CHALLENGE FOR DRILLING CONTRACTORS CONTINUES INTO 1990S

Matthew R. Simmons
Simmons & Co. International

Houston

The keys to success for the drilling contractor of the 1990s include:

Financial prudence, in terms of demanding realistic returns from customers
Resisting the urge to begin speculative rig building when conditions start to improve
Avoiding the temptation to chase various foreign markets through costly rig moves without solid contracts.

In a few months, the contract drilling industry will mark a full decade since it was last healthy and profitable throughout the world. U.S.based land drilling contractors, which still make up the largest single part of the drilling industry, have suffered through 10 years of financial losses. Fig. 1 shows the drop in land drilling activity during this period. These losses eroded the net worth of many independent contractors who had no other substantial resources to subsidize the drilling operations.

By now, even those with external resources have exhausted these funds or have decided to quit investing good money after bad and are leaving this business. The majority of their drilling fleets have also been heavily cannibalized of many critical parts so that a small core group of rigs can continue to work.

For the offshore drilling contractors, the decade has been less severe because the downturn did not start to reach a crisis stage until 1985 (Fig. 2). Geographical pockets of prosperity remained even during the worst times. Also, many regional markets quickly recovered from their lows during 198687. Today, a handful of regional markets are nearing all-time peaks in both rig utilization and day rates.

The international land rig market has also avoided the total collapse seen in the U.S. Like the offshore market, conditions vary by region, and most specific markets are very limited in size with a small number of contractors, each of whom operates only a handful of rigs.

These regional markets are tricky for a newcomer to enter. The logistical learning curve is high, and a new entry can easily collapse the rate structure that attracted the new entry in the first place.

SERVICE INDUSTRY

With some geographic exceptions, there is no clear sign of improvement ahead. Curiously, most other sectors of the worldwide oil service industry recovered over the last several years from the great collapse of the 1980s. This includes even those service companies operating strictly in the U.S., where activity is still 15% off the peak reached 10 years ago.

The recovery in the other parts of the oil service industry has been nothing short of miraculous. Many oil service companies that were suffering cash losses as recent as late 1987 are now generating earnings before depreciation, interest, and taxes (Ebdit) at levels higher than the average Fortune 500 company. The top oil service company financial performers are generating over 25% Ebdit, an astonishing return for a business that is still operating at depression levels of activity (Fig. 3).

For the healthy oil service companies, this incredible comeback is the result of massive consolidation, plant closures, layoffs, reduced product lines, and the introduction of an array of impressive technical changes. Additionally, many companies returned to rational pricing for most services.

As the oil service industry began this consolidation, many oil and gas companies worried that consolidation would be to their detriment because the leverage over their vendors would diminish. In reality, the customer was the net winner from consolidation. Consolidation allowed key oil service companies not only to survive but to implement technical advances which have reduced the total cost of finding oil and gas. This has helped the service sector attract new capital, retain a skilled work force, and begin some reinvestment.

Ironically, the contract drilling industry's lack of consolidation has kept day rates low and has pushed it to the brink of insolvency in the U.S. Over time, this lack of consolidation will cause the oil and gas companies far greater problems than any benefits derived from today's low day rates.

As progressive oil and gas companies prepare detailed plans for the rest of this decade, they should address the problem of how to ensure the survival of the drilling contractor. As the ramifications of a possible extinction of the drilling business become clearer, the customer will realize that it lost from the lack of consolidation.

On a long-term basis, the problems facing both the drilling contractor and its customer are worldwide. Even the relatively prosperous foreign drilling markets have day rates that are not close to justifying any new equipment purchases.

The drilling crisis is most acute for U.S. land contractors. However, because most U.S. land drilling contractors are privately owned, operating five to ten rigs each, the dangerously weak state of this business has little visibility and receives a low level of publicity. An accurate diagnosis of the true health and staying power of this whole sector is frightening.

