Low Oil Prices Increase Pressure on Drillers

Jim Brown
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Offshore drillers are under more pressure than onshore firms because of the large number of new rigs coming out of shipyards over the next several years. The low oil prices make it uneconomical to spend billions finding and developing oil fields and until prices recover companies are going to be cutting back on offshore exploration.

Early last year offshore drillers were charging record rates for their rigs and the future was bright. It was so bright that almost every company placed orders for new rigs that cost from $500-$650 million to build. Because of that order cycle more than 200 rigs are scheduled to be delivered over the next six years. When you consider there are only 288 deepwater rigs available worldwide that represents a +70% increase. Only 250 of those rigs are currently working. Since there are more rigs than there are wells to be drilled today that means that either we are going to have to double offshore drilling activity or retire a lot of older rigs.

When these new rigs are completed they will be the most desirable for those companies looking to contract a rig. The majority of existing rigs are 15-20 years old and some even older. There are some new rigs but relatively few as in 12-15.

The offshore drilling cycle goes from boom to bust to boom very quickly because of the high cost of drilling and producing offshore oil. If you do strike oil in a deepwater field with multiple well potential then companies are looking at spending $1 to $3 billion and 5-7 years of effort before they produce their first drop of oil. With oil prices under $60 and most offshore oil costing $70-$75 or more to produce the metrics for the offshore drilling sector are looking very ugly today.

The most in demand rigs were leasing for $550,000 to $650,000 per day in early 2013 with a shortage of decent rigs. That rate has probably been cut in half today but it is hard to tell because nobody is contracting new rigs. The recent fleet status reports for Transocean. Diamond Offshore, Ensco, Seadrill and Noble have been focused on rigs coming off rent without a new contract. Until oil prices firm significantly the outlook for the sector is grim.

The older rigs are going to be forced onto the scrap heap or sold to small independent companies for pocket change. The sector has undergone several sell down cycles since 2009 when crude prices dropped to less than $40 because of the financial crisis. Really old rigs were scrapped. Old but still serviceable rigs were either sold or spun off to get them off the balance sheets of the major drillers. That means the current rig inventories of the top four companies have already been whittled down but now they are facing another potentially disastrous portfolio restructuring.

Paragon Offshore Plc is a company with 41 older rigs that was spun off from Noble Corp earlier this year and they are reluctant to begin scrapping rigs. All they have is second and third generation gear and once they are hoping they can eventually rent it cheap enough to attract attention.

Analysts expect about 140 rigs will be scrapped by 2020. That will still leave a net increase of +60 new rigs in the market. Since 2000 there have been 123 rigs scrapped according to Bloomberg.

You can't just tow an old rig out to deep water and sink it. The minimum cost to "cold stack" is $12-$15,000 per day. That means they are not ready to scrap it but they have no hope of renting it over the next several years. The rig is put into hibernation in a remote harbor and left to rust while the market moves forward with the new rigs. Very few cold stacked rigs ever come back into the active fleet. Eventually they are towed to a shipyard and scrapped and that costs tens of millions as well since there are serious EPA considerations that have to be dealt with.

The next level higher is the hot stack process where the rig is towed to a shipyard where some maintenance might be performed while it waits for a new contract. This waiting can take months or years while the rig is marketed at ever decreasing asking prices. Eventually either the price declines enough to entice somebody to lease it or the owner gets tired of paying the monthly upkeep and transfers it to cold stack status.

Transocean said last week it was going to scrap another seven "floaters" in addition to four it had previously announced and will take a Q4 charge of up to $140 million. Hercules Offshore has seven shallow-water rigs that have been cold stacked for an average of five years.

The offshore drillers will constantly push their newest rigs out to lease because they have the best capability and the biggest rents. They also have the highest book values so they have to keep them working. Everything else in inventory slowly declines in value as rents diminish.

The offshore drillers are their own worst enemies. They have a captive market. If they had not jumped into the new build market so aggressively they could have kept prices high and rig demand strong. By adding 70% to capacity they diluted their own market. With the drop in oil prices they are facing double trouble. It could be a couple of years before rig demand picks up again and every month that passes ages your fleet and costs millions in maintenance on rigs that are not working.

Simmons & Co expects offshore drilling budgets to be cut 15-20% in 2015. In a sector that generates $61 billion a year that is a major hit and we really don't know how bad it can get because oil prices could be low for a long time.

