Extracting the Basics: An Introduction to Offshore Drilling

Offshore drilling: the state of the industry in 2016

Oil is one of the most important and most frequently traded commodities, and offshore drilling is an integral part of the oil industry.

In 2015, oil prices declined drastically. As US President Barack Obama opened parts of Southeastern US coastline for oil drilling while still restricting oil drilling in the waters of Alaska’s North Slope, it will be interesting to study the offshore drilling industry. In this series, we’ll look at the basics and the key characteristics of this industry. We’ll also analyze important indicators that will help investors assess the outlook of the industry.

Where offshore drillers fit in

The complex process of oil production first starts with finding oil fields. Geological surveys of different areas are conducted to find oil fields. These fields can be on the land (onshore) or under the seabed (offshore). In this series, we’ll focus on offshore drilling. Once oil fields are located, drilling companies are hired, and these companies conduct exploration and development with the help of rigs. Offshore drilling companies engage in the following:

• well exploration—finding new oil and gas deposits by confirming the presence of hydrocarbons
• appraisal—drilling to determine the size of the oil field and to define the boundaries of the reservoir
• development or completion—preparing the well for production, which includes drilling the target as efficiently as possible.

After an elongated process of drilling (We’ll discuss this process further in Part 2 of the series), when oil reaches the surface, the rig is removed from the site and production equipment is set up to extract the oil from the well. The extracted “crude” oil (DBO) is then transported to refineries through pipelines, crude tankers, or rails. At these refineries, the crude oil is processed into diesel, kerosene, gasoline, and jet fuel (among other products).

Key offshore drilling players

Offshore drilling is a multi-billion dollar industry. Key players in this industry include Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Seadrill (SDRL), Transocean (VTG), and Atwood Oceanics (ATW). Investors interested in diversified exposure to upstream companies might consider ETFs like XOP, OIH, and IYE.

Now let’s look at the complex and costly nature of offshore drilling.

Why the Offshore Drilling Process Is so Complex and Costly

The offshore drilling process

In the preceding part of this series, we took a look at the broader process of oil production. In this part, let’s dive into the nitty-gritty details of the offshore drilling process. The offshore drilling industry requires complex machinery and hundreds of people. At every stage, there are things that can go wrong, so extra care needs to be taken at every stage.

Drill a hole, then drill into casing

How are offshore drilling companies getting the oil from the ocean floor? First, a large diameter hollow tube called a conductor is embedded in the seafloor along with a jet drill. When the conductor penetrates about 250 feet beneath the seabed, the jet drill is removed and a different drill bit is introduced. This drill bit is connected to a drill pipe and has special teeth that crush or break the rocks in the seafloor, making a deeper hole. Once the desired depth is reached, the drill bit and drill pipe are brought back to the surface.

A word on cement casing

Once the drill bit is brought back to the surface cement is pumped down the drill pipe and through a nozzle pushed out on the sides. The cement goes between the pipe and the conductor. After a few hours, the cement hardens. Once the cement is set, drilling continues with a smaller diameter drill bit. Drilling goes deep down into fresh rocks.

The blowout preventer and marine riser

After a suitable depth has been drilled, the drill bit is removed and replaced with a steel tube called the casing. The casing is fitted at the wellhead with what’s referred to as a BOP (blow-out preventer) placed on top of the wellhead. The main function of the BOP is to prevent the uncontrolled flow of liquid and gases during the drilling process.

But how does the oil get from the hole in the seafloor to the rig? The BOP is fitted with a riser that allows the drilled fluids to return to the surface, connecting the new oil well to the rig itself. A drill pipe is lowered down from the riser, through the BOP and into the wellhead, extending down into the well itself. Drill fluid or mud is pumped back through the pipe. The mud eventually circulates around up through the marine riser and back to the surface of the oil rig.

Drill resting and checking for oil

As drilling continues, sets of different diameters of casing are used to penetrate into the rock. Each run of casing is cemented to provide integrity. High-tech measurement devices are sent down the hole to detect features of the rock. Using a combination of sound wave tools, electrical tools, and radiation measurements, instrument readings are taken from inside the well to determine the presence of oil. With this information, it is decided whether the well should be completed for production.

