April 22, 2014
Publication: Offshore Engineer, http://www.oedigital.com/
Author: Lars Eirik Nicolaisen, Partner, Rystad Energy
Reporting season Q1 2014 saw deepwater drillers’ reporting numbers in-line with expectations, but still stock prices have plummeted.
The reason for this has not been poor operational performance or lack of ability to deliver revenue growth thus far. Based on the ever more bearish outlooks communicated by drilling company management teams, and their inability to fix new contracts for the next 12 months, drilling stocks have been punished hard by markets which now factor in the apparently softening market conditions and lowering revenue growth expectations.
What happened to the deepwater playground? Is the deepwater resource extraction already coming to an end after reaching 9% of overall oil supply in 2013 (125m+ water depth)? To understand the future of the deepwater drilling markets, we first turn to the customers, the oil companies, to understand their behavior during the past year.
Oil Companies Cut Spending Growth and Allocate Capital to Shale
Given deepwater exploration and exploitation’s technical challenges, there is only a handful of companies with the setup and competence base to carry out these operations. Only 18 companies globally are currently operating ultra-deepwater (7500m+) production.
Many of these companies have dividend policies and other capital discipline instruments to relate to, making their free cash flow a key performance indicator. As such, to maintain margins (which eventually drive free cash flow), in the event of an oil price drop, companies typically reduce their investments. That was the case during the 2008-2009 oil price shock, where we saw oil companies cut back their investment programs.
Although not as drastic as in 2008-2009, and not triggered by an oil price collapse, we are seeing similar behavior today; capex growth is reduced and immediate cash projects are prioritized. In a world where immediate cash has high priority, unconventional shale projects in North America have proven as attractive investment candidates.
Marathon Oil and Talisman’s current efforts to exit the North Sea, partly to focus and pursue more opportunities in the North American unconventional space, provides anecdotal evidence that the economic features of these plays speak to oil companies in the current economic environment.
Examples of companies disfavoring the deepwater space as an investment arena include BP’s postponement of US GOM Mad Dog phase II and Chevron’s postponement of its UK Rosebank project. Moreover, in the current environment, exploration efforts are typically one of the budget items at risk, given the long time to positive cash contributions.
The forecasted, lowered, exploration expenditure in Norway for 2014, (to come down by 12% by Statistics Norway) serves as anecdotal evidence of this. In such an environment, the scene is set for lowered market sentiments for deepwater drilling services in the short term.
But are deepwater drilling markets already coming to an end? Our analysis suggests not. We highlight three drivers that point to continued growth in deepwater drilling markets.
Driver 1 – A robust deepwater inventory
During the past decade, around 50% of the global floating drilling fleet has been allocated to exploration efforts (Figure 4), an activity that has yielded results. The total material resource base in deep water currently amounts to about 230billion boe, of which almost 70% is not yet developed into production (Figure 5).
Among these barrels are high-quality discoveries, with breakeven prices competitive with alternative upstream investment opportunities. We are confident that these will play a key role in supplying the ever growing global demand for oil and gas. As such, the future of the deepwater rig market does not hinge on growth in future exploration levels, as we expect a turn to development drilling – a driver with far more predictable and robust features.
Driver 2 – Capacity needed for infill drilling
Once past the initial investment of an offshore development, infill drilling opportunities could offer significant economics and even satisfy oil companies’ immediate cash flow generation requirements.
The rationale is simple; once the capex for installing export infrastructure (floating production units, subsea equipment, etc.) is spent, the economic benefit of keeping this infrastructure alive is added to the value analysis of an incremental well in that field.
This is especially the case for fields that were sanctioned, and developed (with respect to number of wells), based on oil prices lower than at present. Our analyses suggest that drilling targets containing as little as 1MM boe could provide healthy economics, based on current oil prices, and we believe this is a vastly underestimated activity by other analysts. Evidence of this includes the Troll oil field in the Norwegian sector of the North Sea, where Statoil and partners are stepping up drilling efforts, utilizing four semisubmersibles in parallel, for the foreseeable future.
Driver 3 – Capacity needed for other work
Drilling is the first and obvious activity that comes to mind when analyzing rig demand. However, rigs are full lifecycle workhorses, adding services during the entire lifetime of an oil and gas field. Fields call for activities such as well workovers and plugging and permanent abandonment of decommissioned production wells.
This part of the demand, often not recorded as drilling days, will constitute an increasingly important and inevitable part of the floater demand in tomorrows’ markets. Comparing contracted floater capacity with recorded drilling days, in seven key offshore nations, enables us to visualize this trend (see Figure 5). As seen through the parameter drilling days per contract year, the fleet has ever less time available to do what we expect to be the main job—drilling. The maturation of deepwater basins will make sure this trend continues, and we will see, as we have seen for jackups, more of the capacity being allocated to non-drilling related activities.
Not an End, Just a Growth Pause
Coupling lowered upstream investment willingness with a rapidly increasing rig fleet has created the market sentiment in which we are in the midst of—a cooling down for the deepwater drilling markets.
However, with no abundant sources of easy oil available, deepwater production will play a key role in tomorrow’s energy supply, and the project backlog is already proven. Our analysis does not find any basis for the deepwater drilling market growth coming to an end, but certainly sees the rationale for oil companies to lower short term investment growth.
Long-term, likely triggered by increased oil prices, we will see the demand once again outpacing supply, resulting in the need for added capacity. This scenario will play out before reaching the next decade, and as such – we cannot wait for too long before contracting more rigs.