When the 80 drillships and semisubmersible drilling rigs and 100 to 110 jackups currently under construction come on the market, the current outlook for spending doesn’t support all of the existing rigs generating earnings and all the new rigs generating sustainable earnings growth.

“Clearly, the earnings forecast going forward – because of all the rigs being added by the offshore industry – is boosting the earnings growth profile of the industry over the next several years,” said Jim Wicklund, managing director, energy research, Credit Suisse LLC, at the 2013 International Association of Drilling Contractors annual meeting on Nov. 8 in San Antonio.

“The problem we see when you get into 2015-16 and those companies take delivery of the brand new rigs, it is much more likely the companies will not as aggressively renew the contracts on the older rigs,” he explained. “Those rigs will have to be stacked, and that will have a negative impact on earnings.”

Matt Conlan, senior analyst, Wells Fargo Securities, added, “If all of the newbuilds that are under construction come in and we keep all of the current rigs running at current rates, we would need to increase spending by about 14% per year for the deepwater rigs and 12% per year for floaters overall. I know we’ve exceeded that over the last few years, but I don’t think we’re going to exceed that over the next few years, particularly with Petrobras taking a pause in its very remarkable upswing in spending. Going sideways or even a little bit down in rig spending is going to be a very substantial drag on overall industry spending going forward.”

Moderating Rates Of Return

The question facing offshore drillers is: “Can the market absorb all the newbuilds coming in?” As Conlan said, the rates of return have been fantastic for speculative newbuilds over the past three years. Rigs that cost $600 million to $700 million are getting day rates of $500,000 to $620,000 (and over) in the Gulf of Mexico.

“Those who were smart enough to jump on the speculative construction opportunity in early 2010 are really going to have spectacular returns to show for it,” he continued. “With rig construction costs increasing a little and day rates starting to moderate on the newbuilds, these rates of return will start coming in a little bit and will still be in the mid- to high-teen [percentile] rather than high teens to low 20s [percentile].”

Pressure On Older Rigs

Of the 80 floaters on order, about 67% already have contracts while only 20% of the 100 to 110 jackups have contracts, Conlan said. “Surprisingly we actually feel a little bit better about the length of service ahead for the older jackups than we do for the older floaters.”

In looking at the market for floaters, he noted that ultra-deepwater spending has increased by 30% per year since 2006. When incorporating mid-water rigs, total floater spending has increased by about 22% per year over that time period. Jackup spending since 2009 has grown to about 20% per year.

Maintaining offshore spending is the key to keeping older rigs active. “For every 1% decrease from the 12% annual growth, we need to retire about four older semis. If we are going to have a 9% spending increase in the floater market because Petrobras is going sideways in its spending, we are looking at one rig retirement or stacking per month.
“It is not quite as dire as the land business where the older rigs are already past the obituary-writing stage, but it is clearly coming,” he emphasized.

For jackups at the current day rates and utilization, Conlan thinks the new rigs can all be absorbed with only an 8% to 10% spending increase. “It’s a lot lower bar we have to cross to keep these rigs running for the next couple of years. We’re a little bit more optimistic that the older rigs in the jackup fleet are going to continue to make money and generate a lot of free cash flow.

“That free cash flow, in my opinion, should be redirected to replacing those older rigs with newer rigs. We do see that occurring throughout the industry,” he continued.

Better Pricing Model Needed

The offshore drilling business has been on a steady march upwards, and business is good, Wicklund said. However, offshore drilling contractors need to figure out ways to become better partners with the operators and to charge more appropriately for the value created and provided.

“The oilfield service sector charges whatever it wants regardless of the day rate you get. That sector has been in a better position. All those rigs starting to drill are work platforms for the oilfield service companies,” he emphasized. “Whether deepwater day rates go up or down or plateau, the rigs are still solid work stations and growth margins for the oilfield services business.

“My point here is that as an industry, you guys need to figure out a better pricing model. You are creating a tremendous amount of value for your customers, and you’re not doing a very good job of capturing it,” he added.

People Are Critical Factor

In addition to pricing in the sector, one of the biggest concerns is people. The biggest thing that analysts worry about is labor cost escalation in the offshore drilling industry. Drilling contractors have to compete with other industries for labor.

“There are 25 chemical plant expansions just in the Houston area. Over the next three years, these are going to require 81,000 full-time employees. Those companies are paying $86,000 per year. I know you have people that make more than $86,000 per year, and they work 28 days on and 28 days off or whatever. They don’t come home every night,” Wicklund explained.

“But, for $86,000 where they get to come home every night and have the opportunity of overtime, that is going to be your competition for people,” he continued.

The highest starting salary in the industry is for petroleum engineers. “ExxonMobil hires the No. 1 petroleum engineering graduate from Texas A&M every year. The story that I heard is that this year, ExxonMobil paid a starting salary of a quarter of a million dollars – for an undergraduate in petroleum engineering. If you don’t think the competition out there for talent is not going to get more difficult, you’re wrong,” he emphasized.

Wicklund was optimistic about the future. “The future is bright. But, the capital discipline, cyclicality of the business, and returns that everyone needs to generate are still issues. As an industry we need to innovate and still generate positive returns because return on capital is going to be an increasingly important point on my side and my industry’s willingness to give you money. You guys need to find ways to capture the value.”

Contact the author, Scott Weeden, at sweeden@hartenergy.com.