Driller consolidation begins, but will it continue?

Has the tide begun to turn? For years, a number of leaders in the drilling business have called for consolidation among contractors. Now, the first major consolidation has occurred. Transocean Offshore and Schlumberger's Sedco Forex have combined to create the largest drilling company in the world. The new company, to be dubbed Transocean Sedco Forex, will have a rig fleet of 75 mobile offshore drilling units and a work force of around 7,500 employees.

Dan Pickering, a stock analyst with Simmons & Company International, which advised Transocean in this deal, said the merger might usher in further industry consolidation. Pickering called this deal the first real merger among the drilling companies that has resulted in the creation of a competitor with significant market share.

Historically, in the late 1970s there was a huge influx of companies interested in building and operating floaters. This growth spurt left the industry very fragmented with newbuilds owned by a wide range of companies.

It has taken almost 20 years for one player to emerge with significant market share. Pickering said the marriage of Sedco Forex and Transocean will produce a drilling company that commands a large share of the worldwide floater fleet. While this does not change the effectiveness of the other players in the market, it should prompt them to revisit the merger question. If these competitors are substantially smaller than Transocean Sedco Forex, it could hurt their competitive advantage. On a combined basis of floater fleet capability, Transocean Sedco Forex will hold 24-25% of the market, while the next larger competitor holds only 10-15% worldwide.

These existing competitors may not feel threatened by the merger because they are still capable solid suppliers, but they have to think about the future. "You probably do need more consolidation to truly affect the industry," Pickering said.

More consolidation

What if the industry starts to consolidate? What if Transocean Sedco Forex buys another company? Or, what if one of the new super majors, such as BP-Amoco, decides it wants one global supplier.

This merger may not directly lead to other consolidation, but it forces everyone in the industry to rethink their strategic planning and consider options for future growth.

"It's a wake-up call. It's the catalyst to force people to re-visit their strategic thinking," Pickering said.

While there may be ripples across the drilling industry, the producers are still in the driving seat. It will take far more consolidation to have any affect on the dynamics of the industry, which Pickering said is tilted strongly in the favor of the producer, due to the current supply/demand imbalance.

The advantages of consolidation for the industry are a smoothing of market volatility. A large drilling company with a huge fleet would be able to stagger its contract maturities so that short-term changes in the price of oil would not have such a devastating affect on day rates and profits. Pickering said this strategy would be similar to portfolio management, meaning the more rigs a driller owns in any class, the more flexibility it has to manage those assets.

Before there are further mergers among drilling companies, Pickering said the companies have to figure out if they are buyers or sellers. Smaller companies are more likely candidates to be purchased. Still the idea of two major players tying the knot is attractive. Pickering said it is harder to negotiate a lot of smaller deals as a method of building a fleet.

From the perspective of the amount of work involved in the transaction, a big deal and a small deal aren't that different. There may even be a less emphasis on economics and more on emotion in a smaller deal. Small transactions still require a significant amount of work and the owners are more likely to have qualitative factors that influence the decision-making process - emotions can sometimes overrule economics.

Industry response

Industry response to the merger has been favorable. Larry Dickerson, President and COO of Diamond Offshore said, "I am glad to see it. We were the largest driller in terms of market capitalization. So we are being surpassed, but I would still rather compete with fewer larger companies than several smaller ones. It is unclear yet how the merger of equals will work out, as to what philosophies will come out, or where it will be blended. So, it is difficult to say how it will be to compete with them."

Bob Rose, President and CEO of Global Marine, has been an advocate of consolidation of the sector for many years. "I would have preferred that Global Marine be one of the first companies to start the ball rolling, but I am glad that somebody finally did. The way they did it is exactly what we have talked about all along. We would have discussed the deal that Transocean did with Schlumberger; we wished they had called us first," he said. "I think a number of companies would gladly put themselves in Transocean's shoes for this sort of transaction. They effectively took Sedco and are spinning out as a drilling company and creating a merger of equals with Transocean, and that's exactly what drilling companies are talking about amongst themselves."

Consolidation need

There is a general need for consolidation in the drilling business. Drilling contractors and operators both have long complained about the cutthroat competition in terms of day rates and price gouging. This has been chiefly attributed to having too many players in the market.

According to Rose, the top three participants in the offshore drilling industry only control 27% of the market. This is compared to the top three major oil companies who control 68% of major E&P expenditures.

Rose added, "Most of our industry, with the exception of the offshore drilling and offshore construction companies, has done a pretty good job of consolidation. We have been very poor at it.

"It needs to occur, not because companies need to get larger, necessarily, or because they need to do it for financial survival reasons, but to bring price discipline to our industry. We also need to figure out ways to grow our companies without adding capacity. We can't just build rigs to grow our companies, we need to figure out ways to grow them through consolidation and acquisition."

