Heading for deepwater?

Edward Richardson

April 4, 2014

Infield analyst Edward Richardson examines whether the newbuild rig market is heading for deeper waters.

History shows us that when oil prices are high operators seek to expedite the development of existing reserves and prove up additional resources. Demand for newbuild drilling assets therefore tracks price cycles very closely.

But what of the latest cycle? Since 2005, real oil prices have increased 124%. This has driven billions of dollars of investment into new offshore drilling assets. InfieldRigs data shows nearly 300 newbuild rigs (60% jackups, 21% drillships, and 19% semisubs) over the same period1. Current firm orders suggest that this growth will continue into 2015 but momentum may then begin to slow from 2016.

The exact pace of this slowdown remains difficult to determine, not least because firm contract visibility becomes very patchy beyond 2016. A jackup ordered in 4Q 2014, for example, could be operational in 1Q 2017 but would not yet appear in the data.

It also takes time for changing price signals to feed through into the newbuild market. If a rig manager was considering offering a contract today, it would need to raise the necessary capital, agree a final investment decision, and secure appropriate yard space. Delivery could then take anything between 18-36 months depending on the nature of the asset. Consequently, newbuild cycles tend to lag oil price signals by a year or two.

While the exact timing of the downturn is uncertain, it is clear that the newbuild market may well be approaching its zenith. There are three main reasons for this.

Firstly, demand and supply fundamentals suggest that oil prices may have passed their peak. Improving energy efficiency, particularly vehicle efficiency, the reduced use of crude for direct power generation, slowing emerging market economic growth, subsidy reform, and growing oil substitution are all likely to precipitate a structural moderation in oil demand over the remainder of the decade. On the supply side, output is growing rapidly led by North America’s unconventional revolution.

These two factors will boost global spare capacity over the long term. Indeed, BP estimates this could almost double to 6MMb/d by 20181. That capacity should push down oil prices and help remove some of the geopolitical premium that has so occupied the market over recent years.

Secondly, a decade of high prices has already had a huge impact on global exploration and production activity. It has provided the impetus for the development of North America’s unconventional resources (both tight oil and oil sands). Just as significantly, although perhaps not as newsworthy, volumes are also set to rise from conventional assets across key producers such as Saudi Arabia, Iraq, Angola and, perhaps in due course, Iran. Rig counts across the Middle East are at record levels (403) as of January 2014, while the count in Africa is now more than three times 2000 levels (139)2. It is only a matter of time before this huge investment in new exploration and development drilling begins to bear fruit – and it should be a bumper crop.

In the offshore arena, rising prices have also driven a surge of exploration and production activity in deeper waters. In 2000, global undeveloped offshore oil reserves (2P) stood at 116 billion bbl, with just 21% of these resources in over 500m of water. By the end of 2013, undeveloped reserves had grown to 129 billion bbl, with 54% of that total now in deepwater and ultra-deep water (see fig. 2)1.

In other words, a decade of high prices has already unlocked a vast array of new resources that will support the next generation of developments. The impetus for investing in new exploration may therefore be on the wane – particularly if the oil majors continue to prioritise ‘value over volume’ across their upstream portfolios. This transition is likely to be reflected in new rig orders.

The third key point is runaway inflation. Increasing competition for scarce resources and personnel has seen costs soar right across the oil and gas supply chain. The rig market has suffered its own share of cost escalation, particularly in relation to drilling packages. Indeed, these are now the primary cause of delays to new deliveries. With a more uncertain outlook in terms of rig demand and a rising cost base, rig managers may well begin to think twice before committing capital to new rig projects, particularly more speculative newbuilds.

Given this context, it is more than likely that newbuild orders will begin to decline from 2016. History says it will be a sharp decline. Rig deliveries fell from a 1982 peak of 104 to just 22 by 19842. However, there are two main reasons which lead Infield Systems to believe that the anticipated downturn in newbuilds will not be so severe this time around.

Firstly, the average age of the global fleet has been falling since 2007 but still remains above 20 years3. This, in and of itself, is not a compelling argument because legacy assets can still be used on new exploration and development projects. However, demand is increasingly shifting towards higher-performing assets that meet stringent operational and safety requirements. Older units will find it increasingly difficult to meet these standards.

The natural churn of these old assets should provide continued opportunities for newbuilds over the long term. Jackups are likely to make up the lion’s share of numbers simply because of the fleet’s age profile. By contrast, drillship orders are likely to fall dramatically given that the fleet is now, on average, nine years old4.

The outlook for semisubs is more complex. There is clearly scope for additional sixth and seventh generation newbuilds, not least because of a growing backlog of deepwater development drilling. In all, subsea tree completions5 over the next five years (2014-2018) are expected to increase by a CAGR of 11.8%6. Moreover, new rules on asset capabilities in the US Gulf of Mexico7 are likely to see increased demand for more modern semisubs in this key market.

While on the face of it these factors should provide strong impetus for new orders, the market has in fact been relatively subdued in recent years. This could be for two key reasons. Firstly, the increasing tendency of rig owners to upgrade existing assets ahead of commissioning newbuilds. Secondly, the recent proliferation of drillships may see these assets used on a greater range of development work despite their relative operational shortcomings11. These two factors may mean that semisub newbuild demand will remain relatively subdued despite a booming market for deepwater development drilling.

Leading indicators highlighted by InfieldRigs data therefore suggest that, after more than a decade of rising prices and a booming newbuild market, the wind may be about to change. Predicting the exact timing of that change is very difficult but Infield Systems expects that, from 2016, newbuild orders will slow.

There are, however, good reasons to believe that the downturn, when it comes, may not be as severe as that seen in the previous newbuild cycle. This is largely because the nature of the industry has profoundly changed. Activity has broken ground in deep waters and harsh environments. Moreover, stakeholders have new operational and safety requirements that legacy assets will increasingly struggle to meet. InfieldRigs data therefore shows that the newbuild market is heading into deepwater but it’s unlikely to sink without a trace.

1 Source: Infield Systems Limited

2 BP, Global Energy Outlook to 2035 (February 2014)

3 Baker Hughes, International Rig Counts (January 2014)

4 Source: Infield Systems Limited

5 Source: Infield Systems Limited

6 Source: Infield Systems Limited

7 Source: Infield Systems Limited

8 This refers to subsea satellite well and template well completions

9 Source: Infield Systems Limited

10 Post Macondo rules limit the use of older 4th and 5th generation semisubs in the US Gulf of Mexico

11 Semisubmersibles are often preferred for development drilling because they can be moored rather than rely on more costly DP systems over the course of more lengthy development drilling campaigns.

Edward Richardson is an analyst with Infield Systems’ Business Strategy team. He graduated with a BA in History from St Catherine’s College, Oxford, and completed a post-graduate diploma in law before joining the oil and gas team at research house, Business Monitor International (BMI). At BMI, Edward focused on oil industry analysis and forecasting with emphasis on North American energy markets. With Infield, Richardson has worked across a broad range of projects focused on the offshore market with particular emphasis on support service.