Will $50 A Barrel Oil Revive The Offshore Drilling Market?
“Surveys of oil and gas industry capex spending plans for 2021 suggest another down year for the offshore segment. Could $50 oil actually stimulate more spending than the surveys suggest? We take a look. ”
The offshore oil arena historically has been limited in the number of players – primarily because it is an expensive proposition to operate there, plus the time frame from initiating a project to generating first oil is long. The latter challenge has been shortened by the maturing of the infrastructure in various offshore producing basins. The length of time to first production significantly impacts the present value of the effort, which often keeps companies out. In other words, you better be sure of the timing of your project and the expectation for its reserves and production. If you are off in any of these calculations, the economics of the project will collapse, even leading to a determination that it will never be profitable, i.e., writing off a dry hole. These are reasons why the offshore has traditionally been the battleground of large oil and gas companies – those that have the operational and financial resources to be able to support long-term, expensive projects.
The offshore drilling business was mired in a weak business environment even before Saudi Arabia pulled the plug on oil prices in late 2014. The era of $100+ a barrel oil prices, and expectations that this would become a floor for future oil prices, had emboldened drilling contractors to begin a new rig building cycle. It was accelerated by the expectation for super profits that attracted new entrants, often financed by private equity funds who seek opportunities for financial home runs through adding significant leverage to a company’s balance sheet.
Offshore drilling has always been a high-cost business. Drilling rigs are massive steel units that are expensive to build and operate, but which will last for decades generating healthy financial returns during their lifetimes. Of course, that is the belief and the narrative when a drilling boom begins. It isn’t the narrative when the boom dies – other than that the assets will exist for decades. The problem is that the rigs require ongoing maintenance expense, even if merely tied up and cold-stacked. They cost money to own!
Exhibit 5. How The Offshore Rig Fleet Grew Over Time SOURCE: PPHB
The era of extremely high oil prices drove a huge rig building boom beginning after 2005. An impetus for the boom was producers seeing high prices as a ticket to explore and operate in extremely deep and hostile waters. That meant existing rigs were inadequate for the task, so new generations of rigs were necessary. Even the bread-and-butter offshore drilling market needed a rig refreshment as existing rigs were just “too old” and operators wanted them replaced with state-of-the-art drilling equipment. Not only would the new rigs be more efficient, they would be safer and more desirable for workers seeking employment, a competitive advantage in a highly competitive drilling labor market.
The new rigs began arriving as the oil industry fell into a slump following the collapse in oil prices in late 2014 and early 2015. Earlier, the Gulf of Mexico had been slammed by the drilling moratorium following the Macondo oil spill in 2010. As one would expect, the more costly oilfield activities were the most vulnerable to falling oil prices, and offshore drilling was hit hard. The most impacted region initially was the Gulf of Mexico because fewer rigs operate on long-term contracts, in contrast to international markets where the logistics for rig operations require establishing more infrastructure. That necessitates long-term contracts to justify those expenditures.
Let’s look at what has happened to the offshore drilling rig market in order to understand where the market may be heading. Our first chart shows the global offshore mobile fleet from 2001 to 2018 as compiled by National Oilwell Varco (NOV). What it shows is a wide gap between available (supply) and active (working) offshore rigs in 2001 that closed by 2005 as oil prices soared into the $100+ per barrel range. The market remained relatively tight until after the 2009 recession, which drove offshore drilling lower before it rebounded in 2011, again as extraordinarily high oil prices powered the market. The market remained tight until 2014, after which weakening oil prices (2H2014) were followed by the oil price collapse in early 2015. Although the total global fleet shrank between 2014 and 2018, the number of active rigs fell faster due to the evaporating drilling incentive with falling oil prices.