Costs associated with drilling

Offshore drilling (OIH) companies like Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Seadrill (SDRL), Transocean (RIG), and Atwood Oceanics (ATW) receive day rates for leasing out their rigs to oil companies. Notably, this day rate, which is a rental fee that includes the rig use and crew costs, does not include the equipment rent, chemical costs, and casing costs.

Now let’s look at the largest marine oil spill in history and how it has changed the industry.

The 2010 Gulf Oil Spill Tragedy and Its Aftermath across the Industry

A risky industry

Offshore drilling is risky because it is prone to accidents like massive marine oil spills and fire. As of the beginning of 2016, many such incidents have already taken place, but one particularly big accident has left the greatest scars.

The 2010 Gulf oil spill

The largest marine oil spill caused in April 2010 was the worst environmental disaster in US history. In a nutshell, when the seal of a major oil well in the Gulf of Mexico failed, millions of barrels of oil gushed freely into the water, and for 87 consecutive days, oil and methane gas were emitted from an uncapped wellhead.

The United States federal government has estimated that 4.2 million barrels of oil poured into the Gulf from a single well. Many rig workers lost their lives, and 16,000 miles of coastline along the Gulf were affected, not to mention sea life—birds, fish, shellfish, turtles. BP (BP) was the oil company running the rig, while Halliburton (HAL) and Transocean (RIG) owned of the rig itself.

This incident weighed negatively on the stock prices of offshore drillers such as Diamond Offshore (DO), Noble Corporation (NE), Seadrill (SDRL), Rowan Companies (RDC), and Atwood Oceanics (ATW). The performances of the oil-specific ETFs XLE and OIH were seriously hampered by the spill.

Blowback for the offshore industry

In 2016, the offshore oil industry is still facing tougher rules and regulations due to the 2010 Gulf oil spill. These include new standards for well designs, casing and cementing wells, equipment inspections and verifications, blowout preventers, drilling equipment, well control systems, life-saving measures, and safety controls.

After the oil spill tragedy, the issuance of new drilling permits slowed down, and permitting requirements increased. The number of deepwater drilling permits in 2009 before the oil spill tragedy equaled 76, but this dropped to 32 in 2010. Then in 2012, as oil prices revived, the US government issued the most deepwater oil-drilling permits for the Gulf of Mexico that it had since 2007. But since 2012, the number of permits has dropped back below the pre-2010 levels.

The adverse effect on exploration and expansion

The 2010 Gulf spill has adversely affected the exploration and expansion programs of many oil companies operating in the deep waters of the Gulf of Mexico, including Exxon Mobil (XOM), BP (BP), and Royal Dutch Shell (RDS). For example, the time required to process an offshore drilling permit for the region substantially increased after the accident, though this time wait has come down slowly again over time.

Additionally, the disaster is still fresh in everyone’s mind, and new regulations are still begin announced. In 2015, for example, federal regulators proposed new rules requiring improvements to blowout preventers and other key control functions. According to the director of the Bureau of Safety and Environmental Enforcement, with these newly implemented rules, additional approximate costs for the whole industry will likely be around $883 million over ten years. These costs will be mostly for refitting and updating blowout preventers and installing real-time monitoring of offshore operations from shore.

Continue to the next part for a discussion of the different types of offshore rigs and what they’re used for.

Getting to Know the Types and Characteristics of Offshore Rigs

Different rigs

Offshore exploration and development oil wells are drilled with the use of rigs. Rigs come in varied sizes and characteristics, and they are generally equipped for crews to stay and work for days at a time. But depending on water depth and weather conditions, different types of rigs are required. We can classify these rigs in the following three categories:

1. jack-ups
2. semisubmersibles
3. drillships

Jack-ups

Jack-up rigs are self-elevating drilling platforms attached with legs that can be lowered to the ocean floor. Jack-ups are normally used for drilling in shallow water with water depths up to 390 feet. The legs of these rigs are jacked into the sea floor, and this anchors the rigs, holding them well above ocean waves and offering a relatively steady and motion-free platform for drilling.

