On The Path To Success?

Finlay Johnston, 4C Global Consultancy, UK, shares his insight into whether the oil industry is on track for a rig rate super cycle in the North Sea.

ince mobile drilling rigs first appeared on the UKCS in the late 1960s and early 1970s, oil prices have gone through numerous cycles. This has driven rig demand and, consequently, rig price. Looking forward to what could become a super cycle in rig rates, it is crucial to equip ourselves with the best market knowledge we can find to help us chart a course through the challenges to come.

Whilst offshore drilling rigs are unique in many ways, they are also a commodity just like any other: when demand is high, prices are high. It is interesting to note that the market has fluctuated more in the UK section of the North Sea than on the Norwegian side, even though they both charter very similar, and in some cases, the same type of rigs. The key difference is that, in Norway, rigs tend to be chartered for five years or more at a time, whilst average charter durations are shorter in the UK, resulting in faster changes to pricing.

The UK has therefore always been seen as a rig ‘spot-market’ that does not offer the relative stability of the Norwegian market –or at least that is how it was until everything changed in 2014. Since then, there have been several industry developments which have

The collapse

In 2014, the oil price collapsed and most of the world’s mobile rigs had no work. At the same time, there was a historically large number of rig owners at play, creating fiercer-than-normal competition for work. As a result, rig day rates reached new lows, and a considerable number of rigs that could not find work were stacked in sheltered waters such as the Cromarty Firth in Scotland. Adding to the ‘perfect storm’ for rig owners was the fact that the drilling industry was carrying an unprecedented level of debt, meaning that fleets required high long-term day rates to service their debt and continue paying shareholder dividends. Adding to the pain in 2014 was the fact that the majority of the world’s 1970s and 1980s-built rigs were nearing the end of their working lives. This was a drilling industry where work prospects had evaporated, large numbers of old rigs stood idle, share prices were tumbling, debt default was escalating, and any road to recovery was hard to envisage.

To survive, drilling contractors needed to adapt their business models quickly and dramatically, through massive cost cutting and debt restructures. This had a very real human cost, with large-scale redundancy programmes of rig crews and onshore staff. It also triggered the industry’s first fleet rebalancing, with owners electing to scrap large numbers of rigs. At first, older units were scrapped. But, as the downturn continued, more than 100 relatively-modern rigs were decommissioned and sent to scrapyards. An industry-wide debt restructure also began, with drilling contractors filing for ‘chapter 11’ creditor protection whilst they renegotiated their respective bank and bond obligations. Tens of billions of dollars of debt were lost during this process, with many financial institutions recovering only a small portion of their original lending. The result, however, was a leaner and more fit-for-purpose collection of drillers that were able to survive in a low-margin environment.

Following on from this, ‘fit’ drilling companies became easier to compare in terms of their valuation. This in turn triggered the next phase of the post-2014 drilling industry metamorphosis, whereby a programme of consolidation began.

The recovery

The consolidation led to a still-reducing number of drilling companies through mergers and acquisitions, the purpose of which was to reduce the customer’s choice of rig provider, achieve greater market pricing leverage as a consequence, and maximise returns to battle-weary drilling contractor shareholders. As a result of this, the drilling industry will soon comprise of a small number of rig owners, with most electing to become ‘pure players’ by specialising in only one rig type in order to further strengthen their leverage. This small pack of drillers will push hard for rate increase against a backdrop of reduced rig supply and increasing demand driven by higher oil pricing and the need for non-Russian crude.

The drilling industry is comprised of various rig sub sectors such as deepwater drill ships, harsh environment semi-submersibles, and commodity jack ups – to name but a few. Despite the strong market recovery that is underway, each sub sector is recovering at a different speed for a variety of unique reasons. In the UK, harsh environment semi-submersibles have always been prevalent, but this fleet has endured an above-average level of scrapping over the last eight years, leaving only a handful of active and stacked rigs. What is three today would once have been a couple of dozen that were constantly active.

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The main reason for this is that the UK fleet was predominantly older, ‘vintage’ rigs that were ripe for scrapping. Additionally, regional day rates saw one of the sharpest industry falls from circa US$400 000 to US$100 000, resulting in some larger multi-national rig owners losing interest in the basin.

Rig demand and supply

UK rig demand is clearly increasing, especially following on from recent investment tax breaks. However, it is increasing relatively slowly. A slow increase in demand results in a slow increase in day rate increase. This all changes, however, when the region edges close to running out of rigs, and then day rates suddenly surge.

Working out how many rigs are available in the region is not as easy as it may sound, as some active rigs that have near-term contract end dates are highly likely to remain with the same customer if the contract has an option for extension. Several units have been secured either through direct negotiations, or simply by extending contracts. Both are key indicators that there is concern in the boardrooms that costs will escalate, and so the decision has been made to avoid the risk of a sudden increase in day rates, cost of change, and rig acceptance.

The next supply uncertainty relates to a small number of rigs that have avoided being scrapped, but instead have been stacked for years. These require considerable reactivation costs that can be funded by either a confident rig owner or a desperate rig customer. Either way, it is not abundantly clear how these stacked rigs are viewed in terms of supply, and it very much depends on where we are in the cycle.

The final uncertainty relates to incoming rigs. The UK is a protected market, as only rigs with a high technical capability can enter due to legislative requirements. From the rigs that can enter the UK, most are very high-spec units that are happily working in other regions on longer-term high day rate contracts. That said, there are still a few obvious contenders which would sit well in the UK market for drilling, intervention, and P&A, such as Dolphin Drilling’s Bideford and Borgland semi-submersibles, which are currently smart stacked in Norway.

Industry analysts state that there are currently almost four times as many customer rig enquiries as there are available rigs in the UK. This tells us that oil companies are confident about drilling and are in the final stages of their deliberation. With factors such as constantly high oil prices, significant new tax breaks, a new political will to utilise the UK oil resources, and investment flowing into oil companies, one may be tempted to ask why they are taking so long to deliberate when rig availability is already limited? Oil companies will have their own reasons, but what will trigger change is when the realisation that supply is tighter than they thought and the fear of missing out strikes. When customers realise that there is a real prospect of ending up with no rig, rates will spike in the fight for the last rig, and the super cycle will arrive.

Conclusion

In this type of market, there will inevitably be winners and losers. Rig owners will win as revenues and margins increase and rig crews will win as wage inflation kicks in due to limited availability of experienced personnel. Specialist industry suppliers, such as drilling tubular and tool providers (as well as well planning companies) will see a dramatic increase in demand too. The losers will be oil companies who wanted to drill for oil but waited too long and ended up with rigs that were so expensive that they test the limits of the field of economics – or no rig at all.

Whilst non-value adding works would typically be delayed in the current climate, this time there are several operators that are still committed to reducing liabilities that run into hundreds of millions. Again, this will only add to the removal of assets, thus constricting the market further.

So, what about the all-important day rate? In the newly-balanced drilling contractor landscape, and against the backdrop of a clear need for oil, recovery is underway. Consequently, there is no doubt that key locations such as Aberdeen, Scotland, will be energised once again, albeit not quite to pre-2014 levels.

Figure 1. Dolphin Drilling’s semi-submersible, enhanced Aker H-3 – The Borgland Dolphin.

Figure 2. The semi-submersible holds a current UK safety case.

Figure 3. The Borgland Dolphin is an ideal contender for both UK and International mid water work scopes.