The headline of a recent Financial Times article about offshore drilling read: “Seadrill/offshore oil: under water”. The forecast for this sub-sector is as dark as its product.” It is possible that no other sector of the oil and gas business has as bleak an outlook as offshore drilling. How could it not, given the dramatic decline in oil prices due to Covid-19 and the oil war between Russia and Saudi Arabia, and the high cost of the oil being sought offshore? As an old African proverb states, “when elephants fight, it is the grass that suffers,” meaning the weak get hurt in conflicts involving giants, and who would not argue that Russia and Saudi Arabia are heavyweights in the global oil industry? The oil service industry is among those in the grass, and the offshore sector is even weaker, so they are being crushed by low oil prices.

Baker Hughes reported for the week ending June 5 that only 13 drilling rigs were working in the Gulf of Mexico, down from 23 a year ago. In the early years of this century, the Gulf rig count was consistently 10-13 times greater, and in the boom days of the 1970s, the offshore rig count was well above 200.

What is happening in the Gulf is consistent with what is happening with offshore activity worldwide, as the oil price collapse after Saudi Arabia and Russia failed to agree to extend the OPEC+ oil production cuts collapsed oil prices. Ignoring the few hours when WTI oil prices actually fell into negative territory for the first time ever, the prospect that world oil prices would trade around $25 a barrel for the foreseeable future forced producers to slash their capital spending plans for 2020 and begin reorienting business strategies.

Exhibit 25. How Offshore Rig Counts Have Unfolded

The problem for the offshore industry is its recent history, and the inability of managements to envision the possibility of an extended period of low activity. As a result, managements built budgets and debt repayment plans based on expectations of more historical rates of activity and day rate levels. History shows that since the first OPEC oil price collapse in late 2014, the offshore industry has experienced a dramatic decline in business. From mid-2014, when oil prices were last in the $100 a barrel range, the offshore rig count fell steadily, reaching bottom in late 2017 for floating drilling rigs, but earlier in September 2016 for jackup rigs. Between the high and low in June 2014 and September 2016, the rig count fell by nearly 43%.

Floater rigs, semisubmersibles and drill ships, are used primarily for deepwater drilling and development work, which requires higher oil prices both initially and for the future. The bottom-supported jackup drilling rigs work primarily in shallow water, which tends to be a market that responds faster to changes in oil and gas prices. A reason for that faster reaction time is a function of lower day rates for jackups and shorter contracts. Shorter contracts are tied to the larger fleet, offering greater choices for offshore E&P customers.

The current worldwide offshore drilling fleet of 510 rigs is roughly composed of 72% jackups and 28% floaters. Using data from investment banker Credit Suisse’s latest monthly offshore rig report, there are 315 working jackups and 98 floaters. The respective fleet segment utilizations are 85.4% and 69.5% for jackups and floaters. Overall, the offshore drilling rig fleet has an 81.0% utilization rate.

A point that should not be lost when analyzing fleet utilization is that since 2014, according to oil industry consultant Rystad Energy, 160 drilling rigs have been removed from the active fleet. That means the world’s fleet has contracted by 24% over the past five years. Based on comments from Seadrill Limited and announcements from Transocean Ltd., the fleet will likely continue to shrink. While an extraordinarily large contraction, it is not unprecedented in the history of the offshore industry. It is also a necessary step along a path to restoring industry profitability.

A recent report by Rystad Energy focused on the problems besetting the floating drilling segment of the offshore industry. At its root, the industry has too much debt for the earning power of its equipment. This view was echoed by comments from Seadrill chief executive Anton Dibowitz in the company’s first quarter 2020 earnings call with analysts and investors. He observed:

"This industry has two fundamental challenges which are emphasized by recent events - there are too many rigs carrying too much debt […] a number of our assets are increasingly unlikely to return to the market and need to be scrapped. Assets across the industry also carry debt levels which are unlikely to be sustainable and consequently we should expect to see substantial indebtedness being converted into equity".

In the earnings report, Seadrill announced an impairment charge of $1.2 billion connected to its plan to scrap up to 10 of its rigs. That charge, which contributed to the company reporting an earnings loss of $1.3 billion, doesn’t reflect the ongoing challenge of Seadrill’s $7 billion in debt on its balance sheet. To support large debt loads, offshore drilling contractors need both high equipment utilization and high day rates. As noted above, utilization for floaters is below 70%. Additionally, as Rystad pointed out in its analysis, drilling contractors lack pricing power, or the ability to lift day rates. The combination of balance sheet leverage, a lack of liquidity, and a challenged business outlook is a recipe for a financial restructuring.

It is difficult to understand all the challenges facing drilling contractors operating in the Gulf of Mexico. A new report from industry consultant Wood Mackenzie titled “After the crash: five key changes in US Gulf of Mexico,” provides some perspective, but also highlights the bleak outlook the FT noted. In the report, the reduction of Wood Mackenzie’s long-term Brent oil price outlook from $60 a barrel to $50, wiped 30% off the remaining value of the deepwater Gulf asset base, reducing the magnitude of work for floaters, and likely limiting the pace of recovery for this sector.