MANPOWER SHORTAGE

From a manpower standpoint, the U.S. industry has already lost a large pool of skilled crews that once operated close to 5,000 U.S. rigs. Last fall, when the rig count stayed above 1,000 for more than a few weeks, there were numerous indications that the industry had reached its limit of available crews. Yet, rig operating levels were only one fifth that of 9 years earlier.

Since last fall, there has been a further drain of skilled personnel leaving the U.S. for many of the much stronger foreign markets.

Thus, as the rig count ultimately starts to rise again, no one should be surprised at a manpower shortage emerging at even lower levels of drilling activity than last fall. Decades of cumulative training and field experience have evaporated in a handful of years.

The wage levels for land drilling crews in the U.S. also highlight both the current financial duress and the coming cost pressure for this business. A decade ago, skilled drillers were paid $12-13/hr and were in constant demand. Wages began to fall, and even the most skilled drillers rarely worked a constant full shift for any length of time.

By 1987, pay for trained drillers had fallen to approximately $8/hr, and many were only able to work 50-60% of the time.

Since 1987, wages have been pushed back toward a $12/hr level. But this is now merely a pay scale competitive with the relatively menial labor jobs in many far less demanding industries that also offer steadier work. Over the next few years, if the drilling industry has any chance to attract intelligent, hard working labor, wages will have to rise by at least 50%, and job security has to be guaranteed.

Otherwise, there will be no reason for any sensible worker to enter this demanding business.

DRILL PIPE SCARCITY

Scarce labor is only one problem facing the industry. An equipment shortage is another coming problem. Ten years ago, over 4,500 rigs were actively drilling in the U.S. compared to an average of 900 for each of the last 4 years. Despite this enormous reduction in rig activity, signs of certain types of equipment shortages are starting to appear.

For instance, in the fall of 1988 and again in late 1990, the last two times when the rig count exceeded 1,000 for more than a month or so, surplus drill pipe vanished. Drill pipe is the most visible or "wearable" of all drilling equipment. It is perhaps the best indicator for a massive need to begin replacing many key components of each individual land rig.

The cost of a new string of drill pipe exceeds the total value of many well-maintained, older rigs that constitute a large portion of the U.S. fleet. Many of the contractors who own these rigs have no financial means to replace this drill pipe once the current strings are gone.

A few large contractors have carefully stockpiled top quality drill pipe for the inevitable day when it might dictate whether a rig is capable of taking on any more work. Even these stockpiles could merely postpone shortages on a temporary basis.

For example, one of the largest of these "drill pipe stockpilers," recently calculated that in the past year it wore out drill pipe worth over $12 million on a replacement cost basis. This exceeded the total cash generated by this contractor's entire fleet during the year.

Drill pipe is only the tip of the iceberg for the coming equipment shortage. Various components of drilling equipment will have to be replaced with new equipment instead of spares, auctioned used equipment, or cannibalized pieces from other rigs. However, there are no longer very many manufacturers of this equipment waiting to serve the demand. There are only a few manufacturers remaining that are capable of beginning serious rebuilding of drilling component stock.

A worse surprise could be in store if one presumes that the few manufacturers still in business have ample supplies of 1980-vintage equipment as surplus inventory. Only 5 years ago, major drilling equipment manufacturers had as much as an 80-year supply of certain drilling rig items based on the usage rates at the time. Even these surpluses have virtually disappeared.

OFFSHORE FLEET

In the offshore drilling sector, the financial duress is not as dramatic as that of the onshore sector. The offshore industry stayed much healthier for a much longer period, and day rates for most types of equipment have been above the break-even point for most of the decade.

Moreover, the cost of an offshore rig is so large that it is almost inconceivable that a rig would have to stop working because of an inability to purchase new drill pipe or various individual rig components.

The coming crunch in the offshore arena, however, will be driven by the aging of the offshore fleet. At some point in the next few years, virtually all of first and second generation offshore equipment built in the late 1960s through the mid-1970s will reach an age that either renders the equipment obsolete or only marginally desirable from an operator's perspective.

