A case for optimism in the offshore rig market, despite shale growth

Offshore rig counts have continued to slide over recent months, despite the recovery in oil prices. Offshore rig market conditions are expected to remain challenging in the near-term as shale output surges. But in the longer term, growth prospects will be more positive.

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Nathalia Jewell

Anne-Fleur Plassais

McKinsey Energy Insights

Offshore rig market conditions are expected to remain challenging in the near term as shale output surges. But in the longer term, growth prospects are expected to be more positive.

Offshore rig counts have continued to slide over recent months, despite the recovery in oil prices, whereas the US onshore rig count keeps rising – albeit at a slower pace than seen in early 2017. In the near term, shale oil and OPEC production will be enough to balance demand growth. This will constrain capex elsewhere, limiting offshore expansion and accelerating declines at legacy fields.

However, in the longer term, shale production is expected to plateau, leaving offshore output well placed to meet the subsequent demand growth and supply decline (in non-OPEC mature field output) of 4-5 MMb/d per year from 2025-2030.

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Jackup activity is expected to have mild growth through 2030.

Limiting factors

Following the fall in oil prices in mid-2014, the offshore drilling market was hit hard as operators reduced offshore exploration and development activity. Now, with crude above $60/bbl, some had expected the situation to improve. New offshore discoveries were made in 4Q 2017, such as Neptune and Central Olginskoye in shallow-water Russia and Turbot in ultra-deepwater Guyana. But so far, the rise in oil prices has not translated into a rebound in offshore drilling. It appears that many operators are looking for greater price stability at these higher levels before committing to major offshore capital projects, with their long lead times.

There are a couple of major factors that have kept the offshore drilling activity from returning to growth:

• Growing competition for marginal capex dollars from North American shale oil projects, returns from which have exceeded expectations thanks to improved well economics and capital availability. For example, in a December 2017 press release Chevron announced a ~70% increase in spending on shale projects in 2018 despite an overall reduction in global budget compared to 2017 – meaning shale growth has come at the expense of investment in other resource types.

• Rising output from North American shale and other countries (such as Brazil and Canada) outside the OPEC deal, along with the growth of NGLs, have partially offset the OPEC-deal supply cuts, capping crude price rises, particularly going forward.

Given these factors, many offshore operators have continued to cut capex, leading to lower offshore rig activity, and leaving an increasingly large proportion of the fleet idling or stacked. It is now expected that offshore project development capex will not recover properly until 2020 and will remain below pre-2014 levels for the next five years.

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Floater activity is expected to have a sequential growth through 2030.

After seeing rig activity stabilize during the first half of 2017, it resumed a declining trajectory in the second half of the year, hitting record low levels (estimated at about 300 units for jackup rigs and 140 for floaters). This will keep downward pressure on day rates, with the few rigs that are finding new contracts, doing so at a sharp discount to the rates earned prior to the oil price decline (about 25% for jackups and about 75% for floaters from 2014 levels). This means lower margins for rig owners, even though they have reduced operating costs by around 70% since 2014. The offshore drilling industry has been through significant consolidation over the past three years, helping reduce fleet numbers, with recent examples including Transocean’s acquisition of Songa, and Borr Drilling’s purchase of Paragon Offshore.

Some upside for offshore projects has come from sharply reduced capex project estimates. The reduced rig day rates, along with decreased operational costs and standardization have cut project costs by an average of 30-40% for operators. This has provided the basis for a number of large-scale project FIDs to move forward over recent months, including Johan Castberg in Norway, Kaikas in the Gulf of Mexico, Liza Phase 1 in Guyana, and Mad Dog Phase 2, which saw costs cut by 60%. This trend is likely to continue in 2018, with big ultra-deepwater and deepwater projects such as Libra and Buzios in Brazil, and Golfinho/Atum in Mozambique, poised to move forward with much lower budgets than first envisioned. But, although this cost compression is maintaining some activity, we do not believe it is enough to accelerate FID approvals. So, the future volume of new projects is expected to stay at about half what it was in 2010-2014.

