Drilling recovery: Is it here, or do we have farther to go?

Recovery won't be business as usual

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While one analyst believes a drilling recovery is right around the corner, drilling contractors have differing opinions concerning a solution for depressed day rates. A day rate recov ery could develop as early as January 2000 and as late as the third calendar quarter of 2000, assuming oil prices remain in a reasonable range.

Mergers in the industry, gradual recovery of demand, and continued oil-price stability are key factors in the recovery of day rates, according to Global Marine President and CEO Bob Rose. While another major figure in the drilling market, Bob Palmer, President and Chairman of Rowan, agrees with these factors, he adds that a key factor triggering demand will be lease expiration.

Aggressive exploration by independent exploration and production companies are a major key to recovery, according to industry analyst Matt Simmons of Simmons & Company International.

With the recent recovery and stabilization of oil prices, thanks mainly to OPEC's production restrictions, the offshore upstream industry is gradually emerging from hibernation. But, what will it take to return the industry to its former prosperity?

Price stability

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No one wants to see oil prices climb much higher, according to Rose, president of one of the world's largest drilling contractors. Current oil prices ($20 range) are attractive to operators, but not so high that they tempt OPEC to lift production limits. Rose said the key to a smooth recovery is not a higher per-bbl oil price, but a sustained period of reasonable prices combined with increased consumption.

There will never be a real recovery until the surplus production now in storage is consumed. Rose said OPEC is sitting on its excess capacity to artificially inflate prices. This is necessary, he explained, because even with the low recovery costs in the Middle East, no one can make money at $12 a bbl.

Still, the OPEC move is a temporary solution and will not bring any real confidence back to the industry. Past experience has shown that it is difficult for the OPEC cartel to maintain cooperation among its members over the long term. At best, these restrictions are buying the industry some time. To fully realize a better tomorrow, the industry is counting on increased consumption.

Consumption as a driver

An increase in consumption would quickly erode the shut-in excess capacity of OPEC, effectively removing the option of opening the valve and flooding the market with cheap oil, which is the chief fear of investors and operators. Once consumption grows, then the current oil price will be sustainable.

Rose said this is the primary reason he and many analysts favor a moderate price for oil and gas. The key is not the profit made on one bbl of oil, but the message a moderate price sends to the market. An oil price of $20/bbl is affordable and profitable, so it encourages increased consumption and guarantees a reasonable profit. If the price spikes up past $24-25/bbl, consumption will tail off and a backlog of shut-in production will develop again.

Driving up day rates

Establishing a moderate oil price assumes that OPEC can maintain discipline at least until consumption recovers. At that point, profits will be reflected in higher rig utilization and increased day rates. Palmer said the key to improving day rates is simply demand. "Rig count and day rates run together, and day rates are much more volatile than the rig count."

He added that some of the fluctuation in the rate can be attributed to changes in the market when demand increases. He said, "A lot of people may get out of the spot market and go into the so-called time charter or longer term contract, which then takes them out of the market. That is why you see these spot market rates ratchet so quickly. Fewer and fewer rigs are available in the spot market.

"The top of day rates over time will always level out at about 80% of replacement cost. So, if you go through a theoretical model of what it takes to put a rig into service, rates will peak at about 80% of that."

US Gulf market

Some sectors already are experiencing a dramatic increase in utilization, Rose said. Specifi cally, the jackup MODU market on the continental shelf of the Gulf of Mexico. This area is adding rigs almost daily. "The worst is behind us there," Rose said.

Palmer agrees. "The trigger point in the Gulf of Mexico appears to be about 140 drilling rigs (according to the Offshore Data Services mobile offshore rig count). When we flirted with 140 rigs a few weeks ago, we started to see day rates move. Now, they are up to 146 and continuing to move. They will take another jump at about 150 rigs. They could easily double again, if the rig count gets up above 150, and it appears to be sustainable at 150."

This is a result of the strengthening of the domestic gas market in the US and the fact that these rigs are very versatile. A jackup can be mobilized quickly to access a shallow-water gas field, in response to an increase in demand. These rigs are typically "hot stacked" on the coast line with minimal crews, awaiting the opportunity to drill profitably for gas, once the price recovers. The day rates for these rigs have increased as much as 40% over their recent low, Rose said. This translates to an increase of $19,000-29,000/day.

At the same time, Rose said, the ultra-deepwater market was not affected by the recent dip in prices. These super modern rigs are tied up in long-term contracts on fields where the investments are very large. The operators could not afford to let their options on these high-dollar leases expire. At the same time much of the drilling going on in deepwater is exploratory.

The thinking is to drill as many holes as possible while the price is low. By the time the oil price recovers, it is likely there will be a number of these new deepwater fields ready for production.

West Africa market

West Africa is one area that concerns both contractors. Though it appeared early on that this booming area would escape the industry downturn, it was just slow to respond. While rigs were cold stacking up and down the US Gulf coast, West Africa was happily accepting the excess for work on new fields. This, Rose said, is no longer the case.