The age of the worldwide offshore drilling fleet now averages about 13 years. If all the rigs over 20 years old were suddenly scrapped, as some argue should logically happen, the worldwide rig utilization rate would suddenly jump to 88%. If all the rigs that are 17 years or older stopped working, the utilization of the remaining fleet would reach almost 100% (Fig. 4).

This is the case even while the Gulf of Mexico drilling, historically the largest offshore market in the world, is so depressed. Therefore, some new offshore rigs will need to be built during the coming decade merely to keep offshore activity at its current levels.

DAY RATES

When new offshore rig orders begin, it is vital for the financial well being of the offshore industry that these new rigs go hand-in-hand with much higher day rates and, more importantly, long-term contracts. Historically, most new rig building has only occurred when day rates approached a yardstick of a $1,000/$l million of equipment costs.

In other words, an $80 million rig would need a day rate of $80,000/day. Moreover, other than the speculative splurge of rig building that took place between 1979 and 1982, most other rig purchases also had at least a 2-year contract in hand for the rig before any construction started. For most offshore contractors, the need for a long-term contract to support new construction is imperative, not just financially prudent, even if day rates rise to the "$1,000/$l million" threshold. Few contractors have a balance sheet strong enough to support any speculative building.

The cost of a fourth generation semisubmersible exceeds the entire net worth of all but a small handful of drilling contractors. To undertake a speculative building program without a fairly longterm contract in hand exposes the particular contractor to huge financial risks. If there is merely a weak market for 1-2 years while the debt of an expensive new rig is incurred, a contractor could be forced into bankruptcy or reorganization.

Offshore drilling has always been cyclical with at least mild downturns every few years. It would be difficult for a contractor to assume that this cyclical trend has now disappeared and to bet the survival of the company on an expensive, speculative rig building program.

Unfortunately, the logical need to obtain long-term contracts from the oil and gas companies is in total contrast to the current plans of the operators. While they are financially strong, these operators are working hard to posture themselves with the maximum amount of future flexibility. This will allow the operators to switch from one geographic arena to another, adjusting their long-term activities as rapidly as possible. Thus, the current planning mode and mind set of the industry do not fit with the concept of committing to 5 or more years for a particular type of drilling profile.

Recently, several operators announced some giant discoveries in the deepwater Gulf of Mexico. There are only a few rigs in the world capable of drilling at the water depths of these new discoveries. Yet, several of these deepwater rigs have recently been released from their contracts because the operators want some time to decide on the next phases of these programs.

The operators face the risk that specific rigs might take long-term work in other parts of the world during this "breather." Their alternative is to tie up unique deepwater drilling equipment when no immediate work is needed. Day rates may have to more than double current rates to justify building new equipment for this deepwater work to proceed.

FINANCING

Another problem surrounding the need to build new offshore rigs is finding a party to provide the financing for such equipment, even if good contracts were in hand to cover part of the risk. Over the past 30-40 years, four sources of financing supported the construction of virtually all offshore rigs:

The shipyards
A handful of knowledgeable commercial banks, who essentially loaned against the overall balance sheet of the contractor and not against a specific rig
Governmental financing programs designed to stimulate shipbuilding employment
Tax shelter sources from parties willing to put up equity in return for the tax benefits of this equipment.

At present, each of these four traditional sources has disappeared. There may always be a special situation lender capable of financing a limited number of rigs, particularly if the perceived returns look reasonable. However, there are no obvious lending sources with resources large enough to replace just the 20+ year old equipment.

These offshore challenges will dominate the drilling industry's agenda throughout the next decade.

ONSHORE RECOVERY

Land drilling in the U.S. is so troubled that it is difficult to imagine a credible recovery case.

The U.S. relies on the onshore production from the lower 48 states for approximately 70% of its current oil and gas production. Thus, it is a large problem.

Although frontier areas and deepwater offshore drilling get most of the industry's attention and publicity, the entire energy infrastructure is still anchored on the land-based hydrocarbon production from the lower 48 states.

To keep even a reasonable portion of this production in place requires a healthy drilling industry. The U.S. would face political disaster if it let this core oil and gas production atrophy merely because the land drilling contractors disappeared.