Semisubmersible

Semisubmersibles do not rest on the sea floor. Instead, the rig is partially submerged in the seawater, whereas the working deck is well above the surface. Semisubmersibles can drill in water as deep as 10,000 feet, and these types of rigs are very stable for deep drilling because much of their bulk stays below the water surface, making them more suitable for drilling in rough waters. Depending on the technology, year of construction, water depth capability, and deck load, submersibles are generally classified according to generations. The seventh generation, for example, is the latest one.

Drillships

Drillships are used in very deep water because they can drill in water as deep as 12,000 feet. These are especially used for exploration, due to cargo carrying capacity and mobility. That said, drillships are not as stable as semisubmersibles and are thus unsuitable for rough waters.

Jack-ups, followed by semisubmersibles, drill most of the existing offshore wells today, and drillships come in third place. The jack-up market is more volatile in terms of demand and rates. Recently, major new discoveries are being made by floaters, which include both semisubmersibles and drillships.

Companies and ETFs

Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Seadrill (SDRL), Transocean (RIG), and Atwood Oceanics (ATW) all have diversified fleets of rigs. A comparison of these companies can be viewed here. Investors interested in diversified exposure to upstream companies might consider SPDR S&P Oil & Gas Exploration & Production (XOP) ETF.

In the next part of this series, we’ll take a closer look at the role of geography and climate when it comes to choosing rig type.

How Geography and Climate Impact Offshore Oil Rig Choices

Key six offshore basins

Oil deposits can be found deep under the earth either on land (onshore) or under sea beds (offshore). The majority of offshore operations around the world occur in six key locations. These locations differ widely in terms of water depths, weather conditions, and remoteness from their logistical bases. The type of rig used also differs according to the differing characteristics of these locations.

Offshore oil locations

The Gulf of Mexico is one of the most important regions for energy resources in the world. According to the EIA (US Energy Information Administration), offshore oil production in the Gulf region accounts for 17% of total US oil production. This is due, in part, to the fact that the Gulf represents one of the lowest-cost offshore drilling markets. The maximum number of oil rigs in the world are found in the Gulf of Mexico.

The second-largest number of rigs in the world can be found in the North Sea, from which almost 90% of the UK’s oil production comes. Other key offshore oil drilling locations include the Brazilian Coast, the west coast of Africa, the Persian Gulf, and the Asia-Pacific region.

Ocean depth and climate

The choice of rig type depends heavily on water depth and climatic conditions. When water levels are up to 400 feet, jack-ups are preferred. We see the most jack-ups in the Asia-Pacific region, the Gulf of Mexico, and the Persian Gulf.

By comparison, harsher environments are characterized by frequent and severe storms, and we see such conditions in winter in the North Sea, in the North Pacific, and in Eastern Canada. In such conditions and locations, semisubmersibles are the preferred choice. But such harsh climates are rarely seen in Brazil, West Africa, and the Persian Gulf, and so standard drillships are used in addition to semisubmersibles in these locations.

Major offshore drilling companies including Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Seadrill (SDRL), Transocean (RIG), Rowan Companies (RDC), and Atwood Oceanics (ATW) operate in these various locations depending on the rigs they own. Investors interested in diversified exposure to upstream companies might consider the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).

But what’s driving all this? What about the demand side of the offshore oil drilling industry? Continue to the next part for further analysis.

Understanding the Demand Side of the Offshore Drilling Industry

Services based on contract

Offshore drilling (XLE) companies such as Rowan Companies (RDC), Ensco (ESV), Seadrill (SDRL), Diamond Offshore (DO), Noble Corporation (NE), Transocean (RIG), and Ocean Rig (ORIG) provide their services based on contracts. These contracts are obtained through bidding or by direct negotiations.

Contracts can be based on a well-to-well basis or on a fixed-period basis. Well-to-well contracts specify the number of wells to be drilled. These contracts earn a basic fixed day rate, and day rates are impacted by the demand and supply dynamics of the rigs, which, in turn, are affected by oil prices.

The impact of oil prices

Oil is a commodity that is highly volatile in nature. As oil prices impact the offshore drilling industry, they make the industry volatile and cyclical. More specifically, demand for contract drilling is driven by the capital budgets of oil companies like BP (BP), Exxon Mobil (XOM), and Royal Dutch Shell (RDS). These companies’ budgets are based on expectations of future oil prices, current profitability, and the availability of free cash. When oil prices are expected to increase, the capital spending plans of oil companies increase. With this increase in spending plans, the demand for rigs goes up, which improves the company’s rig utilization rate (defined as working rigs in the company’s total fleet).

