Covid-19 crisis setting the stage for restructuring of offshore drilling market

There is a case to be made that the coronavirus crisis has been setting the stage for the restructuring of the offshore drilling market, which was not in an enviable position even before the pandemic.

The oil market has not even fully recovered from the previous downturn when another crisis hit the market earlier this year as the oil price crashed to levels never seen before.

The oil price war and the coronavirus pandemic destroyed the oil demand pushing producers around the world to curb their outputs in an effort to salvage the industry.

At the latest OPEC+ meeting, it has been decided that the production cuts of 9.7 million barrels will be extended by another month, i.e. until the end of July.

In a chain reaction of events, the crisis in the oil market also affects the supply chain, including rig contractors, offshore vessel providers, and oilfield services specialists.

The offshore drilling industry has been in a difficult situation even before the coronavirus crisis but the pandemic has put even more pressure on the contractors struggling to survive in an environment now featuring contracting rig demand, lower day rates, early terminations of existing contracts, and depressed and volatile oil market.

A question arising from the current market situation is whether the coronavirus pandemic will accelerate the offshore drilling industry’s structural change and push the rig players into consolidation.

But before delving into the effects of the coronavirus pandemic on offshore drilling contractors, we need to examine the condition of the offshore drilling market before the pandemic.

A case could be made that the offshore drilling sector has not been in good shape even before the current crisis ensued.

Lars Eirik Nicolaisen, a Senior Partner and Deputy CEO at Rystad Energy, claims that the offshore drilling industry, especially the floater market, has been suffering even before the Covid-19 due to a couple of factors, the first one being the long-cycle discrimination.

In a recent webinar hosted by Rystad Energy, Nicolaisen described the issue of the long-cycle discrimination as a lack of willingness by E&P operators to deploy capex into long-cycled projects as they require years and years to be paid back.

“Oil companies tend to finance their exploration budgets by relying on their cash flow from operations. However, after the 2014 downturn, the correlation was broken suggesting that, even though cash flow from operations saw an increase following 2016/17, exploration activity did not.

“This is what we mean by long-cycled discrimination – a lack of willingness to deploy capex into these long-cycled projects”, Nicolaisen said.

S&P Global Ratings said back in October 2019 that oil and gas producers’ capital allocation had shifted away from long-cycle offshore projects in favour of the shorter-cycle projects that offer lower operational risks and costs.

“The long lead-time and high capital spending prior to the first production for offshore projects [do] not conform to [exploration and production] companies’ newfound capital discipline to live within cashflows and return excess cash to investors”, the ratings agency said.

As pointed out by Nicolaisen, another issue for the drilling contractors was the length of the contracts as oil companies were no longer willing to enter long-term deals. This was a key weakness of the floater market in 2019.

A further key issue that the offshore drilling industry has been facing is fragmentation.

But there are two sides of the story here, a customer and a supplier side. According to Nicolaisen, the number of E&P customers contracting floating drilling capacity shrunk from 65 in 2014 to 30 in 2020 with only 11 of those 30 contracting ultra-deepwater drillships.

With this said, it is obvious that there has been a massive contraction in the number of customers.

On the supplier side, currently, we have 33 suppliers offering floating drilling capacity and 11 of these are offering ultra-deepwater drillship capacity. This means that now we have one supplier of floating drilling capacity per customer, Nicolaisen said.

“This is what we mean by fragmentation and this is a key concern for the industry and, in my mind, one of the key explanatory factors for the lack of pricing power during 2018/2019. The industry remains way too fragmented and this is a pre-Covid-19 phenomenon”, Nicolaisen explained.

Even before the coronavirus pandemic, S&P Global Ratings in October 2019 pushed back its forecast recovery for the offshore drilling industry to 2021.

“A sustained sector recovery depends on supportive crude oil prices, higher rig attrition, and the industry’s ability to continue lowering costs and improving efficiency”, S&P Global Ratings said.

The rating agency said at the time that market conditions would remain challenging for the beleaguered offshore drilling sector until the latter half of 2020, with more meaningful recovery in 2021.

