Offshore Drilling Crash

Jim Brown
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With the price of crude oil rapidly declining and approaching $50 again the cost of offshore drilling is forcing some companies to reconsider their programs. Some of them will pay huge penalties to reduce E&P expenses.

Last week Conoco said they had canceled delivery of the Ensco DS-9 deepwater drillship and would pay the early termination penalty and take a charge to earnings. This is a material change to the outlook for the sector for multiple reasons.

First the Ensco DS-9 is a brand new state of the art drillship scheduled to be delivered to the Gulf of Mexico later this year. The contract day rate was $550,000 per day for three years. Conoco has to pay for two of the three years in order to cancel the contract. That amounts to $401 million Conoco is paying to not explore for oil in the deepwater Gulf. Conoco is in talks with Ensco over the termination penalty but whatever they mutually decide it will still be in the hundreds of millions.

The Ensco DS-9 is a new build drillship being delivered by Samsung Heavy Industries and cost about $625 million. It can drill in 12,000 feet of water with well depths of 40,000 feet. These are the most advanced drillships in the market today. This is not a rusting tub that Conoco just decided to dump.

Because a big company like Conoco has decided to pay this monster penalty to stop the bleeding in offshore exploration it has caused serious questions about the offshore drillers. These companies always brag about their "order backlog" which is the remaining lease term on existing rigs and new rigs currently being built. With more than a dozen rigs under construction with an average price of $625 million each this is a big problem. Banks loan money to drillers to build the rigs based on contracts to lease the rigs. If Conoco can walk a away, even with a big penalty, then other, less financially stable companies, could walk away as well.

This means the contract backlogs may not be real. The contracts may exist but they could be cancelled at any time. Having Conoco take the first big step will tell other companies that the market is soft and expectations are dim. They may also elect to terminate rather than continue pouring money into a deep hole in the ocean.

Even if they do not terminate they can also renegotiate. If the number of surplus rigs continues to grow at the current rate then a $500,000 per day lease rate may be negotiated down to $250,000 per day rather than outright cancelled. In the onshore fields, producers have forced a decline in fees from service companies by 30% to 50%. If you want our business then here is our price. The same could be true in the offshore area. If you want our business then we want your best rig and this is the price we are willing to pay. With every offshore driller now sitting on a portfolio of unused rigs they are willing to put them to work at almost any price.

Shares of the offshore drillers, Transocean, Diamond Offshore, Ensco, Noble, etc, are all setting new lows. The future of offshore drilling is bleak. Leases are expensive. Drilling is expensive. If you do strike oil then additional wells have to be drilled and a billion dollar production platform built. Pipelines have to be laid to shore. There is always the risk of an accident like the Deepwater Horizon and insuring against that is very expensive.

This makes deepwater oil very expensive compared to onshore production. Deepwater oil starts at about $75 a barrel and can run up to $115 a barrel. With prices threatening to move under $50 for what could be a long time there is no future in drilling for $75 oil or higher.

There will still be some wells completed because the process has already begun. Producers have to complete the wells and platforms in order to recover their initial investments. There is always the hope that this oil crash will evaporate just like the 8 other crashes since the 1970s. Oil prices cycle. When oil is cheap for a long time, exploration stops. Rigs are stacked and workers find a new job. When oil production slows and prices rise the cycle repeats with new rigs bought, new workers trained and new production coming online.

With current global production at about 93 million barrels per day and annual depletion at about 6% that means we need to find and produce about 5.5 mbpd every year just to keep production level. The instant we don't find and produce that amount the price of oil will begin to rise. Analysts are predicting that to happen in 2017 with first signs of the trend appearing in late 2016. Meanwhile oil producers that can make a profit at $50 oil, actually $40 or lower in the shale fields, will continue to operate. Those that can't make a profit are facing some tough times in the months ahead.

Comerica (CMA) warned last week that problematic energy loans in their portfolio were growing. Delinquencies were rising and they were forced to add to reserves for questionable loans. Comerica is not alone. Banks all over the country are facing the same problem and lower WTI prices for the rest of the year could increase the rate of defaults. Stock prices are reflecting this fact with shares of those with the least problems still sinking as fast as those with known risks. Investors beware!

Active Rigs

Active drilling rigs fell -6 to 857 for the week ended on Friday to wipe out the gains from the prior three weeks. Oil rigs declined -7 for the week to 638. Active gas rigs rose +1 to 218. Active rigs have now declined -1,074 since the high of 1,931 in September. That is a -60% drop. Active offshore rigs were unchanged at 31 and -29 off their peak.

Oil Inventories

Crude inventories declined -4.3 million barrels to 461.4 million.

Refinery utilization rose slightly from 94.7% last week to 95.3%. Imports rose +38,000 bpd. U.S. production declined -42,000 barrels to 9.562 mbpd and a three-month low. Demand rose +230,000 bpd.

Cushing inventories rose slightly to 57.1 million.

Gasoline inventories rose +.1 million barrels to 218.0 million. Gasoline demand fell by -128,000 bpd.

Distillate inventories rose +3.8 million barrels to 141.3 million and a three-month high. Demand fell -329,000 bpd.

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

Jim Brown

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