Day rates and rig demand

Day rates instantaneously react to rig demand. Higher demand for rigs attracts higher day rates, and vice versa. Day rate is thus a market indicator that helps us gauge where the oil industry is heading. Also, drivers that impact day rate also drive other service and support industry. So when the day rate rises, the cost of supply boats, mud, and equipment, for example, also increases. When day rates are anticipated to rise, drilling companies are encouraged to increase their fleets by adding more rigs. This, in turn, pushes up the prices of rig newbuilds and in the secondhand rig market.

Continue reading this series for a more detailed discussion of day rates, utilization rates, rig counts, and how they are impacted by oil prices.

Day Rates and Lifelines of Offshore Drilling Companies

Oil rig day rates

Offshore Drilling (XLE) companies such as Rowan Companies (RDC), Ensco (ESV), Seadrill (SDRL), Diamond Offshore (DO), Noble Corporation (NE), Transocean (RIG), and Ocean Rig (ORIG) rent out rigs to their customers and charge a rate known as day rate for this service. Day rate refers to the daily rental fee charged to oil drilling companies, but this rate includes only the rig and labor costs—not the other costs related to construction, such as equipment rent and chemicals, among others.

As we discussed previously in this series, day rates are impacted by the demand and supply of rigs. As the demand rises, day rates go up, and as the demand falls, day rate goes down.

Day rates and rigs

Different types of rigs command different day rates. For example, day rates for floaters are much higher than day rates for jack-ups, and the rate of increase in day rates has been much higher for floaters than for jack-ups. This is because the day rate for floaters is highly influenced by rig specifications.

Over the years, with different generations of semisubmersibles coming up, rigs have become more technologically advanced, with greater water depth capability and greater carrying capacity. Also, semisubmersibles are now equipped to operate in harsh environments, and with these advancements, day rates have increased much more for semisubmersibles than for jack-ups.

Other factors affecting day rates

Even in the same category of rigs, different water depth capabilities cause day rates differ. The higher the water depth capabilities, the higher the day rates. But day rates are also impacted by region, especially in the jack-up market. Historically, we’ve seen rates in the Gulf of Mexico and the Persian Gulf stay lower than in the North Sea, and because water depths vary from region to region, the utilization rate of each region is different, further affecting day rates.

Day rates are also affected by the age of the rig in question, including the specifications of the particular rig and the job it undertakes. There is a negative relation between rig age and day rate, which implies that companies with younger fleets receive higher day rates. Appraisal drilling is more technically challenging as well, and this generally receives a higher rate than development or exploratory drilling.

Now let’s connect rig count and day rates with oil prices for another piece of the larger offshore oil drilling picture.

How Oil Prices and Rig Count Go Hand in Hand

Oil rig count

Rig count represents the total number of active rigs in the world. It’s important for us to note that oil prices and rig count have exhibited a positive relationship. When oil prices increase, the demand for drilling and so the rig count increases. Similarly, falling oil prices are often followed by lower rig counts. But for the rig count to fall, prices need to decrease substantially to the point that drilling becomes unprofitable for oil companies.

Oil prices and rig count

The offshore drilling (OIH) industry works on contracts. These contracts normally range from four months to more than one year. Falling or rising crude oil prices do not affect the planned offshore drilling in the short term, but the effect of price changes on rig count can definitely be seen after four or six months, once existing contracts cease. Thus, we can still say that oil prices are a leading indicator for rig count.

After crude oil prices increased between 2005 and 2007, we saw a period of global recession that included a drastic fall in crude oil prices in 2008, which was followed by a drop in the world rig count. Similarly, as oil prices recouped in 2009, the rig count also started an upward trend. In 2015, we witnessed another situation wherein a drop in oil prices was followed by a drop in rig count.

Falls in oil prices

Thus, any decrease in oil prices negatively affects rig counts, while rising oil prices positively affect companies like Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Seadrill (SDRL), Transocean (RIG), and Atwood Oceanics (ATW). But any change in rig count also affects these companies’ utilization rates. Let’s examine this further in the next part of our series.

