U.S. DRILLING CONTRACTORS COULD FACE STIFF CHALLENGES

Matthew R. Simmons
Simmons & Co. International
Houston

Although the outlook for most segments of the contract drilling business is now more optimistic than in the past decade, the increased activity has brought several problems: the availability of fully trained crews, the need for new capital, and the limited number of quality drillstrings.

These problems will grow in importance if natural gas deliverability begins to decline visibly and once the scramble to correct this decline begins.

As the drilling recovery unfolds, the most important lesson to remember, based on worldwide activity in the past year, is how rapidly conditions can change and how quickly excess capacity can turn into chronic shortages.

The various segments of the worldwide contract drilling industry's prospects have changed dramatically during the past 12 months, and oddly, some market sectors have improved while others have become worse. These quick changes highlight the unpredictable and volatile nature of the markets for contract drilling and other services needed to drill and complete oil and gas wells.

U.S. LAND

One year ago, the land drilling business in the U.S. was finally starting to rise from its record low levels hit earlier in the year. By the end of 1992, this rally sent the number of land-based rigs at work up to more than 900 from a low of less than 600 the previous spring. Much of this rise in activity, however, was driven by the expiration of the Section 29 gas well tax incentives on Dec. 31, 1992. More than 25 % of all rigs at work in the U.S. in the final quarter of 1992 were drilling these Section 29 wells.

In early 1993, the number of land-based rigs at work in the U.S. began to plummet as the Section 29 gas wells were completed. By the end of April, the rig count had again fallen to a level seen only during the worst of the depression era of the 1930s before finally starting to rise again. However, as activity has increased by less than 20% from the recent all-time low, shortages of both manpower and some consumable parts have already started to surface. This is a very troublesome sign as the current level of drilling is still 60% below the country's 50-year average.

U.S. OFFSHORE

Offshore drilling in the U.S., which has now become almost entirely a Gulf of Mexico drilling story, was extremely depressed a year ago. Most offshore contractors with rigs in the Gulf of Mexico were busy trying to identify international work prospects to enable them to move their remaining rigs elsewhere, despite the fact that over 50 rigs had already left the Gulf for more attractive work outside the U.S.

By last summer, Gulf of Mexico drilling had fallen to a level last experienced in the early 1960s, when offshore drilling was still in its infancy. There were fewer than 60 rigs under contract with less than 40 of those actually drilling, a decline of nearly two-thirds from the steady level of Gulf of Mexico drilling which occurred for 3-4 years before gas prices began to collapse in early 1991.

The demise of Gulf of Mexico drilling was tied entirely to the collapse in natural gas prices which began in the winter of 1991 and climaxed in the winter of 1992 when prices fell to about $1/Mcf. As offshore drilling bottomed out last summer, gas prices had already begun a surprisingly strong recovery. Hurricane Andrew, which temporarily shut in about 15% of the Gulf's gas deliverability, sent U.S. gas prices soaring from an already high level of more than $1.80/Mcf. X major recovery of Gulf of Mexico drilling was under way.

Despite the large number of offshore rigs that have migrated back to the U.S., in some cases only after recently having arrived at a foreign site, and the reactivation of a sizable number of cold-stacked rigs, Gulf of Mexico rig utilization and day rates have both soared. Today, virtually every rig that is capable of working in the Gulf of Mexico is now at work.

As of mid-August, approximately 120 rigs were under contract in the Gulf of Mexico, more than double the level of offshore rigs at work 1 year ago. The increase is a pleasant surprise for offshore drilling contractors, but the number of rigs at work in the Gulf of Mexico is still only about 80% of the previous 10-year average.

The potential implication of possibly being limited to this lower level of drilling for some extended period could have direct consequences on the deliverability of natural gas in the U.S.

CANADA

Another very depressed drilling region was Canada, where drilling virtually ceased in early 1992.

As the extremely cold winter of 1993 wore on, the Canadian natural gas producers could not even supply their country's needs. For various periods, U.S. gas producers exported gas into Canada. The irony here is that Canada has become the swing producer of gas for the growing U.S. demand which had already outpaced the available supply from U.S. sources alone several years ago.

This surprising tightness in the Canadian gas market had a quick impact on Canadian drilling, and by winter peak in 1993, Canadian drilling was up more than three-fold from its low point a year earlier. After the spring thaw, Canadian drilling rebounded again and is now more than double the level of last year.