West Africa is in the midst of its own day rate slide - partly a delayed response to the drop in oil price, and partly a result of the region's political instability, Rose said the industry has not yet seen the worst from West Africa. "I think we're still a year away (from day rates bottoming out) in West Africa," he said.

While Rowan does not operate in the West African market, Palmer said he does keep an eye on it, at least in terms of stacked rigs. "Some places have good politics, but poor geology. West Africa has beautiful geology, but poor politics. That is what is creating the turmoil there. The situation causes the rig count to go up and down by 10-15 rigs at a time. For example, when Nigeria and Angola have political problems at the same time, you see a lot of rigs being stacked," he said.

North Sea market

The contractors see the worst of the downturn still afflicting the North Sea - the most mature of the major offshore theaters. "The big problem at the moment is the North Sea, where the geology looks good, but the problem is economics and politics. As a result, you see a lot of idle rigs," Palmer said. "We have moved four of our rigs out of the North Sea this year, and we only have one rig currently working in there," he added.

Rose said there is a broad trend downward in day rates in the region. The North Sea requires a unique class of rig and thus has its rigs tied up in long-term contracts. This practice shields the day rates in the short term. Because of this, Rose said the North Sea is the last theater to see the day rate decline and thus will lag the rest of the world in recovery time.

"There is no work in the North Sea and there is work in the Gulf of Mexico and Eastern Canada," Palmer said. "I keep saying over and again that the reason we call these mobile offshore drilling rigs is they are very mobile and we can move them with a minimum amount of cost from one area to another."

Brazilian market

Another key market contractors are looking to for some added cushion is the new Brazilian market. With the first licensing round, Brazilian industry is gearing up for the first internationally operated well.

Gavin Strachan, Director of Bassoe Offshore Consultants (UK), a company that tracks rig activity, said that Brazil appeared to be a guaranteed bright spot for deepwater floating rigs - more so than anywhere else. "But, you need to see it in context. There are going to be 20 or so rigs working in Brazil. Out of the total fleet, that is not a lot of rigs."

Rose concurred and said that it will have a positive effect on the day rates for the ultra-deepwater, but overall, it is not going to be a large factor."

Consolidation

In 1996, oil prices began a steady march upwards and day rates seemed to follow in lockstep. In no time at all, activity resembled an oil boom, but was followed soon afterward by a bust when oil prices slipped. Now, prices have recovered to a level that appears maintainable, assuming again that OPEC remains vigilant and global consumption picks up. The large question is why has this recent price surge has not produced a recovery in drilling activity?

Rose explains that this prolonged recovery is the unattractive side effect of industry consolidation, which itself was a result of recent low oil prices. Companies in the midst of massive consolidation have internal audiences, investors, government regulators, and customers they must answer to. The mechanics of merging two major service companies or two major oil companies is staggering by any scale.

Some of these mergers will result in the largest companies the world has yet known. An organization preoccupied with such a historic effort has little time to conduct day-to-day operations. What happens, Rose says, is that new drilling programs are put on hold while all the details of the merger are sorted out. The unavoidable reductions in staff that accompany these mega-mergers also upset the relationships contractors have with operators. Often, the person who was planning the drilling program in the past has been reassigned or laid off.

Not business as usual

Even after the merger storms blow themselves out, Rose said he doubts the oil industry will return to business as usual. Oil companies are not quick to dismiss the painful lessons of the last 18 months. With such short-term uncertainty about oil prices, a number of the majors will be looking for programs that return a profit with oil prices as low as $14/bbl. Such fields exist, but they are not nearly as common as those with a return for $17/bbl.

This very conservative approach is not unusual, Rose said. He predicts that if the oil price remains stable, then next year these companies will be able to justify projects with a greater level of risk (assuming an oil price of at least $17/bbl).

As things stand now, Rose said he would expect this process to be complete enough to affect rig utilization as soon as the third quarter of 2000. Of course, any estimate of recovery not only assumes the mergers will progress smoothly, but also that OPEC will maintain discipline among cartel members to support prices long enough to allow recoveries in consumption to deplete excess reserves and thus deliver a truly sustainable $20/bbl for oil.

"All bets are off, if oil prices drop," Rose said. The ongoing recovery in the Asia Pacific region bodes well for this scenario. Rose said that once Asia/Pacific gets its house in order, OPEC will be able to increase production and start affecting depletion of reserves.

Independents step in

Once merged companies begin settling into day-to-day operations, Rose said they will begin trimming their combined portfolio of offshore leases. This will be of great benefit to the industry. Many of the discarded leases will be picked up by independent companies interested in moving quickly on drilling programs.

The independents are the only operators that are aggressively drilling at the moment, Palmer said. "Eighty-five percent of the rigs working on the shelf today are working for independents. In fact, we have 17 rigs in the Gulf of Mexico, and they are all working for independents. It may be the first time in 30 years that we have not had a rig working for a major oil company," he added.

Within the independent market, Palmer pointed out that lease expiration is going to be a huge factor, especially in the Gulf of Mexico. He said that over the next three years, 1,240 leases under 200 meters of water will expire in the Gulf of Mexico. More than half of those leases belong to independents.