Exhibit 6. How The Offshore Rig Fleet Evolved SOURCE: NOV
To appreciate how the offshore rig market works when oil prices weaken, we have a chart showing the number of idle rigs during the year-long period from September 2014 as oil prices were weakening rapidly. The rigs are classified by the level of preparation made for them being idle – either cold, warm, or hot stacked. Those terms describe the amount of preparation the rig owner has done to reduce the cost of maintaining an idle rig. “Cold stacked” means drilling and rig power equipment have been prepared for not operating for months and/or years while hopefully not deteriorating. These rigs are often parked together to enable cutting manpower to a minimum for overseeing them. “Hot stacked” means the rig has been parked and the crew dismissed, but the equipment is maintained in a state of readiness that would allow the rig to return to work in a matter of days or weeks. “Warm stacked” is a less-well-defined state in which the rig’s equipment is protected for a reasonable time period of inactivity, while also reducing the effort and expenditure to return it to service.
What the chart shows is that the fleet averaged 150 idle rigs over September to November for the three different classes of idleness. Ten months later, an additional 125 rigs had been idled. As the chart shows, while the number of cold stacked rigs increased by ~25, the warm and hot stacked categories soared by over 150 rigs, roughly a threefold increase. It was obvious that rig owners anticipated only a brief downturn, so they wanted to be ready to return to work quickly.
Exhibit 7. The Nature Of Rig Stacking In Downturns SOURCE: IHS
Our third chart shows the total offshore rig fleet supply, the marketed supply, contracted rigs and the fleet utilization rate from 4Q2018 to 3Q2020. Between 4Q2018 and 4Q2019, the total fleet grew slightly,
Exhibit 8. Offshore Drilling Suffered In 2020 SOURCE: IHS
as did the marketed supply. The number of contracted rigs rose even more than the overall supply, but has now dropped sharply with the collapse of oil prices in 2020.
The latest data from IHS Markit showing the offshore rig count as of January 13, 2021, shows the current week, the prior week, the prior month and the week a year ago. Utilization for the most recent two weeks shows a lower rate than experienced for 2020’s third quarter. That is not a good trend, but the rig count always lags the fundamentals of the market. Thus, we believe we can say that the current level of offshore drilling is a reflection of oil prices in the upper $40s per barrel and not their current $50+ level. Moreover, until the OPEC and Saudi Arabian moves to support and then boost the global oil price above $50 occurred, the conventional oil company view was that higher oil prices would not arrive until the middle of 2021, or later.
Exhibit 9. Offshore Rig Utilization Still Lags Oil Prices SOURCE: IHS, PPHB
It will take a while for the $50+ oil prices to establish a support level before offshore E&P companies feel comfortable in embarking on new projects. Producers need to be confident about the future of oil prices. Therefore, the surveys about offshore industry capital spending in 2021 being published are suspect since they reflect E&P management views from mid-November to mid-December when oil prices averaged $47 per barrel. The Barclays survey of spending for 2021, the dean of capital spending surveys, suggests a seventh consecutive year for offshore spending to decline. Because many producers do not breakout their onshore versus offshore spending amounts when responding to the survey, a certain amount of inference by the Barclays’ analysts is used to arrive at the estimate of offshore spending. The survey projects a 4% decline for offshore spending in 2021.
There were two charts in the Barclays report that we found interesting. The first showed the estimated historical reinvestment ratio for the E&P industry. This is a measure of how much of their cash flow from operations was plowed back into new drilling and production, as measured by the amount of capital spending. While the chart does not have the oil price plotted, what we know is that the period when reinvestment rates were historically high (2010-2016) oil prices were also high, often in excess of $100 per barrel. Those high oil prices were also stoking optimistic forecasts for future years with ultra-high oil prices. With plenty of cash flow and optimism for the future, it was not surprising companies were borrowing money to pour into new E&P efforts, thus reinvestment rates above 100%.
Exhibit 10. Will $50 Oil Boost Industry Optimism? SOURCE: Barclays Research
The second chart shows the sensitivity of capital spending changes at various industry reinvestment rates compared to an array of crude oil prices. The industry sensitivities were separated between Large Cap E&P’s and Small/Mid-Cap E&P’s. At reinvestment rates of 56% and 57%, respectively, for Large Cap E&Ps and SMid Cap E&Ps, consistent with the latest data, capital spending is projected to decline by 5% and 4% at an oil price of $47. However, if the oil price were to average $50 a barrel, Large Cap E&Ps would increase spending by 1%, while SMid Cap E&Ps would only reduce their spending by 1%. That magnitude of sensitivity to oil prices should not be underestimated this early in 2021. If companies believed that the $50 price level will become a floor, and higher oil prices are on the horizon (2022-2024), they might be inclined to lift their reinvestment rates to say 60%. That would result in Large Cap E&Ps boosting spending by 9%, while SMid Cap E&Ps upping their spending by 11%.