INTERNATIONAL MARKETS

Throughout much of the rest of the world, drilling activity (which had been perceived as so promising only a year earlier), began to weaken in 1992 and has continued to either soften or stagnate during 1993. A combination of weak oil prices, tax uncertainties in the U.K. sector of the North Sea, and a reevaluation of several foreign areas by the major U.S. oil and gas companies in light of the surprisingly favorable changes in the U.S. gas outlook has created a big question as to how robust the overall foreign drilling markets will be. These factors also call into question whether the "bloom is off the rose" for highly touted foreign exploration opportunities.

International drilling markets have been generally disappointing. Two factors clearly contributed to the decline in international drilling:

The 1991-1992 natural gas collapse in the U.S. had a serious impact on the discretionary exploration and production (E&P) cash flows of virtually all sizable U.S.-based oil and gas companies, all of which were gearing up for ambitious international expansion. As gas prices have now recovered, it would appear many domestic and international spending cutbacks are easing.
The second factor impacting a low international rig count is the spending pattern inherent in most foreign drilling projects. The cash outflows typically last 5-7 years before oil and gas deliverability begins to produce a positive cash return, a sharp contrast to the 2-year average for a typical U.S. E&P project.

Given these spending patterns, it is useful to examine the actual E&P spending in 1992 for all non-U.S. projects as recently reported in Arthur Andersen's Resource Disclosure report, This report reveals that foreign exploration and development spending was still $30.8 billion in 1992, 93% of the record $33 billion spent in 1991.

Much of this expense, however, was focused on "soft dollar" projects, such as concession and lease payments, data gathering, geophysical interpretation, and other logistical expenditures (which include mundane tasks like road construction to planned drilling sites). Although these activities do not immediately affect the rig count, such expenditures pave the way for future "hard dollar" spending which becomes revenue to the international drilling contractor. As gas prices continue to firm and predrilling soft dollars finally become hard dollar rig expenditures, foreign markets could finally become as strong as so many forecasters predicted 12-18 months ago.

CAPACITY

The various segments of the contract drilling business have become very fragile, as illustrated by regional changes from chronic excess capacity to extreme tightness in less than I year even with activity levels far below historical averages.

These changes have raised a question as to how effectively the contract drilling business could respond to a need to increase activity levels significantly. There are several lessons to be learned from the recent drastic changes in the drilling markets:

The consensus view of the industry has often been wrong, yet so many industry participants continuously assume that any revised consensus outlook must now be the correct view of the future. There seems to be little or no institutional memory as to how inaccurate consensus forecasts have been in this unpredictable area. Only 18 months ago, many people thought the overall U.S. and Canadian drilling activity was dead and the only place to be was anywhere outside either area. Now, just the opposite is true.
The drilling markets respond quickly to surprises. In a period of less than I year, Canadian drilling almost tripled, and Gulf of Mexico drilling more than doubled. If one carefully scans all the various petroleum publications, it is hard to find anyone who predicted such changes.
The drilling industry has dramatically reduced its overall capacity, and the industry's capacity constraint may become a near-term limit to any further growth. For instance, by the end of 1992 when there were still less than 100 rigs at work in the Cuff of Mexico and the apparent utilization rate of Gulf of Mexico rigs was less than 70%, a close examination of the real supply and demand showed that the effective utilization was nearing 90% and that day rates would soon increase if activity rose any further.

For U.S. land-based drilling, the capacity limits might be even more severe. For instance, when overall drilling in the U.S. finally reached 700 active rigs earlier this summer, many land drilling contractors suddenly found that they had run out of trained drilling crews. One of the country's largest land drilling contractors began to nm advertisements for additional drilling crews for the first time in many years- during a time when the rig count was less than 20% of the high level recorded only 12 years earlier.

These surprises raise several major questions: Can the drilling industry respond in a reliable manner to a sudden need to drill at much higher levels than today? Where are the biggest vulnerabilities in achieving such increases? If the drilling contractors could not easily respond to a "wakeup call," how will the overall health of the domestic oil and gas business be affected?

NATURAL GAS

Some people question whether such a wake-up call is ever likely to occur because of an assumption that a U.S. rig count of 700-900 or a U.S. offshore rig count of 110-120 is normal. The answer rests in an appreciation of the U.S. natural gas market's importance to the health of the domestic energy business, the livelihood of the entire oil service industry, and the well-being of the majority of worldwide oil and gas companies because so many of them have a significant amount of their discretionary cash flow tied to the price and volume of natural gas produced in the U.S.