"We are talking about a substantial number of leases expiring. That is going to continue to drive demand. So there are some good solid reasons to be drilling wells out there."

Technology and depletion

There is a lot of discussion about the value of high technology in the industry. Technology has allowed drilling and production to move into deeper water, not only by making such drilling possible, but by making it profitable. Early production, Rose said, is a key component in the economics of many deepwater fields.

Likewise, rapid depletion plays a role in containing costs and allowing operators to realize profits quickly. Rapid depletion and early production have a less obvious benefit for drilling contractors. As drilling becomes more efficient, on and off the continental shelf, the need to find new fields increases.

Gas wells in the Gulf of Mexico, Rose said, typically deplete at a rate of about 20-25% per year. Thanks to new technology, ranging from 3D seismic to improved drilling techniques that minimize formation damage, these wells are currently depleting at twice this rate, or 50-55% per year. This is more money in the operator's pockets, but it also means the wells are fully depleted twice as fast, increasing the need to drill for new reserves.

Rig fleet size

With the last boom in activity there were a number of new vessels built for deepwater drilling as well as a wide range of upgrades for existing rigs. For the foreseeable future, Rose said, there should be plenty of deepwater and ultra-deepwater rigs to handle the required drilling. The area, he said, where there may be a coming shortage is in production vessels.

There are a number of innovative floating concepts hitting the market, but even so, Rose predicts there will be a tight market for production vessels. Rose said the new ultra-deepwater drillships his company is building will have storage capacity designed specifically to make them viable candidates for conversion to production vessels when the time comes.

The logic of such a market shift is simple. While there is an exploration drilling boom taking place in deepwater around the globe, eventually there will be a production boom, as those successful finds are completed and production brought to market.

Major confusion

Simmons said most day rate estimates are driven by what the oil companies tell their contractors. This may seem to be set in stone, but the fact is, what oil companies say and what they do are two different things. "Oil and gas companies are totally lost in a maze of utter confusion," Simmons said.

It is interesting to note how conservative the majors have become while some independents are getting quite aggressive. Simmons gave the example of Coastal, which is building the new Buccaneer gas pipeline to supply Florida. To feed this new line, Simmons said, will require a 7% increase in gas production from the Gulf of Mexico. To shore up this proposal, Simmons said Coastal has become the number one driller in the US. The industry has a significant task ahead just keeping the lights on in Florida.

The independents, four or five at least, are trying to crank up drilling activity as fast as they can. They want to secure rigs while there are bargain rigs to be had. While it may be true that West Africa and other markets are lagging behind the US Gulf in rig rate recovery, Simmons said there were a lot more bids out in mid-November than there were at the beginning of October. "This whole situation is much more fluid than all the pronouncements the contractors are getting from their customers," he said.

Turnaround in four

Rig rates rise, according to Simmons, when supply and demand lines come together. The raises the question: Where is demand? Simmons said even if the US Gulf of Mexico continues to outpace the rest of the world in recovering day rates, at some point, it will begin siphoning rigs out of other markets, such as West Africa. And, this should stimulate higher rates for the remaining rigs in that market. If West Africa remained dormant, while day rates in the Gulf of Mexico doubled, day rates there would move up.

Simmons expects to see a recovery in drilling between one and four months from now. All of the exploration and production companies will observe how low their production rates are and how high their cash position is, and they will go back to work. There will also be fear developing among oil companies of being the last one to move, resulting in having to pay the highest day rate.

This will happen quickly, but it can only grow so far before the mistakes of the past will result in problems. Simmons estimates the industry can increase activity levels 15% from where they are today before running out of people. Contractors have enough rigs to increase drilling further, but contractors don't have the manpower either.

Labor shortage?

Due to the most recent round of layoffs, Simmons said, skilled and unskilled labor will be hard for the oil industry to find, especially in the US. He cites the fact that the US unemployment rate is near a 30 year low. This makes it difficult for any industry to find qualified employees.

The recent round of layoffs in the oil industry has added to its reputation as a boom-and-bust employer. The painful process of recruiting new workers before the recent bust will be more difficult this time around. "We have to have the most unattractive sales pitch for new employees in the US," Simmons said.

When the oil service industry laid these people off, they were responding to their customers who told them the oil price would be at $10/bbl for the next 5 years. The downsizing was in response to poor prediction by oil sector analysts. "How someone could ever believe we would have $10 oil for five years is just an utter embarrassment," Simmons said.

The response to this negative prediction was swift and severe. Simmons estimates that include such companies as Halliburton Energy Services, Schlumberger, and Baker Hughes, as many as 30,000 workers were laid off in the last two years. These people will be hard to win back and difficult to replace.

The industry wasted the decade of the 1990s, Simmons said. "It really is a tragedy. We should have been in training for tackling deepwater. The industry should have built even more rigs than the 30 it is now struggling with. Rather than laying off, the companies should have worked to recruit more people. "We basically wasted a decade," he said.

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