Exhibit 11. Assumptions Key To Forecasting Capex SOURCE: Barclays Research
While we can speculate on what might happen with higher current and future oil prices, the Barclays analysts need to operate on the basis of what the operators have told them in response to their survey. Based on the assumption for 2021 offshore spending falling by 4% from last year’s level, Barclays is expecting the offshore drilling rig count to continue to slide throughout all of this year. That may prove to be an accurate forecast. On the other hand, it is possible that we may be witnessing the bottom in the offshore drilling industry cycle, with better times ahead. The greatest impediment to such a recovery is the existence of a significant number of idle and, in many cases, obsolete offshore drilling rigs. The overhang of this potential supply of rigs will act to retard a rapid recovery in drilling rig day rates, something their owners are desperate to see happen.
The industry needs to scrap a large number of rigs, but the willingness of owners, and the cost of doing so, remains an anchor holding back the industry’s recovery. Several charts from the recent annual overview of last year’s offshore drilling rig market from Bassoe Offshore, a leading offshore rig brokerage, advisory and project development company, provides some perspective. Bassoe reported that 42 rigs were either sold for scrap or converted to alternative uses, such as producing platforms or accommodation units. That is a healthy number.
Exhibit 12. A Healthy Number Of Rigs Left The Fleet SOURCE: Bassoe
However, the global drilling rig construction boom begun in the late 2000s and continuing through the 2010s in response to the ultra-high oil prices has yet to end. Bassoe shows that six newbuild jackup drilling rigs were delivered in 2020, but more importantly, 65 new drilling rigs remain stranded in shipyards. As the chart shows, there are 41 newbuild jackups, 6 semisubmersible rigs and 18 drillships among that new rig supply overhang. This new rig supply represents 155% of the number of rigs scrapped or converted. It will take a lot more rigs leaving the fleet to restore any semblance of a stable market.
Exhibit 13. There Are Many Rigs Yet To Enter The Fleet SOURCE: Bassoe
A motivator for moving rigs out of the market is their value. Bassoe showed what happened to rig values over the course of 2020. They estimate that the entire offshore rig fleet value dropped from about $73 billion last January to only about $43 billion at year-end. Interestingly in their chart, we see an uptick in the fleet value in December from the lows seen in September to November. It is difficult to attribute that uptick to anything other than initial reactions to a strengthening of oil prices and expectations for a demand recovery building throughout 2021. Such a scenario will drive oil prices higher and stimulate more demand for offshore drilling. It is the prospect of rigs returning to work that influences their values, as there is little use for them other than drilling wells. While this is good news, the media will continue to focus on the extreme situations, of which there are many. One report was about a 10-year-old rig that cost $600 million to build that was recently sold for scrap at a $6 million figure. This resembles the last major offshore drilling bust associated with the 1985 oil price collapse. At that time, drilling rigs were sold by the pound, i.e., the value of the pounds of cutup steel in the scrap market. The above figure is likely reflective of that condition today, but we understand the ship and rig breakup yards are finding scrap steel prices depressed due to oversupply. That doesn’t help rig owners in reaching decisions to scrap rigs.
Exhibit 14. How Offshore Rig Values Have Fallen SOURCE:
Bassoe
Offshore drilling contractors are hopeful that their industry’s depression may be ending. For many managements, they have experienced false hopes for recovery before. Therefore, they will take a wait-and-see attitude about a recovery. They are accepting and preparing for a market outlook in 2021 reflected by the survey and forecast offered by the Barclays’ analysts. It is always better to be surprised to the upside, rather than have to shelve an optimistic outlook.