Sedco and Transocean concur. Davie said, "There was a feeling amongst our senior management that the drilling industry is a bit fragmented at the moment and that larger combinations of drilling companies would be beneficial."

Bernie Stewart, President R&B Falcon Drilling (US), said, "Consolidation is where some of the best staff support can be obtained, and also a way to obtain standardization between the contractors in operations and achievement expectations. It tends to take some of the swing out of contract negotiation. The more everyone agrees to accept those standards, and there is no alternative to acceptance of bad contract terms, then it creates a new low water market that everyone has a responsibility to address."

Dickerson added, "I think its better for the industry if the (consolidated) company is a solid participant in the industry. During the last building boom, there were so many small drillers building for deepwater, that there did not appear to be as much of a barrier to entry that people thought. If there was any overbuilding, where did it come from? If you had fewer larger players, there would have been some more rational decisions on building."

Global positioning

A major benefit to consolidation is the addition of efficiency through better global positioning. Besides the addition of the actual assets, the companies are granted access into other sectors of the world and a broader customer base. For the Transocean Sedco Forex deal, this was a major factor.

"The company now has a global presence, which Transocean did not have on its own," Jeff Chastain, Director of Investor Relations for Transocean, said. "Transocean now has an entreé into the West African and South East Asian market. Sedco will have access to the Gulf of Mexico and both companies will become larger in Brazil and the North Sea. It will make a true global player and create a more diversified and strong customer base."

In addition to adding to the global presence, it can also decrease costs, especially in terms of mobilization. With a consolidated company, Rose said, "If an operator needs a rig anywhere in the world, then one would probably be available. Smaller companies don't have a large amount of geographic dispersion, and they are often precluded from bidding on work. A rig they might available elsewhere would result in a costly mobilization. Consolidation adds efficiency in that it reduces mobilization of rigs. With larger fleets, you can take care of these programs without mobilizing equipment."

Magic number

It appears that the industry consensus is for more consolidation among the contractors. But how much consolidation can take place and how will it be handled - in the merger fashion, or through acquisition?

Stewart said, "Most of the people that are left are a pretty good size. There are not too many of the smaller players. The bigger the companies get, the greater the tendency toward mergers of equals."

Rose agreed. "This is not one-size-fits-all. The common thread running through these is an all-stock merger of equals. It is time consuming to buy these small companies, instead of just buying the rigs. You must obtain scale."

When trying to decide how many major companies will remain, most have looked toward the non-drilling service side as a prime example, where there are three to four major players. These major players have become the "magic number" drilling contractors believe they need for consolidation. "Placing the existing fleet in the hands of fewer companies should bring about better price discipline," Rose said.

Watershed

But the mergers cannot stop there, at least in Rose's eyes. "To ideally accomplish what needs to occur, we need a series of mergers resulting in three or four significant players in this business, each controlling 100 rigs or so. Our philosophy has been to have a balanced fleet. You can't assume that your first transaction is going to mirror your organization. Our fleet is pretty balanced and there is not another organization we could combine with that would give us a balanced fleet. Therefore, our first transaction might skew our fleet toward shallow water or deepwater. The first transaction is not the end game - it's the process."

Chastain added, "We are pretty happy with the fleet that this merger results in, but I'm not saying we are going to sit back and say we have done what we needed to do. I think long-term, the combined company will continue to look at opportunities to enhance shareholder value."

Future mergers

This does not mean that there will be a rush by the companies to merge. Many believe that this will just cause them to reevaluate their positions with regard to future consolidation.

"There have been other companies looking all year long and probably longer at the different combinations that might make sense in their operations," Chastain said. "We certainly spent time looking at the number of possibilities and I suspect others are doing the same. And whether that comes to a point where a decision can be made and agreements and any obstacles to be overcome, we will wait and see."

Rose did not expect a stampede among drilling companies because of the merger. "Companies will probably re-think the discussions that have been going on for an awfully long time with a large number of people."

Holdup

So what is keeping these drillers from narrowing the scale down to the three or four? Most attribute this stall to social issues, in particular, the large egos and personalities that exist in the drilling industry.

The Transocean Sedco Forex agreement effectively began in April and was settled by mid-July. One of the reasons for quick agreement was the lack of social issues, several sources commented. With Schlumberger being the parent company of Sedco Forex and arranging the deal, many feel that the social issues were avoided. This resulted in smoother negotiations and a beneficial agreement.

That may not happen again. Dickerson said, "With other contractors, the social issues are still there. People may believe that this merger is the beginning of a trend. I question whether or not that actually is the case, because the dynamic - the social issues - has not changed."

If this is the case, then the wait for the next big merger may be long. "If the Transocean-Sedco Forex transaction is the only transaction in this business," Rose added, "its not going to mean too much for the industry long-term. But, if more consolidation occurs, it is going to put pressure on all of us to ensure that we are among the surviving players."