Seadrill And North Atlantic Drilling Discuss Conditions In The Offshore Drilling Industry – Seeking Alpha

One of the things that I have always appreciated about the quarterly reports of sister companies Seadrill Ltd. (NYSE:SDRL) and North Atlantic Drilling Ltd. (NYSE:NADL) is the in-depth way in which the two companies discuss the conditions in the offshore drilling industry. In general, the two companies have historically made somewhat congruent statements. In the latest quarter, however, this was not the case. In this article, I will discuss what the two companies have to say and attempt to make sense of it all.

As any long-time follower of my articles, or indeed of the offshore drilling industry in general, is already well aware, the market has been oversaturated with drilling rigs for just over three years now. When combined with the strained cash flows that most exploration and production companies have suffered from since oil prices declined sharply in 2014, these rigs have seen their competitive new contract dayrates decline as this large number of rigs competes for those few contracts that are actually being awarded. Unfortunately, this situation is unlikely to change in the near future. As both Seadrill and North Atlantic Drilling state:

The short to medium term outlook for [the] chartering market continues to be extremely challenging. While tendering activity has continued at increased levels over the past few months, especially in the North Sea, near term drilling programs continue to be largely based on opportunistic spot market activity and a number of oil companies continue to have excess rig capacity on contract. Available work is fiercely competitive with drilling contractors bidding below cash breakeven in some instances in order to keep rigs active.

Interesting, however, and perhaps counter to some media reports, both companies note that tendering activity has begun to increase. For those who are unfamiliar with the industry, that means that the number of contracts actually being awarded has begun to increase. This is a positive sign, as it indicates that oil and gas companies are once again interested in developing their offshore oil fields, although thus far this increase has not been sufficiently large to offset the glut of available rigs.

However, things could certainly improve for the industry over a longer time period, particularly for those companies like Seadrill and North Atlantic Drilling whose fleets consist almost entirely of new, modern drilling rigs. The reason for this is rig scrapping. As I have discussed in previous articles, a large percentage of the currently in service floating rig fleet is either over 25 years old or close to that milestone and will be due for their five year special surveys within the next few years.

When we consider that such surveys can cost in excess of $100 million to perform, it may make more economic sense for the rig owner to scrap the rig rather than spend the money to perform that survey. This will result in a gradual shrinkage of the oversupply of floaters, although Seadrill believes that a meaningful increase in demand will be needed before the industry fully recovers and that is not expected to occur until the end of the decade.

North Atlantic Drilling expects that this broader trend will also apply to its more focused market. In the next six months, a total of fourteen floating rigs and eight jackups currently in operation in the Norwegian North Sea and United Kingdom will be completing work on their current contracts. Of these, twelve, or 54.5%, are at least 25 years old. When added to the already idle units, there will then be a total of 33 idle rigs in this one market alone that are 25 years old or more. Although thus far, few contractors have been scrapping their harsh environment rigs, North Atlantic Drilling expects that scrapping activity will increase due at least in part to the age of these rigs and the costs involved in bringing them back to service. If the company is right, this scrapping will eventually return balance back to the North Sea market.

The market for jack-up rigs is perhaps more dynamic than the market for ultra-deepwater rigs. This is because of the relatively short-term nature of jack-up contracts. During the most recent industry upcycle that ended in the latter stages of 2013, the longest jack-up contracts that were being awarded were approximately one year in length. Meanwhile, floating rigs were routinely getting contracts of three to five years in length or longer. As a result of this, jack-up rigs are more exposed to changes in the marketplace. Therefore, the jack-up market typically bottoms out earlier and recovers faster than the floating market.

Unfortunately, Seadrill does not expect the market for jack-up rigs, at least the market for benign environment jackup rigs, to recover within the near- to medium-term (North Atlantic Drilling is somewhat more optimistic about the market for harsh environment rigs, as already discussed). One reason for this is that the supply glut in the jackup market is greater in scale than the one present in the floating rig market.

In addition, the company expects that a smaller proportion of the jackup fleet will be scrapped in the coming years compared to the floater fleet. This is at least partly due to the fact that the supply glut was exacerbated by offshore drilling contractors aggressively building up their jackup fleets during the last industry boom. It is unlikely that the industry will scrap brand-new rigs in aggregate or en masse. Thus, Seadrill expects that it will take longer for this segment of the industry to recover than the floater segment.

Interestingly, Seadrill expects that the jackup market will be more stable than the floating rig market going forward. There are two reasons for this. The first is the driving factor of oil company spending on jackup rigs. While exploration and production companies largely contract floating rigs to explore for new sources of oil and gas, an area in which spending has all but dried up, jackup rigs are generally contracted to develop resources located in shelf regions.

Oil companies are still willing to spend money to develop these resources, albeit perhaps not as much as they were a few years ago. A significant factor in the dayrate decline in this market segment comes from the supply side of the market: The oversupply of rigs has resulted in contractors aggressively bidding against each other to secure contracts and thus driving prices down.

A second reason why the jackup market s somewhat stable is economics. Unlike deep- and ultra-deepwater production, shallow-water shelf drilling is profitable with oil prices at today's levels. Here is a chart showing the approximate cost of producing a single barrel of oil in each of the environments being exploited today:

Sources: Seadrill, Morgan Stanley Equity Research.

Admittedly, this chart is a few years old at this point and technological improvements made since 2014 have brought down some of these costs. For example, several North American shale plays can produce oil for under $40/barrel. However, as is clearly shown, the costs of shallow-water shelf production are below today's oil prices. Therefore, it is still economically viable for an oil company to develop these fields. Thus, the jackup market remains relatively stable even though dayrates are unlikely to improve anytime soon.

In conclusion, North Atlantic Drilling appears to see the overall drilling market recovering somewhat faster than Seadrill does. However, it is worth considering that North Atlantic Drilling operates in a much more focused segment of the drilling market than Seadrill itself. It is certainly possible that the harsh-environment segment will recover faster than the industry as a whole. Regardless, it appears certain that dayrates will not recover anytime soon, and thus drilling contractor cash flows will be challenged over the near to medium term.

Disclosure: I am/we are long SDRL, NADL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Seadrill And North Atlantic Drilling Discuss Conditions In The Offshore Drilling Industry - Seeking Alpha