Rig Contractors Shrink Fleets Via Sale or Scrap as Higher Day Rates Remain Elusive

Although signs of the long-awaited recovery in offshore exploration and production are beginning to appear on the horizon, rig contractors may still be several years away from the levels of utilization necessary to drive a recovery in day rates off of the current depressed levels. And while some specialized units - specifically, harsh-environment semisubmersibles and jackups - are obtaining stronger rates, ultra-deepwater drillships are unlikely to return to the half-million-dollar-plus level that the most advanced rigs could command prior to the 2014 downturn.

Over the past four years, a consensus emerged that a massive scrapping program, aggressive consolidation and a much higher crude price were necessary to return the market to equilibrium. The albatross around the industry’s neck since the downturn began has been overcapacity: Despite an uptick in demand for harsh-environment semisubs and jackups, there are still too many floating rigs - a global fleet of 246, with nearly 40 scheduled for delivery from Asian shipyards through 2021 - chasing far too few opportunities.
 
The industry is doing its part. According to Evercore ISI, 20 floaters and 36 jackups were retired in 2018, bringing the total since 2014 to 119 floaters and 83 jackups. Worldwide floater utilization has reached 60%, up from the cycle low of about 50% seen in January 2017. Jackup utilization is at 66%, with particular strength in the North Sea and West Africa. Deepwater capex is on the rise: Wood Mackenzie said it expects deepwater capex to increase to nearly $60 billion by 2022 from about $10 billion in 2018.

On the consolidation front, the industry has also taken some significant steps. According to data compiled by David Carter Shinn, a partner at rig brokerage Bassoe Offshore and head of Bassoe Analytics, there were seven major transactions in 2018, including Transocean’s purchase of Ocean Rig following its emergence from chapter 11 in September. He also notes nine other major deals, primarily for jackups, including the Deepsea Metro I - a Hyundai Heavy Industries-built 6th-generation drillship - selling for $262.5 million.
 
However, 60% utilization is not quite enough. Wallet-opening by major oil companies cannot come soon enough for contractors whose fleets are weighted toward floaters.
 
2018 was definitely an improvement over 2017, according to Bill Ebanks, a managing director for AlixPartners in Houston. And while utilization did tick higher, that will not - except in very specific markets or with very specific rig types - drive a lot of improvement in day rates. Ebanks noted that harsh environment semisubmersibles, most of which are deployed to the North Sea, have shown some rate improvement, as have certain long-legged backups.

“We need need to get to 80% utilization for the rig contractors to get enough clout to meaningfully move prices, and we’re a long way away from that,” Ebanks said in an interview with Reorg. “We will need significantly higher oil prices - $60 to $70 per barrel - to make offshore hum again.”

Brent crude, after plunging to $50 per barrel in late December 2018 from a post-2014 high of $86.07 in early March, has rallied about 14% from its December lows, helped by a recovery in stocks amid hopes for positive developments in U.S.-China trade talks and dovish noises from the Federal Reserve Bank. In addition, Ebanks said OPEC and its partners do seem serious about taking action to strengthen oil prices. On Jan. 9, Saudi Arabia’s oil minister said he was “confident” that the oil market would be brought into balance and that he would not rule out calling for further action by OPEC and its allies in the future, according to Reuters. In November, OPEC agreed to cut output by 800,000 bbl/d, while Russia and allied producers will cut by 400,000 bbl/d.

As Ebanks noted, day rates for harsh-environment semisubmersibles have shown marked improvement. IHS Markit says that harsh-environment semisub day rates increased 25% year over year in the third quarter, compared with 3% for all other floating rigs.

Yet even within the harsh-environment class, “not all rigs are created equal,” IHS Markit associate director of upstream consulting Erik Simonsen said in a report.

“[T]here is no shortage of HE floaters - the industry is oversupplied and global utilization for HE semis is comparable to other floating rigs - far below the 80 percent that would be considered a boom or tight market,” Simonson said. The best harsh-environment floaters are working off the coast of Norway, he noted, and can command significantly higher day rates than older ones. Companies are willing to pay a premium for more efficient rigs, according to Simonson.

