Understanding The Current Market Environment In The Offshore Drilling Industry - August 2017 Edition

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

Summary

The most recent IHS Markit trends report shows clear signs that the offshore drilling market has begun to improve, albeit at a very slow pace.

The ultra-deepwater sector shows the least signs of improving.

The shallow-water sector shows that the supply glut of rigs that has been plaguing the sector has clearly begun to abate.

Overall, new contract dayrates continue to remain low in all market sectors, so don't expect profits to return anytime soon.

Potential investors should continue to watch the sector but continue to avoid it for now.

It has become something of a recurring tradition for me to discuss the dayrate and utilization trends in the offshore drilling industry in an effort to keep both investors and other readers of this column informed as to the true situation facing the industry. Fortunately, now that the latest Offshore Rig Day Rate Trends report has been released by leading offshore consulting and analytics firm IHS Markit, we can see some signs of improvement during the month of July over the very weak environment that the industry has been plagued by for the past few weeks, but the improvements are quite weak. This points to an industry that still has a long way to go before truly recovering.

As I have discussed in previous articles in this series, the IHS Markit report discusses the leading new contract dayrate and utilization trends for four different classifications of rig that IHS Markit believes serve as proxies for the entire industry. For the most part, these rig types are effective proxies as the categories do include most of the rigs in operation today. However, it is important to keep in mind that by doing this, the report does deliberately exclude some rigs and nearly half of one company's (North Atlantic Drilling Ltd. (NADL)) fleet.

Ultra-Deepwater Drillships

The first type of rig discussed by the IHS Markit report is ultra-deepwater drillships. For the purposes of this report, an ultra-deepwater drillship is defined as an independently mobile drilling rig that is capable of operating in at least 7,500 feet of water. As such, these are among the newest and most technically capable rigs in operation today, at least in the deepwater space. Furthermore, this is a category that includes most recently constructed ultra-deepwater units as their independently mobile nature makes these rigs more versatile than semisubmersibles (discussed below). IHS Markit has compiled the fundamental statistics for all ultra-deepwater drillships operating or idle worldwide, which makes sense as there are three primary areas in which these rigs operate. Therefore, this chart will include all ultra-deepwater drillships in existence.

Here are the leading new contract dayrate and utilization trends for the ultra-deepwater drillship fleet:

Source: IHS Markit

As this chart shows, utilization (the number of rigs in operation compared to the number of rigs in existence) remained relatively steady over the past month, albeit at a very low level. This is just the latest continuance of a trend that began back in the middle of 2014, which was, incidentally, around the same time that oil prices began to decline. With that said, though, most industry analysts consider the current offshore drilling industry slowdown to have begun during the fourth quarter 2013, and while the leading new contract dayrate began to decline at approximately that time, utilization rates did not, which is likely a function of the long-term nature of ultra-deepwater drilling contracts that were commonly used during the previous upcycle. However, we are now far enough into the downcycle that many of these contracts have started to end and offshore drilling contractors have been experiencing difficulty securing new contracts for their rigs (although the number of contracts being awarded has slowly begun to trend upward). Thus, they have started cutting their prices en masse in an effort to compete for those few contracts that are available, but there are not enough new contracts to replace those that are ending. This caused both the utilization and new contract market dayrate to decline over the past few years. Interestingly, though, as the chart shows, the utilization rate has been relatively steady since January of 2017, which could be an indication that the utilization rate has bottomed out, and oil and gas companies have indeed started awarding contracts at a rate relatively equal to the rate at which older contracts are expiring. The same cannot be said for the leading market dayrate however, as this declined over the past month.

Ultra-Deepwater Semisubmersibles

The second type of rig whose dayrate and utilization trends are discussed by the IHS Markit report is ultra-deepwater semisubmersibles. As with ultra-deepwater drillships, these rigs are capable of drilling wells in at least 7,500 feet of water. However, unlike their drillship cousins, these rigs are not capable of independent movement. Rather, they must be towed into place using a support vessel of some kind, what is most commonly called a "tugboat." Partly due to this lack of flexibility, there have been fewer of these rigs constructed in the current generation than drillships, although there have been some. For example, Seadrill (SDRL) has constructed a few of these rigs in recent years. With that said, however, there are still quite a few older rigs still in operation that would be considered as part of this category. As is the case with ultra-deepwater drillships, ultra-deepwater semisubmersibles are used all over the world with the most common locations being the U.S. Gulf of Mexico, Brazil, and West Africa. Therefore, it makes sense that the IHS Petrodata report would include data from ultra-deepwater semisubmersibles located all over the world.

Here are the leading new contract dayrate and utilization trends for the ultra-deepwater semisubmersible fleet:

Source: IHS Markit

Here, we see many of the same trends that are present in their drillship cousins, albeit with more volatility, particularly in the case of leading market dayrates. As this chart shows, the utilization rate for ultra-deepwater semisubmersibles initially began to decline towards the end of the first quarter of 2014 (although it was a very slow decline), then declined much more sharply beginning in the early second quarter of 2015. It has continued to decline until this day, falling slightly in the most recent month. Overall, the utilization rate for this type of rig has fallen much more steeply than that of ultra-deepwater drillships to the point that now more than half of the global semisubmersible fleet is currently idle. This could partly be a factor of age. As my long-time readers are well aware, for quite some time now, I have consistently made the point that the world's oil and gas companies have had a marked preference for contracting modern rigs due to their efficiency and performance characteristics. This has remained true throughout the current downturn. Thus, it is reasonable to assume that ultra-deepwater drillships have been able to more easily secure replacement contracts, although neither type of rig has had a particularly easy time in that regard. As was the case with ultra-deepwater drillships, this has incentivized drilling contractors to reduce their prices in order to aggressively bid for what little new business has been available. Unfortunately, in this case, these rigs are also now difficult to operate profitably, given new contract dayrates. One reason for the significant volatility in new contract dayrates might be the very low number of new contracts being awarded to an ultra-deepwater semisubmersible rig; thus, a single new contract can have an outsized impact on the leading new contract dayrate.