Offshore capex outlook

Low oil prices mean global capex is not expected to rise much over the next few years. This year, despite starting from a low base, we only expect growth of 4-6%, and most of that will be in the US onshore. Under the base case scenario, we do not expect oil prices to fully recover to $70/bbl until late 2020, due to an increasing number of supply sources with short lead times that break even at $50/bbl or below.

In the longer term, it is estimated that by 2030 E&P companies will need to have added at least 35 MMb/d of new crude production from unsanctioned projects to meet projected demand. Both shale and offshore oil output are expected to play an important role in closing this gap; with offshore responsible for about half of the new crude production. More than a quarter of the total is expected to come from deepwater and higher cost ultra-deepwater resources, which will offset declines from shallow and deepwater sectors. Most of the growth in offshore production is likely to take place after 2022.

Jackup outlook

We project that there will be a large number of jackup rig retirements up to 2022. Many new rigs ordered before the crash that are now coming into the market will replace older rigs, as operators seek assets that can meet modern specifications. Nevertheless, rig owners are expected to keep deferring delivery of new rigs, with about 20% of the backlog likely to be delayed beyond 2021 or cancelled altogether. As a result, under our base case scenario, we forecast a decrease in jackup numbers of around 7% between 2017 and 2030, as retirements outstrip deliveries in the transition to higher average specification.

Taking into consideration contracts that are coming to an end and the positive impact of recent oil prices on new contracts and extensions, we believe that the number of contracted jackups bottomed out in 2017 – with 2018 looking a lot like 2017. The contracted count is expected to experience limited growth in 2018-19; before accelerating to growth of 2% per year up to 2030, as non-NOC operators shift to more commercially attractive deeper water projects. Under this trajectory, the large number of anticipated retirements mean jackup utilization should recover to 2014 levels by 2022, driven by retirements rather than demand growth.

Floater outlook

In the near term, the supply of floaters is likely to stay relatively stable, impacted significantly by delays and cancellations, along with retirements. The scrapping of the oldest floaters (generations 1 to 3) will likely continue, due to obsolescence and high cost of reactivation. It is expected that some of the generation 4 moored rigs will remain cost-competitive in severe weather environments, and in projects where dynamic positioning is not feasible – despite newer rigs with mooring capabilities being built. However, a portion of generation 4 and 5 rigs will be retired due to their relatively lower cost efficiency compared to generation 6-7 (and beyond) rigs, which will remain the most relevant and competitive going forward.

In the longer term, with around half of the current rigs on order expected to be cancelled or deferred past 2021, it is projected that floater supply will grow by some 17% by 2030 under a balanced market case.

As with jackups, we estimate that floating rig activity reached the bottom of the current cycle in 2017/18. We now expect market growth for floaters of about 4% per year from 2018 to 2022, and stronger growth of 6% beyond that up to 2030. Key growth regions are Africa, the Gulf of Mexico, and Brazil; where higher-spec rigs are required. As a result, the outlook for floater utilization in the longer term is positive, with a recovery to 2014 levels by 2025-26.

However, as longer-term offshore growth prospects improve, it is important to note that there are sizeable downside risks. These include:

• Higher than expected liquids supply (as a result of OPEC output), or a lower than expected rise in demand – both of which put downward pressure on oil prices.

• An intensification of competition among sources of liquids’ supply – with the strengthening of international shale, re-fracs, and enhanced recovery at legacy fields pushing offshore resources to the far-right end side of the supply cost curve.

• Continued low rig utilization rates, due to an undisciplined offshore rig market. Older rigs may not retire as projected, keeping utilization low as activity remains depressed.

The authors
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Nathalia Jewell is a manager in the oilfield services group within McKinsey Energy Insights, and has served multiple oilfield services, upstream, and private equity (PE) players on strategy, portfolio management, M&A, and performance improvement. Prior to joining MEI, she worked on some of the world’s highest profile deepwater and ultra-deepwater projects at Schlumberger.

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Anne-Fleur Plassais is a senior analyst with McKinsey Energy Insights’ oilfield services group, working with oil and gas clients across the value chain on strategy, due diligence, and performance improvement projects. Prior to joining MEI, Anne-Fleur worked as an economist at Total, focusing on upstream markets.

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