Lengthy contracts prevent rig use collapse in wake of soft oil prices

There was even perceived to be a shortage of rigs, especially ones suitable for deepwater, which led to operators paying high day rates and signing long-term contracts so they could have rigs available to work their projects.

Even when prices began falling in early 1998, it was viewed as a temporary market aberration that would pass, and operators kept seeking increasingly hard-to-find rigs in the busy Gulf market. The party began to thin in mid-1998, however, when prices kept dropping. By the time most concluded the oil market was in over-supply, companies had overextended themselves on personnel and (sometimes extremely expensive) rig contracts.

Producers respond
Some of those offshore drilling rigs started coming off contract in late 1998, leading to a dip in mobile rig utilization. As rig utilization rate worsened, day rates began falling. This single factor probably kept more rigs working, as some producers saw an opportunity to drill more wells for less money.

A few producers even increased their exploration budgets to take advantage of this opportunity. Those companies had the financial reserves to keep operating in low-price commodity environments, but even they suffered eventually. It was quite a bit more common to simply cut exploration budgets.

The budget shortfalls caused by getting far less for oil and gas than expected affected the industry at large. One common reaction was to look for merger opportunities. For example, Arco attributes its merger overture to the recently combined BP Amoco to low oil prices. Service companies also contributed to this developing merger mania.

Another method to keep afloat was selling assets. Several companies refined their exploration and production focus to a certain area and sold off other assets. Layoffs were inevitable.

Amid the chaos, exploration activity was put off or simply canceled. Production growth targets fell by the wayside as companies strove simply to maintain net income and return on capital numbers. In the rat-race of Wall Street, continuing poor performance can be a self-perpetuating spiral. Shareholders and market analysts, who both tend to look at the short term, were pleased with production cuts because the bottom line didn't look quite as bad. Unfortunately, in the long term, lack of exploration means lack of producible reserves when they are needed.

A supply shortfall will occur if exploration in the Gulf of Mexico and elsewhere remains at a low level for some time. Just as important and far more noticeable in the short term, many workers who depend on exploration activity for their livelihood are out of work.

Current situation
While this is being written in early May, oil prices have bounced sharply back up to $18.98/bbl, up from a period low of $10.83/bbl in December. This appears to be mainly attributable to harmonized OPEC and non-OPEC production cuts announced in March.

At the present, it is impossible to determine whether the higher oil prices are sustainable. In the accompanying graphs, Gulf of Mexico rig utilization is on the way up, reaching 64% from a low of 58% on April 12. Again, sustainability is in question.

If oil prices remain high, rig utilization may creep back up into the vicinity of levels last experienced in mid-1998. But if OPEC members - who are more tempted to raise production as prices rise - begin cheating, supply will increase and oil prices weaken.

High oil stocks will force down oil prices again, and inevitably affect Gulf rig utilization rates and the industry that serves exploration. This could have serious effects if these commodities are needed suddenly.