Seadrill is the best positioned according to analysts with 75% of its fleet backed by long term contracts. They are the third largest offshore driller by market cap where all the driller's value has been cut by half over the last year.

Some companies are paying a penalty to defer construction of new rigs while others are leaving new rigs at the shipbuilder's harbor to avoid the costs of towing them to the projected market until they have a contract.

I would avoid the stocks of those companies mentioned above because the full impact of the oil price collapse has still not hit them.

Saudi Arabia said it was facing a $39 billion budget shortfall in 2015 as a result of oil prices. However, the oil minister said "We will not cut production in 2015, or ever again." In fact he said their production capacity was nearing 12.5 mbpd and they would be happy to increase production from the current 9.62 mbpd if there were buyers. That is not a good sign for oil prices. This suggests that OPEC is dead as a price fixing cartel and every country is on its own. That means everyone is going to be ramping up production to maximum levels to try and raise more money. The only way to overcome a decline in export prices is to export more oil.

These guys have shot themselves in not just one but both feet. They have gone from controlling the price at $100 to expectations of $50. They have killed their country budgets and the potential for social unrest is very strong as social programs fall victim to budget cuts.

I can't conceive of the conversations that must have occurred behind closed doors. Clearly the big dog here was Saudi Arabia and while they have the most excess production capacity they also have the most to lose with 9.62 mbpd of production. Because of their actions their revenue has declined nearly 50%. What were they thinking? You have to believe that the severity of the oil price decline caught them off guard by a wide margin. Would they have taken this action if they knew the price would drop from $100 to $60? I seriously doubt it.

Crude prices ticked slightly higher midweek on news of fighting around the main oil terminal in Libya. Three storage tanks caught fire before the army pushed the militants away from the facility. Libyan output declined to -320,000 bpd because of the fighting and terminal damage. Production was 1.6 mbpd before Qaddafi was killed. It fell as low as 150,000 bpd last year because of the civil war currently in progress. Shipments from Es Sider and Ras Lanuf ports were halted earlier this month.

Energy stocks could see some tax selling in the coming week. Investors hoping for a rebound may give up and decide to take their losses to offset gains elsewhere. Crude prices are slightly positive late Sunday at $55.40 but there may be a real test of $50 in our future.

Oil Inventories

Crude inventories rocketed higher last week with a +7.3 million barrel gain. This was entirely unexpected since refiners normally want the lowest amount of oil in inventory as possible at the end of December to avoid paying property taxes on it. Imports were the culprits with a huge increase of 1.2 mbpd. I have to think somebody did not get the message to hold the ships in the harbor and not take delivery until January 2nd.

Inventories at Cushing rose 1.0 million to 28.8 million barrels. U.S. production declined -10,000 bpd to 9.127 mbpd.

Refiners continue to run at record rates of 93.5% as they try to convert as much oil as possible into refined products before tax day. Product supplied to the market rose to 21.04 mbpd and the highest level in recent memory.

Gasoline inventories rose +4.1 million barrels to 226.1 million and a multi-month high. Gasoline demand surges another 145,000 bpd to 9.52 mbpd and a multi-month high.

Distillate inventories rose +2.3 million barrels to 123.8 million and another multi-month high. Distillate demand rose +64,000 bpd to 4.3 mbpd and a multi-month high.

I hope you are getting the picture here. Demand is rocketing higher as a result of the lower prices and refiners are racing to keep up before gasoline prices decline to the point where it is no longer profitable to refine oil. This will eventually happen. Oil prices will rebound while gasoline prices are declining and for a short period there will be no margin. Gasoline prices have declined for a record 92 days according to AAA.

In the graphic below green represents a recent high and yellow a recent low.

Propane inventories declined by -.55 million barrels to 77.84 million. Demand declined slightly from 1.45 mbpd to 1.25 mbpd.

Natural gas inventories declined -49 Bcf to 3,246 bcf. Inventories are now -4.9% below the five year average at 3,415 Bcf and +4.8% above year ago levels at 3,096 Bcf. There were big declines in the last four weeks in 2013 and that offset the mild weather we have seen over the last several weeks.

The blue line in the chart below shows the current inventory relative to the five year average.


The market wandered slowly higher last week to close at new highs on very low volume. The coming week should maintain a bullish bias but is likely to be choppy as the remaining tax selling takes place.

Jim Brown

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