Understanding the Fight between Offshore Drillers and Lower Utilization Rates

Utilization rate

In offshore oil drilling, utilization rate equals the ratio of working rigs to the number of available rigs. The so-called “rig zone” includes cold-stacked rigs in the total available rigs. A fall in rig count signifies a decreased number of working rigs, and so a fall in rig count negatively impacts the utilization rate.

More specifically, higher utilization rates signify a lower mismatch between supply and demand for rigs. A lower utilization rate indicates a greater mismatch between supply and demand for rigs, meaning that a higher utilization rate attracts a higher day rate, and vice versa.

How companies react to lower utilization

When the demand for rigs is low, companies find it difficult to secure work for their rigs, and because the cost of maintaining rigs is very high, profit margins of companies tend to tumble if companies have idle rigs. Thus, to reduce costs and maintain profit margins, offshore drillers such as Diamond Offshore (DO), Noble Corporation (NE), Ensco (ESV), Transocean (RIG), Atwood Oceanics (ATW), Rowan Companies (RDC), and Seadrill (SDRL) resort to stacking rigs. There are two main types of rig stacking: cold stacking and warm stacking. Stacking helps offshore drillers (OIH) fight industry downturns because it significantly reduces costs.

Warm stacking versus cold stacking

Warm stacked rigs are idle but still operational. In this state, the rig retains most of its crew. These are generally actively marketed. By warm stacking, the company avoids some maintenance expenses and some labor costs.

Generally, when the offshore drilling company does not have work prospects for a rig for a long period and it wants to significantly cut down its costs, it cold stacks the rig. In cold stacking, all the rig crew is laid off and almost all the fixed costs are avoided, except for insurance.

Continue to the next part for further discussion about the rig market.

The Rig Market’s Integral Role in Offshore Drilling

The oil rig market

As we discussed previously in this series, offshore drilling (IYE) companies such as Rowan Companies (RDC), Ensco (ESV), Seadrill (SDRL), Diamond Offshore (DO), Noble Corporation (NE), Transocean (RIG), and Ocean Rig (ORIG) own and operate different types of rigs. These rigs are supplied by the newbuild and secondhand markets and are upgraded and maintained in the upgrade market. Rigs complete their life cycles in the scrap market.

Newbuild market

Newbuild markets are shipbuilding building markets, where labor and capital are used to convert steel and other equipment into rigs. The newbuild market is closely related to the drilling service market, and the cyclical nature of drilling industry causes similar cycles in the newbuild market.

It takes about two years to build a new rig. Prices in the newbuild market are dependent on the demand of drilling services and on steel and equipment costs. The supply of rigs cannot be changed in the short run. As oil prices (DBO) increase, the demand for new rigs increases and drives prices across the newbuild market. This market was started in the US but is now dominated by the Asian countries. Almost 70% of all newbuild rigs are constructed in Asia.

The secondhand market

In this market, used rigs are sold between contractors or other market participants. Prices in this market vary widely due to differences in rig age, rig condition, and market participants’ expectations of future market conditions. When oil prices rise, second-hand rigs can be more valuable because they are obtained immediately, while rigs under construction can take several years to deliver.

The upgrade market and scrap market

The upgrade market takes care of ship repair, maintenance, and upgrading rigs. As rigs age from wear and tear, they need the technology absolution to be repaired and upgraded in order to remain competitive in the market.

This also increases the useful life of the rig and its value. Ship breaking firms purchase scrapped out rigs, sell the steel to steel mills, and remove the equipment to reuse or sell it. If the difference is large between scrap steel prices and old vessels prices, this can affect the scraping activity. Due to this market, drilling companies tend to get at least some value when their rigs become useless or are destroyed due to accidents or natural disasters.

Now let’s discuss the role of new entrants in the offshore drilling industry.

Gauging the Threat of Potential Entrants in the Offshore Drilling Industry

Competition among offshore drillers

It’s time now to analyze the level of competition and attractiveness of the offshore drilling industry by looking at the industry from its supplier side, customer side, substitutes to the industry, and potential entrants. In this part of our series, we’ll measure the practical threat of new entrants to the industry.