The drop in oil prices, coupled with a less attractive outlook, has contributed to a 22% reduction in spending, the loss of $4 billion. As a result, exploration in the Gulf will fall to historical lows, and a rebound will require time. The firm sees only 15 exploration wells being drilled this year, a reduction of 55% from last year, a level of drilling Wood Mackenzie had predicted for 2020.

The reduced spending will also result in no greenfield projects being sanctioned this year, and subsea tie-back will also struggle. The inability to bring new wells into production this year will contribute to the expected decline in production. That would mark the first drop in production since 2013, which came courtesy of the Gulf of Mexico moratorium following the Macondo well disaster and the reduced investment that followed. Based on the history of the Gulf, it is likely the reduced spending and activity this year will cause a greater loss of production in 2021 and beyond, necessitating the industry stepping up spending at some point.

Exhibit 26. GoM Exploration Drilling To Change

The Rystad presentation showed that starting in 2015, following the 2014 oil price drop, E&P companies’ exploration spending no longer tracked their cash flow, a first for the industry. As exploration and greenfield development spending accounts for 38 and 39 percent, respectively, of total E&P company spending on floating drilling rigs, the change in company strategies for managing their long-term future has cut in half the market for these rigs.

Exhibit 27. How Offshore Capex Broke From CFO

Reduced spending is only one problem besetting the offshore drilling sector. The other is too few customers. Rystad showed that in 2005, there were 51 floater customers (oil companies conducting deepwater drilling), which grew by four to 55 in 2010. The oil price boom following the Great Recession in 2009 led to a 10-customer increase in 2014. In hindsight, the 65 customers that year appears to mark a recent peak in customers. By the end of 2014, the industry downturn commenced, and in two years the customer number fell by 30 to 35. Today, the customer base has shrunk by another five to only 30.

During this period, the number of contractors who could supply floaters to oil and gas customers expanded from 24 to 34, then to 35 and to 38, before shrinking to 33 this year. The impact over the nine-year period 2005-2014 was that the ratio of suppliers to customers ranged around 50% (0.47 in 2005, 0.62 in 2010, and 0.54 in 2014). With the collapse in the number of customers in 2016, the ratio of suppliers to customers rose to 1.09, and is now 1.10.

With essentially a one-to-one ratio of customers to floater contractors, any pricing leverage that existed earlier for contractors has evaporated. Pricing leverage comes from multiple customers wanting rigs, and facing few options. The lack of pricing leverage jeopardizes future rig utilization and earnings. Without cash flow, debt restructurings will be mandatory. Long-term, the absence of customer competition for floaters will drive industry consolidation. In that regard, Rystad focused on major floater contractors, showing how this universe shrank from 15 to 11 following the acquisitions of smaller competitors by Transocean and Valaris, the company formed through the merger of Ensco Ltd. and Rowan Drilling. Rystad speculates the industry may be headed to only four major floater contractors, although Rystad doesn’t predict when consolidation might occur. If they are right, there is a hurricane of pain and suffering ahead for this industry, something it can’t avoid.

The initial phase of consolidation is already underway – and has been for a while. That phase involves restructuring of company balance sheets, which basically means less debt and more equity. Several offshore drilling contractors are already in bankruptcy – Diamond Offshore being the most recent – with others preparing to file. Several contractors confronting bankruptcy will be doing so for a second time, suggesting more drastic overhauls may be necessary. The failure to adequately restructure balance sheets in their first bankruptcy is why these troubled contractors are at bankruptcy’s door again. A different outlook for the future will be needed to underpin balance sheet restructuring this time.

The contractor bankruptcies will result in companies having new owners, as debt is swapped for equity, leaving current shareholders with little or no value. New company directors, and often new managements, may lead companies in different directions. Changes are often driven by the desire of the new owners to monetize their investments. In reality, they are trying to recoup as much of their past investment as possible, and as quickly as possible. This is the catalyst for industry consolidation. How quickly consolidation occurs will depend on the willingness of contractors to engage in transactions in which one management and organization disappears. These deals make it easier to shrink the global rig fleet. Fewer contractors and fewer rigs will help restore pricing leverage.

The history of the offshore industry consolidation of the 1980s and 1990s will be the model for this cycle’s consolidation. Healthy contractors will be necessary for the offshore drilling industry to be able to deliver quality service for its customers in the future as the industry continues to expand in the challenging deepwater and harsh environments offshore. At some point, these challenges, coupled with the desire of oil and gas companies to want to explore and develop resources in these areas will necessitate a new generation of equipment, something that can only be done with a healthy contracting industry. This will happen because the promise of the offshore is too great for such a reformation to not occur. Predicting the timing is impossible, and a great frustration.

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Energy Musings

Offshore Oil Service Sector Being Pressured To Restructure