“The most modern HE floaters have seen an average year-over-year growth (3Q 2017 to 3Q 2018) in day rates of 33 percent compared to increased rates of just 4 percent growth for older HE floaters, so there is a huge difference in day rates and demand, depending on the age and capability of the rig,” Simonsen said.

One non-HE floater was recently awarded a contract at a day rate approaching $400,000. Transocean, which in addition to the Ocean Rig purchase also acquired in 2018 Songa Offshore and its fleet of seven harsh-environment semisubmersibles, on Dec. 28 announced a five-year, $830 million contract with Chevron for an ultra-deepwater drillship currently under construction at Sembcorp’s Jurong Shipyard in Singapore. The vessel is Sembcorp’s Espadon III design. Transocean ordered two of the rigs at a cost of $520 million each in February 2014. The original delivery dates of the second quarter of 2017 and first quarter of 2018 were pushed out by 24 months in June 2015.

The rig, according to the release, will be the first-ever ultra-deepwater floater rated for high pressure/high temperature, or HP/HT, operations in pressures of 20,000 psi. It will include dual 20,000-psi blowout preventers, while existing blowout preventers are not rated for any pressures greater than 15,000 psi.

The rig will commence operations in the Gulf of Mexico in the second half of 2021. According to Bassoe’s Shinn, about $130 million of the $830 million contract value reflects capex for the HP/HT-qualified enhancements, resulting in an aggregate day-rate value of about $700 million. This implies, Shinn said, a clean day rate of about $380,000 to $390,000 for the contract.

“Five years ago,” Shinn said in an interview, “it might have commanded a day rate around $700k. It’s not great, but still a lot higher than the market, so it’s a pretty good number, relatively speaking.” Shinn noted, however, that while there may be a couple more 20,000-psi-qualified rigs coming into the market over the next two years - the second Transocean rig under construction at Jurong could be a candidate for a similar update - there is not likely to be an industrywide move toward such vessels.

At the same time, the contract does indicate that the major integrated oil companies have not given up on deepwater and are willing to push technological, geographic and geological boundaries in search of new finds. The Norwegian Petroleum Directorate, in its Exploration 2018 report, noted a decline in exploration activity following the 2014 downturn and said that companies “must explore and discover more in order to maintain activity and production over time.” Offshore is where the deepest and most long-lived reservoirs are found, and for companies such as Chevron, Exxon and Total it is the optimal method to build reserves. Sometimes overlooked in the excitement about the Permian is the fact that the Gulf of Mexico produces massive amounts of crude: a record 1.65 million bbl/d in 2017, according to the EIA, and 1.7 million bbl/d in October 2018, making it the second-largest producing region in the U.S. after Texas.

Exploration activity is picking up, according to Rystad Energy, after total discovered volumes reached a record low of 7.5 billion barrels of oil equivalent in 2017. In 2018, however, monthly discoveries increased to 800 million boe, with total volumes reaching 9.4 billion boe for the year - an increase of 25% over 2017.
 
Major discoveries in 2018, according to Rystad, include the North-Obskoye field in the Russian Arctic, estimated to hold over 900 million boe of resources; the Ballymore field in the Gulf of Mexico, with 550 million boe of resources; and the Longtail and Ranger fields offshore Guyana, with resources of over 450 million boe each.

BP on Jan. 8 announced it had discovered an additional 1 billion bbls of oil in place at its Thunder Horse field in the Gulf of Mexico, while new discoveries near its Na Kika platform offer possibilities for additional tiebacks. The company also approved $1.3 billion for a major expansion of its Atlantis field.

Added to this: Operators and rig contractors have replicated much of onshore’s success in cutting costs, with project costs in the $35 to $40/bbl range. Rystad forecast offshore deepwater to account for 590,000 bbl/d growth in liquids production next year.

Offshore Brazil is a bright spot, according to AlixPartners’ Ebanks, who pointed out that recently elected President Jair Bolsonaro included in his platform the reopening of offshore subsalt exploration to international players.

International participation is “desperately needed” in Brazil, Ebanks said, which once had as many as 35 rigs off its coast. Now there are only five. Bassoe’s Shinn projected that there could be four to five rigs from international oil companies and up to 20 from Petrobras.