New entrants

A new entrant in an industry refers to the increased supply of products or services offered by the industry, which puts pressure on prices and costs. New entrants put a ceiling to the profit potential of existing companies in the industry, and the threat of new entrants is determined by barriers, regulatory requirements, initial investments, consumer switching costs, and economies of scale, among others.

Threat of potential entrants

Offshore oil drilling (IYE) is a highly capital-intensive industry. The price of a newbuild rig, for example, ranges from $200 million to $530 million. But a new company, when entering the market, can’t compete with a single rig and needs the minimum of a couple of them in its fold. It is thus very difficult for new entrants to raise the huge amounts of capital needed to enter such a market.

Additionally, specialized workers holding licenses to work offshore are required, and it’s not easy for new companies to get hold of the highly skilled workers required either. As operating rigs in deepwater involves risks oil companies generally prefer offshore drillers which are well established, having a good track record, having a sufficient experience in the industry. New entrants find it difficult to break the ice and secure contracts from E&P (exploration and production) companies.

Thus, the threat of new entrants for companies like Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Rowan Companies (RDC), Ocean Rig (ORIG), Seadrill (SDRL), Transocean (RIG), and Atwood Oceanics (ATW) is quite small, and this represents an advantage for all these companies.

Now let’s look at the role of bargaining and buying power in the offshore drilling industry.

Is the Customer the King in Offshore Drilling?

Bargaining power

In the preceding part of this series, we discussed the fact that the threat of potential entrants is low in the offshore oil drilling industry. Now we’ll assess the industry’s position with respect to the bargaining power its customers and suppliers have—or don’t have.

Buyer power

We benefit from analyzing the bargaining power of customers because it helps us assess a customer’s ability to demand value for themselves by commanding either low prices or higher service quality. The customers of oil drilling companies are E&P (exploration and production) companies like BP (BP), Royal Dutch Shell (RDS), Exxon Mobil (XOM), Chevron (CVX).

The bargaining power of offshore drilling customers is influenced by oil prices and utilization rates. When oil prices are high, the demand for drilling increases, which then decreases the available rig capacity. As rig supply cannot be changed in the short run, this situation leads to an excess in demand of rigs oversupply, which gives a higher negotiating power to drilling companies and allows them to demand higher day rates. This situation changes when oil prices are low and E&P companies are not willing to invest in drilling activity. At this time, the rig supply exceeds the rig demand, and oil companies exert their power by demanding lower day rates.

One more factor to consider is that drilling companies have high operating leverages. To cover fixed costs, drillers need to keep their rigs engaged, even if it means lower day rates. Also, services offered by drilling companies are almost standardized, and E&P companies can choose from the different drilling companies—namely, the drilling company giving the best deal.

Supplier power

The suppliers of oil drilling companies include shipyards providing vessels and rigs. The supplier power for this industry mainly depends on the capacity at shipyards, or the yard utilization rate. When this rate is high, shipyards demand higher prices for rigs. On the other hand, when the yard utilization rate is low, even if the demand for newbuild rigs is increasing, it puts a downward pressure on rig prices.

Understanding this buyer and supplier power should help us better analyze companies like Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Rowan Companies (RDC), Atwood Oceanics (ATW), Ensco (ESV), Seadrill (SDRL), and Transocean (RIG), all of which have a diversified fleet of rigs. Investors interested in diversified exposure to upstream companies might consider the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).

Now it’s time to look at the high level of competition among these offshore drilling companies.

The Intense Competition in the Offshore Drilling Industry

Offshore drilling competition

When assessing the offshore oil drilling industry’s competitiveness, we’ve already seen that the threat of potential entrants is low (see Part 11) and that the buyer and supplier power is medium (see Part 12). Now we’ll assess the offshore drilling industry’s position with respect to substitutes for offshore drilling and competition among existing companies.

Competitor rivalry

Even if the industry has experienced many consolidations in the past, it still has many participants, which serves to boost competition. Contracts for offshore drilling are obtained through competitive bidding where price, rig quality, rig location, and safety equipment are key determinants.

Notably, the industry has a high degree of financial and operating leverage, and this forces the participants to engage in price competition in order to defend their market shares and to cover their fixed costs. The industry is also characterized by standardized services, and there are high exit barriers, due to the cost and lack of alternative uses of offshore drilling rigs. This forces unprofitable companies to stay in the industry anyway, which drives down oil prices due to excess capacity and increases competition across the industry even further.

