polaris at a day rate of $625,000 for two years or $575,000 for four years.

This recent spate of rig commitments suggest that E&P firms are eager to lock up the few remaining rigs that are available in 2012 and 2013. The day-rates in some fixtures could easily exceed $600,000-one of the reasons that SeaDrill may have held out on Total.

Rising day rates on deepwater drilling rigs bodes well for margin expansion in international markets. CEO Pall Kibsgaard explained why rising day rates are bullish for Schlumberger during a conference call on Jan. 20, 2012:

Analyst: [T]he deepwater rigs are becoming, again, very, very scarce. You highlighted what's going on in Angola pre-salt and the potential demand there. With rates maybe pushing back to $600,000 again, historically, those have been levels where oil companies really start paying attention to technology that can improve reliability or technology that can shorten cycle time, and yet you don't really talk about pricing. So could you help us a little bit with how you view the tightness in the rig market and the higher rates impacting either the service quality for pricing or whether it's the standard technology or whether it's new technology?

Paal Kibsgaard: Yes, and like I said in the previous question, I think there is typically a lag between the moves in the rig rates and the moves in our service pricing, so I think that's the first point. But to your point in terms of what our customers are looking for, I think, like I said, there's a growing focus on operational performance. Obviously, that is even more where the rig rates are high, like in deepwater, but we also see that in more conventional offshore operations as well.

The potential return of pricing power to Schlumberger's deepwater business lines by mid-2012 would be another catalyst for the company's undervalued stock.

Disclosure: I am long SLB, SDRL, KOS, OTCPK:TUWOY.