If such a risk seems overblown, remember that about 75-80% of the land rigs at work at any time in the U.S. are not exploring for new oil or gas but are drilling development wells.

Simplistically, this is merely punching more straws into known hydrocarbon reservoirs to keep production from declining even faster. Although seismic, wire line, or stimulation services could disappear without shutting down the oil and gas industry, there must always be a contractor on the drill site before anything else can happen.

All of these other services, although needed, are irrelevant without the drilling contractor first drilling the wells.

GULF OF MEXICO

Another problem specific to the U.S. is the state of offshore drilling in the Gulf of Mexico. The health of so many attractive foreign markets is rapidly draining all the younger offshore rigs from the Gulf. In the past when a bad market occurred in the Gulf of Mexico, most of the rigs would get stacked in Sabine Pass or other offshore rig parking lots to wait for better conditions.

For the past 18 months, little of this stacking has taken place because many non-U.S. markets have been so healthy. Instead, the good rigs have left the U.S. for better markets elsewhere. Thus, the industry now witnesses the biggest drain of good equipment and scarce, well-trained crews since offshore drilling was first introduced in the Gulf of Mexico some 45 years ago. Fig. 5 shows the number of rigs that left the Gulf of Mexico over the last 1-1/2 years.

Unless a variety of foreign markets weaken or the Gulf of Mexico improves, this critically important area faces a dual risk. It may become the dumping ground for all the oldest offshore equipment in the world, and all the new equipment may migrate to attractive foreign markets. Then, the Gulf of Mexico operators will be forced to pay two to three times current day rates to lure newer equipment back to this area or to stimulate new rig building.

FUTURE MARKETS

The foreign markets should remain healthy relative to the U.S. for the near future, provided the various governments that control these markets keep attractive energy policies in place. This generally means a combination of access to attractive acreage on reasonable financial terms and tax policies that encourage drilling and production regardless of the current pricing for oil and gas.

Curiously, the U.S. is virtually the only country in the world with any meaningful oil and gas production which has gone the other directions by:

Taking away attractive acreage
Charging unattractive terms
Often prohibiting drilling after a lease is held
Systematically taking away most forms of meaningful tax support.

All of these are measures that discourage additional energy development despite the U.S. remaining the world's most voracious energy consumer.

The biggest risk facing the foreign markets is too much speculative rig migration. Most foreign markets are relatively limited in size. A rolling collapse of healthy markets is possible as contractors move rigs from weak markets to good markets, only to find that the good market collapses on the arrival of one additional rig. Thus, the contractors will need to adopt a high level of financial discipline to avoid these speculative rig moves. Few contractors have the financial resources to make many wrong bets.

The only certainty is that new equipment will someday have to be added both offshore and onshore. When this occurs, replacement cost pressures will force a rise in day rates. The uncertainties include how much this new equipment will cost by the time a massive rebuilding begins and what kind of equipment will need to be built.

In the offshore market, it is hard to foresee many contractors building shallow water jack up rigs, given the limited working areas of this equipment. Most of the 150-250 ft jack ups were built when the majority of offshore drilling took place at such water depths. It seems logical to conclude that most contractors will try to build rigs capable of drilling in as many water conditions as possible.

It would not be surprising to find that the average new jack up costs $60-75 million and a new semisubmersible costs over $200 million. To support this new equipment, jack up day rates would need to be at least around $6075,000/day (current day rates for jack up rigs in the Gulf of Mexico range $10-20,000/day). And a fourth generation semi would need to have a contract probably exceeding $200,000/day.

Similarly, the industry has probably seen the last of mechanical rigs. A newly built land drilling rig will likely have all the latest electronic equipment, along with some modified top drive or other form of rig automation. Even now, a land rig costs in excess of $6 million, and only a few are being built. By the time new rig orders are commonplace, it would not be surprising for the total cost to exceed $8 million per rig. Thus, onshore drilling costs will need to skyrocket from current levels.

Given these probable day rates, the future will be bright at some point in the decade of the 1990s, but only for drilling contractors who outlast these terrible conditions.