According to Wood Mackenzie, the oil majors and national oil companies made some high-impact discoveries in 2019 even as volumes remained subdued compared to long-term exploration trends.

Similar high-impact drilling plans were in place for the year ahead.

WoodMac’s annual survey of the global exploration industry, conducted just before the coronavirus hit and the oil price crashed, showed signs of cautious optimism.

“Despite the existential threat posed by the energy transition, explorers were looking forward to another 30 years of profitable exploration. There was, however, a keen awareness of the challenges ahead – the fight to remain investible, the need to increase capital efficiency, and the opportunities and risks presented by deepwater exploration”, Wood Mackenzie said.

Optimistic explorers acknowledged they need a minimum price of $40 per barrel of oil and, even at that price, many existing drilling plans were uneconomic, particularly some deepwater wells.

Little did they know they were about to experience the biggest oil crash in history with the US benchmark, WTI, briefly falling into negative territory in late April 2020.

In this kind of environment, the oil and gas operators were forced to drastically reduce their capital spending for the year, which has put even more pressure on drilling contractors.

Nicolaisen noted that, on average, around 28 per cent worth of 2020 capex has been taken out and the offshore drilling industry is certainly impacted.

Oil majors like Shell, Total, Equinor, Chevron, BP, ExxonMobil, ConocoPhillips and a plethora of others decided to wield the axe and slash billions from their spending for the year as the coronavirus pandemic spread across the world putting extreme pressure on the global market.

Rystad has recently said that global upstream spending is now forecasted to reach $383 billion this year, which is the lowest level in 15 years, and a staggering 29 per cent decrease of $156 billion compared to 2019.

With 2019’s upstream investments calculated at $539 billion, the decline is set to bring annual investment to a level lower than that of the previous downturn. The scenario for 2021 is not much different and is expected to be largely flat, landing only marginally higher than 2020 at $386 billion.

Before the Covid-19 pandemic, Rystad Energy had expected total upstream investment would maintain last year’s levels, both in 2020 and 2021.

Compared to the previous downturn, this time around, the industry spending is falling from a lower mountain to a deeper valley, which will very quickly affect industry performance, even in the short-term.

Due to the oil price war between Saudi Arabia and Russia from earlier this year and the coronavirus pandemic, the offshore drilling industry has suffered a direct impact as the E&P operators moved to cancel and or terminate their drilling contracts and lower day rates in an effort to save costs.

A Rystad Energy impact analysis from April estimated that drillers would see up to 10 per cent of their contract volumes cancelled in 2020 and 2021, representing a combined loss of revenue of about $3 billion.

Rystad’s analysis showed that offshore drillers and offshore vessel providers would generally be unable to pay their total outstanding debt of 2020 based on their cash flow from operating activities unless they were able to make sufficient capex cuts.

Otherwise, they will have to turn to capital markets for refinancing.

Valaris was one of the contractors that, in late March, received contract terminations.

These terminations were for two rigs operating offshore Angola, one from Total and the other one from Chevron.

Less than a month later, Valaris was hit by more terminations and day rate reductions.

By early April, Shelf Drilling got three rig contract terminations in less than a month. In more recent news, Saudi Aramco suspended its contract for the Shelf Drilling-owned High Island IV jack-up rig for 12 months.

Transocean has also received a contract termination for a drillship operating in Egypt.

Borr Drilling in mid-April received notices of early termination for several of its drilling rig contracts, but it was also awarded new contracts for its rigs. As a result, Borr’s total revenue backlog has been impacted negatively by about $16 million.

Maersk Drilling’s backlog was also negatively affected as Shell and Aker BP terminated their contracts for Maersk rigs in mid-April.

Further, following a contract termination from Beach Energy for the Ocean Onyx drilling rig, Diamond Offshore in late April filed a complaint against Beach Energy claiming that the oil company’s termination of a drilling contract for the Ocean Onyx rig was invalid.

