Measuring competition in the offshore drilling market

According to basic microeconomic theory, perfectly competitive industries are characterized by unrestricted entry and exit of firms, large numbers of firms, and undifferentiated (homogenous) services being offered.

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Analysis finds jackup market unconcentrated; floater market moderately concentrated

Mark J. Kaiser
Brian F Snyder
Center for Energy Studies
Louisiana State University

According to basic microeconomic theory, perfectly competitive industries are characterized by unrestricted entry and exit of firms, large numbers of firms, and undifferentiated (homogenous) services being offered.

In the final part of this series, we consider whether the offshore drilling market is competitive based on a qualitative examination of these factors, and characterize the market concentration of the sector.

Barriers to entry

Significant barriers to entry exist in the offshore drilling market. Over the past decade, newbuild jackups have cost between $150 and $300 million to construct, with floaters costing between $500 million and $1 billion. Firms entering the industry typically build three or more rigs to take advantage of economies in the construction process and in administrative costs. It is difficult to raise this amount of capital to enter a mature and competitive industry.

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New entrants may enter through the secondhand market, which is cheaper than the newbuild market, but this depends on availability and also carries risk since old rigs tend to receive a lower utilization and day rate than newer rigs, and may be less able to compete.

Successful entry also requires significant human capital. A high degree of specialized knowledge is necessary in management and operations positions; most often, this kind of talent is only available to those already in the industry or recently retired. Drilling is an intangible service and contractors are difficult to evaluate without prior experience. For an operator, a good prior experience with a contractor creates customer loyalty.

New entrants

New entrants do not have the capital to compete across multiple regional and water depth markets, and usually specialize by region and/or rig class. Recent regional specialists include SeaWolf Oil Services in Nigeria; PV Drilling in Vietnam; Seahawk in the US GoM; Sete Brazil in Brazil; Aker Drilling in the North Sea; and GSP in the Black Sea. With the exception of Sete Brazil and Aker Drilling, all are jackup specialists. In some cases, entry by regional specialists is facilitated by laws favoring locally-owned firms (SeaWolf Oil Services and Sete Brazil) or is by a state-owned drilling contractor (PV Drilling). Scorpion Offshore (jackups), Hercules Offshore (jackups), and Songa Offshore (semis) represent class specialists.

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Seadrill is the most notable new entrant. Seadrill was established and listed on the Oslo Stock Exchange in 2005, and grew by acquiring Odjfell, Smedvig, Mosvold, and Scorpion, and through an aggressive newbuild campaign. In 2012, Seadrill was the largest drilling contractor in the world as measured by market value.

Mergers and acquisitions

A number of mergers and acquisitions have consolidated the industry over the past two decades. Recent mergers and acquisitions include Ensco/Pride in 2011; Transocean/Aker in 2011; Noble/Frontier in 2010; Seadrill/Scorpion in 2010; and Global Santa Fe/Transocean in 2007.

Competitive advantage

Much of the impetus behind industry consolidation is the competitive advantage associated with a larger capital base and greater asset diversification. Size implicitly incorporates a degree of diversification by geography, rig class, rig quality, contract duration and customer base. Large companies benefit from greater asset diversification, financial resources and liquidity, and economics of scale, and can withstand shocks or market downturns better than smaller firms. Large companies also tend to be correlated with other characteristics such as market power and diversification. Mergers are a critical growth strategy for large-cap contractors and are a means to renew and upgrade their fleets without entering into newbuild construction.

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Number of firms

In the 1980s, there were approximately 160 drilling contractors, and the top 10 firms owned between 35% to 40% of the total rig fleet. Between 1989 and 2004, the industry experienced a prolonged downturn and consolidation eliminated nearly half of the contractors. Since 2004, the number of firms has increased and new entrants have emerged to take advantage of high day rates and greater access in regional markets. The top 10 drilling contractors in 2010 owned slightly more than half of the world fleet.

Industry concentration

Economists use a variety of measures to assess the concentration of a given industry. Common measures include four firm concentration ratios (CR4), eight firm concentration ratios (CR8), and Herfindahl-Hirschmann indices (HHI). CR4 and CR8 measure the percentage of sales accounted by the top four and eight firms in the industry. The HHI is the sum of the squared market shares of firms in the industry.

Using contracts (not sales) as the evaluation unit, with each contract considered one unit of market share, industry concentration measures were calculated for the offshore drilling market in 2010.

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The floater markets are more concentrated than the jackup markets, and the top four firms accounted for over half of the jackup market and nearly 70% of the semi and drillship market. The eight largest firms accounted for approximately 80 to 90% of the industry in all three markets.

Market concentration measured via HHI increased in the US GoM jackup market as several firms left the region, but declined in Southeast Asia and the Persian Gulf as new firms entered in response to growing demand. In the floater market, concentration declined in West Africa and Southeast Asia, but remained relatively stable in the North Sea and GoM markets over the decade.

According to accepted criteria for determining market structure, industries with HHI below 1,000 are considered unconcentrated (i.e. more competitive); industries with HHIs between 1,000 and 1,800 are considered moderately concentrated (i.e. moderately competitive); and industries with higher HHIs are considered heavily concentrated. Based on these criteria, the offshore drilling jackup market continues to be globally unconcentrated even after an increase in merger activity, while the floater market is moderately concentrated. On a regional basis, a higher degree of concentration is apparent.

Firm competition

Firms can influence prices for their services by differentiation through technology, safety record and crew experience, and using marketing to establish company loyalty. However, by the nature of their operations, drilling rigs are relatively similiar, providing a homogeneous product (wells) via the drillbit. There is little substantive difference between rigs of the same generation and across generations, when upgraded. While there may be some instances where service differentiation is important, these are expected to be isolated. Crew experience may be a significant factor, but is difficult to measure. Overall, the market is commodity-like in nature which impedes the ability of firms to differentiate their products.

Barriers to entry, market size and other factors impact competition among firms, but it is difficult to quantify the magnitude of this effect, and it seems unlikely that individual companies are able to significantly influence market prices. Overall, the market appears competitive with potentially transitory non-competitive periods in certain concentrated regions or specialized markets.

Editor's note: This article is the last in a three-part series by Mark Kaiser and Brian Snyder on the offshore contract drilling market.

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