Rig contractors, then, have reason to be constructive on the long-term outlook. Transocean CEO Jeremy Thigpen, on the call discussing his company’s acquisition of Ocean Rig, said that “while the precise timing and trajectory of that recovery is still materializing, all of the data points clearly suggest that we are poised to experience an increase in demand in the ultra-deepwater market.” Thigpen also noted an increase in offshore contracting activity. “And based on our frequent and direct conversations with customers, we know that there are multiple ultra-deepwater projects on the horizon for development and exploration across our customer base and in every major ultra-deepwater basin around the world.”

Near-term challenges, however, remain considerable. Shinn noted that competitive utilization for a group of the largest drilling rig owners - ARO/Rowan, Borr Drilling, Diamond Offshore, Ensco, Maersk, Noble, Odfjell, Pacific Drilling, Saipem, Seadrill, Shelf, Transocean and Vantage - rose to 61% from 55% over the course of 2018. But while the group began the year with 410 years of backlog, it ended with 375 years.
 
The culprit? Recent contract awards have been of short duration. And without Saudi Aramco’s award of long-term contracts to ARO Drilling, its joint venture with Rowan, the backlog would have looked even worse, Shinn said. Bassoe provides the following snapshot of recent awards and average day rates in its most recent floater report:
 
Shinn noted that he expects net backlog to benefit this year from major tenders and extensions in Brazil, Qatar, Saudi Arabia and West Africa, along with a ramp-up in drilling activity in Southeast Asia and the United States.

“But the likelihood of [backlog] reaching an acceptable level is now more difficult to obtain,” Shinn wrote in a report. “We’re looking at 2020 at the earliest for most of the market (harsh environment rigs excluded).”

A rebound in day rates, however, may prove to be sluggish. According to research analysts at Jefferies, in mid-2018 oil companies began to “more seriously” ask about longer-term projects for jobs starting in late 2019 or early 2020. “Sensing this,” the analysts wrote, “the contractor community, led by Transocean and Ensco, allegedly started bidding significantly higher dayrates than leading edge cash breakeven rates ($250K+ versus today’s $130K-$160K) while speaking publicly about this pricing push so as to create a collective resistance to cash breakeven rates among their contractor brethren.”

“It is our sense that oil companies did not appreciate these higher dayrate bids and - lo and behold - have had oil price uncertainty to point to as a reason for hesitation to commit to these programs at these higher dayrate bids,” the Jefferies analysts wrote. “As such, we could either see lower long-term dayrate contracts signed in the coming months to the extent operators are even willing to go ahead with some of these programs (our bias is that they will), or we see a game of chicken as each side holds out on signing commitments, thus doing nothing in the interim to actually improve the rig supply/demand imbalance for the intermediate/long-term.”

It is entirely possible that day rates never return to their pre-2014 levels, when the most-advanced ultra-deepwater floaters could command rates in excess $500,000. As has been the case in onshore shale, companies have made immense strides in efficiency, productivity and bending the cost curve lower. According to Wood Mackenzie, since 2013, the cost to develop new deepwater projects has fallen by more than half, as project costs have fallen and returns improved.

One consequence is that for the most efficient units, it takes fewer days to deliver. Roddie Mackenzie, Transocean’s SVP of marketing, noted on the company’s third-quarter call in October that some of the gaps between harsh-environment semisubmersibles rolling off and taking on new contracts are due to those rigs “delivering well ahead of schedule. So they are actually creating their own gaps by delivering the wells quicker.”

Another consequence may be a cap on day rates, at least over the medium term. Transocean, in a presentation discussing its purchase of Ocean Rig, forecast day rates returning to the $400,000 level in 2020-’21, assuming that utilization will be north of 80%.
Sean Meakin, an analyst at JPMorgan, wrote in a research report that he does not expect an “inflection point” in day rates until the second half of 2020. “Longer-term, we believe supply/demand balance shouldn’t necessarily return to newbuild economics prior to the bulk of 6th/7th gen assets reaching service life retirements in ~2035-2040, so we see leading edge dayrates capped medium term below ~$450k,” he said.