Diamond Offshore also filed a voluntary Chapter 11 petition in the United States bankruptcy court in the Southern District of Texas to restructure and strengthen its balance sheet.

Seadrill was also hit by early termination of a drilling contract for a drillship operating in Southern Asia.

All this points to the fact that the next two years are going to be extremely challenging for the offshore rig market.

“We are now going to have two years – 2020 and 2021 – where we see contracting demand for both floating drilling services and jack-up drilling services”, Nicolaisen commented.

Since March 2020, the industry has re-accelerated the attrition numbers and it has taken out 15 units out of the supply stack, according to Nicolaisen.

He believes that this will continue to unfold as the industry re-structures in the next two years.

Danish offshore drilling contractor Maersk Drilling has recently said that many stacked rigs across the offshore drilling industry continue to incur stacking costs despite unfavourable commercial prospects and, given excess supply in most market segments, Maersk Drilling believes continued scrapping of rigs is needed to obtain a healthier balance between demand and supply.

At the end of March, Maersk Drilling’s forward contract coverage for the remainder of 2020 was 63 per cent for the North Sea jack-up segment and 62 per cent for the International floater segment.

The average backlog day rates for the remaining part of 2020 were $174,000 for the North Sea segment and $230,000 for the International segment.

Nicolaisen also observed that the rig contractors were running at a loss in 2019 and that there’s an inevitable path towards restructurings.

The drillers are eating into their cash reserves and some of the names are quickly approaching a state where they need to address their balance sheets. In addition, a wall of maturities of debt is approaching, particularly in 2022.

Nicolaisen said: “This is the challenging backdrop of the offshore drilling industry – not only are we facing fundamental headwinds on the demand side of things, but we also have a makeup of balance sheets that are extremely challenging.

“It’s fair to say that most of the names in the industry will not be able to address and comply with their cost of capital and debt repayment schedules.

“This sets the stage for the restructuring of the balance sheets, which in turn sets the stage for consolidation. Consolidation will be the key to address one of the headwinds, the fragmentation of the industry”.

We have already seen a certain amount of consolidation over the past couple of years with Transocean and Valaris as main drivers.

To remind, Transocean completed the acquisition of Songa Offshore in January 2018 and the acquisition of Ocean Rig in December of the same year.

Valaris, on the other hand, was formed through a merger between Ensco and Rowan, which was completed in April 2019. Before that, Ensco acquired Atwood Oceanics in a transaction which closed in October 2017.

Now, we have 11 management teams and 11 companies, which are offering drilling services on an international level.

“With this, we argue that the industry should continue this trend and we think that the restructuring of the balance sheets will be an enabler for that trend to continue”, Nicolaisen said.

Nicolaisen and Rystad Energy argue that we should go down to about four management teams and that obvious survivors in this space would be Transocean, Valaris, Diamond Offshore, and Maersk Drilling.

An interesting feature of some of the offshore drilling companies is their debt burden. Rystad has studied the amount of overlap between debt owners in some of these companies names and found that there is a high degree of overlap.

This means that there might be a high degree of coinciding interests between the current bondholders and future equity owners of these names.

“In particular, we found a high overlap between Diamond Offshore, Pacific Drilling, and Valaris. Meaning, if these names completely equitize their debt positions, you’ll see a high degree of coinciding ownership between those three companies.

“That is one argument for those three companies binding together in a potential consolidation of this industry”, Nicolaisen argued.

Commenting on rig day rates going forward, especially in the ultra-deepwater space, Nicolaisen said the key moving part is the extent to which this industry exploits the opportunity that will unfold over the next two years to restructure their balance sheets and then consolidate.

“That will determine the pricing power”, Nicolaisen said.

Depending on consolidation, the rates could go as high as $450,000 per day, maybe even slightly north of that, he said.

“But if the industry does not consolidate and it remains fragmented and in fierce competition in each individual tender process going forward rates are likely going to settle long-term at slightly shy of $300,000 a day.

“The jury is out, but it all depends on to what extent these names consolidate”, Nicolaisen concluded.

Header photo by SP Mac