High-Specification Jackup Rigs

The third type of rig whose dayrate and utilization trends are tracked by the IHS Petrodata report are high-specification jackup rigs. Unlike the former two rig types, these are only capable of operating in a shallow-water environment. More specifically, for the purposes of this report, a high-specification jack-up is defined as an independent leg cantilever drilling rig that is capable of operating in at least 350 feet of water. These are generally unable to operate in more than 400 feet of water but some, such as Rowan's (RDC) Gorilla-series, are able to operate in up to 450 feet of water. These are therefore the most modern and technically capable shallow-water drilling rigs in existence and should not be confused with standard jackup rigs such as the ones that Ensco (ESV) acquired when it purchased Pride International several years ago. Those rigs are much less capable and are not considered for the purposes of drafting this report. It is also worth noting that unlike in the case with the two classes of ultra-deepwater rig, in this case, IHS Markit chose to only report on the current market dayrate and utilization trends of those rigs specifically operating in Southeast Asia instead of all the ones operating globally. This is not necessarily a problem, however, as Southeast Asia was historically the region where shallow-water rigs primarily operated, and to this day, it remains by far the largest market for them. Therefore, this chart still captures the lion's share of the worldwide fleet of high-specification jackup rigs and thus provides an effective proxy.

With all that said, here are the leading new contract dayrate and utilization trends for shallow-water rigs operating in Southeast Asia:

Source: IHS Markit

As the chart shows, jackup rigs have also suffered from the same decline in current market dayrates that have affected their larger cousins over the past few years. However, while utilization rates were also declining sharply heading into this year, there was clearly a very strong recovery here, although not so strong as to put utilization back to where it was prior to the start of the downcycle. As I have noted in a few articles earlier this year, contracting activity does seem to be increasing, and we can clearly see this in the jackup utilization rate. There are two reasons for this. The first is that shallow-water contracts have always been much cheaper than ultra-deepwater contracts and until recently have typically had a much shorter duration. Thus, putting one of these rigs under contract is typically a much smaller commitment of resources than putting an ultra-deepwater rig under contract. The second reason for the sharp increase in utilization rates is that drilling companies have greatly increased the rate at which they scrap older rigs heading into this year. While high-specification jackups are typically relatively new and so would be less impacted by an increase in scrapping activity, this has still reduced the overall supply glut that has been plaguing the industry for the past few years. With that said, the current market dayrate has been flat throughout this whole year despite the improvement in utilization rates and still remains at levels that are either equal to or lower to cash flow breakeven levels, thus greatly limiting the profit that offshore drilling contractors are able to generate off of their rig fleets. This indicates that, despite some fundamental improvements in the supply-demand balance of the shallow-water market, oil and gas companies in aggregate are still unwilling or unable to devote significant resources to developing their shallow-water fields.

Harsh Environment Jackups

The final class of rig tracked by the IHS Petrodata report is harsh-environment jackup rigs. These rigs are, as the name implies, shallow-water drilling rigs that have been specially equipped to operate in some of the harshest conditions in the world such as those found in the North Sea and the Arctic regions. Unlike the high-specification jackups just discussed, IHS Markit specifically limited the data used to make this chart to the trends data for standard jackups and not the more capable high-specification harsh-environment jackups used by companies such as North Atlantic Drilling. This is acceptable, however, since nearly all harsh-environment jackups in use are standard units. Furthermore, IHS Markit specifically excludes those rigs not operating in Northwest Europe. Once again, this is acceptable as the majority of harsh-environment rigs do indeed operate in Northwest Europe.

Here are the leading new contract dayrate and utilization trends for standard harsh-environment jackup rigs operating or present in Northwest Europe:

Source: IHS Markit

Here, we can also see a slight recovery in the market over the past few months, but it clearly has a long way to go to even reach the dismal state that it was in during the middle of last year. In its latest quarterly report, North Atlantic Drilling stated that it has seen an increase in both tendering activity and rig scrapping activity. This is shown in the utilization rate above, as both activities will reduce the oversupply of rigs in the market and thus increase the number of rigs operating compared to the number of rigs in existence. As standard harsh-environment jackup rigs tend to be older models than North Atlantic Drilling's too, they are more likely to be scrapped than the latter company's modern units. However, with that said, clearly more than half of the harsh-environment jackup rigs in existence remain without contracts, which will pressure new contract dayrates and threaten North Atlantic Drilling's survival as a company because older rigs are oftentimes paid off, and the latter company remains heavily indebted without the cash flow to make the payments on its debt (which will also force it to need higher dayrates than some other companies to make said payments). As the chart above shows, the market has seen a small improvement in new contract dayrates, reflecting the improvement in the utilization rate. Despite this, though, the new contract dayrates have remained steady for the past three months and still remain at levels significantly below cash flow breakeven levels, continuing to threaten the profits of all participants in this market. This will almost certainly continue to be the case for some time.

In conclusion, the most recent report does show a slight improvement in the offshore drilling market over the past few months. However, it clearly continues to have a long way to go before the historically cyclical market turns around. Thus, investors may want to continue to avoid the sector until more promising signs emerge.

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

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.