Substitutes to offshore drilling

Crude oil (DBO) can be drilled from onshore oil wells as well as from offshore wells. Offshore drilling is far more costly, complex, and time-consuming than onshore drilling, however, and the risks of accidents like oil spills are far greater in offshore drilling. If more onshore wells are discovered, it’s thus reasonable to assume that the demand for offshore drilling will decrease, as long as everything else stays constant.

This, of course, would have a negative impact on offshore drilling companies (IYE) like Diamond Offshore Drilling (DO), Noble Corporation (NE), Pacific Drilling (PACD), Seadrill (SDRL), Transocean (RIG), and Atwood Oceanics (ATW).

In the next part of this series, we’ll analyze in detail the costs, payback periods, preferences of exploration and production companies, and returns for offshore and onshore drilling.

How Offshore and Onshore Drilling Perform when Oil Prices Tumble

Conventional versus unconventional sources

Oil drilling is mainly classified into two categories: offshore and onshore. But the industry can also be classified as conventional or unconventional. Unconventional sources of oil do not flow to the surface, as the conventional sources do, and the former sources need different methods of extraction. Onshore unconventional oil sources include heavy oils, oil sands, shale oil, and tight sand. These unconventional sources have started gaining popularity in recent years, but the crude from these sources are more costly to produce than conventional sources are.

Comparing costs: onshore versus offshore

Traditional onshore drilling is cheaper than offshore drilling, but the overall cost of unconventional onshore oil is on par with or exceeds offshore drilling costs. These costs also differ according to the region of oil production. For example, the lowest breakeven cost is $25 per barrel for onshore oil production in the Middle East (According to Rystad Energy Research). Due to lower breakeven costs for onshore compared to offshore drilling, these companies tend to perform better when oil prices tumble. Offshore drilling companies include Diamond Offshore (DO), Rowan Companies (RDC), Pacific Drilling (PACD), Ocean Rig (ORIG), and Transocean (RIG), among others.

Capex of E&P companies

Global Oil Company’s capex, to use one example, has climbed rapidly over the past few years. According to industry analysts, the approximate investment for offshore drilling in 2005 was around $150 billion, but this figure jumped to $360 billion till 2014. This increase in capex was due to increases in oil consumption as well as to the rising demand for offshore production and to inflation. As oil prices decline, oil company’s profits decline, and this cuts its upstream capex budget.

Falling oil prices more adversely impact the onshore drilling industry as offshore drilling (XLE) contracts and investments have longer lead time. Capital budgets for shale decline the most when oil prices are tumbling, but shale-producing companies are more flexible to short-term price collapses. Operators can drop shale rigs more quickly than they can with offshore rigs. But once oil prices rebound, shale will likely be the fastest to recover. That said, investments in shale have the lowest payback period and the highest internal rate of return.

Continue to the next part for a deeper discussion of high leverage among offshore drilling companies.

Measuring the Double-Edged Sword of High Leverage in Offshore Drilling

Leverage in offshore drilling

The term “leverage” refers the use of fixed costs. These fixed costs may be fixed operating expenses, such as salaries, leases, and rent or fixed financing costs, which include interest payments on debt. High leverage can be either good or bad, depending upon the revenues of the company in question. In good times, when revenues are high, fixed costs are distributed among greater units, which increases the marginal profitability of the company.

The negative side of leverage is seen in bad times when revenues are low and costs relatively remain the same. This drastically decreases a company’s profitability. In this sense, leverage can act as a double-edged sword in that it increases the company’s riskiness while at the same time magnifying its potential returns.

Capital-intensive industries

Offshore drilling, like other upstream oil companies (XLE), is a capital-intensive industry, and this is due to the enormous costs of offshore drilling rigs. Rigs can cost between $200 million and $600 million, depending on the type and specifications of the rig. To meet these high capital requirements, offshore drilling companies take on a lot of debt.

In 2014, the industry average debt-to-equity ratio for offshore drilling companies was about 70%, which represents a high level of debt in the very capital structure of these companies. The average industry ratio is calculated by taking the average of the following companies:

• Diamond Offshore (DO)
• Noble Corporation (NE)
• Ensco (ESV)
• Transocean (RIG)
• Atwood Oceanics (ATW)
• Rowan Companies (RDC)
• Seadrill (SDRL)

Increasing financial leverage

As the above graph shows, debt levels in the offshore drilling industry have been consistently increasing. Rig costs over the years have shot up due to high demand, technological advances, and increasing steel prices, and higher debt levels translate into higher fixed financial costs or interest costs. These higher debt levels also increase the riskiness of the companies and have an impact on their debt ratings.

Now let’s take a look at specific ETFs with exposure to major offshore drilling companies.

ETF Exposure in the Offshore Drilling Space

How ETFs work

An ETF, or exchange-traded fund, is a marketable security traded on the stock exchange. ETFs can be bought and sold throughout the day, and ETFs either track an index, a commodity, bonds, or a basket of assets. ETFs are thus an attractive option for investors interested in diversified exposure to various stocks because the performance of a given ETF is closely related to the stocks the fund invests in.

Among the biggest ETFs in the offshore drilling space, investors can choose between ETFs like OIH, XLE, and IYE—just to name a few—for exposure to offshore drilling companies.

The VanEck Vectors Oil Services (OIH)

This ETF tracks an index of the twenty-five largest US-listed oil services companies. OIH is heavily weighted toward the oil and gas drilling industry, with 24.3% position in this industry. Among the other ETFs we’ve discussed here, OIH has the maximum exposure to oil drilling companies. Transocean (RIG), Seadrill (SDRL), and Noble Corporation (NE) have a high allocation in this ETF among the oil drilling companies.

The Energy Select SPDR (XLE)

This ETF tracks US energy companies in the S&P 500. XLE has just over 1.6% of its holdings in oil and gas drilling companies, but XLE is famous for being the largest, cheapest, and most liquid US energy ETF. It has an expense ratio of 0.15%, compared to OIH and IYE, which have expense ratios of 0.35% and 0.45%, respectively.

The iShares US Energy (IYE)

This ETF tracks US Energy companies as classified by Dow Jones. This ETF has the broadest offerings, with a position in 92 stocks. Oil and gas drilling stocks have over 2.1% allocation in the total holdings of the ETF. IYE’s top three holdings include Exxon Mobil Corporation (XOM), Chevron Corporation (CVX), and Schlumberger (SLB), which together make up 40% of the fund’s total holdings. Interestingly, for the past two years, IYE and XLE have given almost the exact same returns.

In the next and final part of this series, we’ll talk valuation multiples across the offshore drilling industry.

How to Interpret Valuation Multiples in the Offshore Drilling Industry

Why EV-to-EBITDA?

Offshore drilling (OIH) companies are cyclical and volatile in nature. They’re also capital-intensive companies, have high levels of depreciation and amortization, and have varying degrees of financial leverage. Thus, the EV-to-EBITDA (enterprise value-to-earnings before interest, taxes, depreciation, and amortization) multiple is a preferable choice in the valuation of such companies.

A key valuation multiple driver

The forward EV-to-EBITDA reflects what investors are willing to pay for the next four quarters of estimated EBITDA. In the offshore drilling industry, we believe this metric reflects the perceived riskiness of investing in offshore drilling companies as well as of investor expectations for the industry’s outlook.

Historical valuations and companies included

Since 2009, we’ve observed that the industry’s valuation multiple has closely followed crude prices. With the 2015 fall in crude oil prices, the outlook of offshore drillers has become bleak, which has increased the risk of investing in offshore drilling companies and has lowered valuation multiples.

To calculate the industry EV-to-EBITDA, we have included the following companies: Ensco (ESV), Diamond Offshore (DO), Rowan Companies (RDC), Noble (NE), Pacific Drilling (PACD), Seadrill (SDRL), Transocean (RIG), and Atwood Oceanics (ATW).

Since 2005, the lowest average valuation multiple was 3.23x, observed in March 2009, while the highest multiple was 11.84x, which we saw in 2006. The average multiple for the offshore industry since 2005 is 7.25x.

For related analysis, check out Market Realist’s Energy and Power page.