For the U.S. to maintain a healthy long-term natural gas business, it is critical that deliverability of gas stay high, particularly in the peak winter months.

It is also important for prices to stay as steady as possible because the biggest competitor to natural gas is coal, an energy source which can be offered to its customer base via comforting long-term contracts.

There is only one way to ensure that natural gas prices and natural gas deliverability remain relatively steady: Gulf of Mexico gas deliverability cannot drop.

GULF OF MEXICO

Natural gas from the U.S. Gulf of Mexico accounts for close to 30% of the total U.S. gas deliverability base, or currently close to 15 bcfd. Furthermore, a typical Gulf of Mexico gas well has an initial flow rate of about 810 MMcfd compared with less than 1 MMcfd for an onshore well. The U.S. would need to begin drilling almost ten onshore gas wells for every offshore well if the Gulf of Mexico gas well deliverability ever started to fall.

An examination of the number of offshore rigs that drilled the prospects that have created the current Gulf of Mexico natural gas deliverability compared to the number of rigs drilling in the Gulf over the last 2 years (120 rigs at work now), shows that a big drop in gas deliverability is inevitable. The number of Gulf of Mexico gas wells drilled during the past 2 years is far less than the historical norm of the past decade, and the present, much higher drilling level is still only 80% of this same historical base of well completions.

Given this lower drilling level, the only prevention to a coming gas deliverability drop would be for the acreage currently being drilled in the Gulf to be a lot more productive than similar prospects in the past. There is no evidence that this could occur, however.

In 1983, area-wide leasing was first introduced throughout the Gulf of Mexico outer continental shelf. Since then, any tract deemed to be productive could be leased. In response to this acreage availability, the number of leases purchased almost tripled during a relatively short period. Thus, the most promising gas tracts in the Gulf have already been leased and drilled. As a result, the acreage still to be drilled is likely to be less productive than in the past.

Thus, more rigs will be required, supporting the argument for a minimum of 160-180 mobile rigs at work in the U.S. Gulf of Mexico for the near future. To reach such a drilling level (40% higher than today's rig count), virtually every jack up rig not now under contract throughout the world would have to migrate quickly into U.S. waters.

To appreciate how long it would take for a collapse in Gulf of Mexico gas deliverability to occur if drilling for new wells suddenly dropped by a significant amount, consider that a typical Gulf of Mexico gas well has an initial flow rate of approximately 8 MMcfd and a total drainage of 8 bcf. If the flow rate stayed constant (actually, the rate declines), the well would be depleted in less than 3 years. This depletion rate gives support to those who argue that an average Gulf of Mexico gas well produces 35-40% of its total deliverability in its first year and is ready for abandonment by the fifth or sixth year (based on decline curves). If true, Gulf of Mexico gas production is highly vulnerable to significant declines, which should begin relatively soon as the unfortunate but dramatic downturn in Gulf of Mexico drilling activity is now history.

CHALLENGES ONSHORE

An obvious drop in Gulf of Mexico gas deliverability should trigger a burst of drilling in the deeper gas-prone basins of the onshore U.S. When this increase occurs, the deep land drilling contractors in the U.S. will also quickly encounter a limit in their ability to respond to a sudden upturn.

The U.S. would reach its current limit for deep well drilling activity if only about 200 new deep well drilling programs began. Although increases of this magnitude might seem farfetched, similar increases have materialized almost overnight in both Canada and the Gulf of Mexico in the past 12 months.

Two additional problems will inhibit land drilling contractors from responding to a material increase in U.S. exploration spending: a shortage of drill pipe and a shortage of trained personnel.

DRILL PIPE

A pending drill pipe shortage could conceivably begin to impair the 700800 rigs currently at work. In the spring of 1989, Simmons & Co. International conducted a major survey of drill pipe availability in the U.S.; at the time, there were close to 1,000 rigs at work. The survey found that there was apparently enough drill pipe left to support about 3,000 rig-equivalent drillstrings.

This was evidently the last time any effort was made to sample drill pipe availability, and unfortunately, there is no scientific manner in which total drill pipe capacity can be measured. Today, many of the largest and most sophisticated land-based drilling contractors have abandoned their old systems of carefully tracking the wear and total use of their drill pipe on a joint-by-joint basis. A pending drill pipe limitation can only be estimated from the 1989 survey and extrapolated to the present.

If one starts with a presumption that a typical drillstring can sustain 4 full working years (1,460 days) of continuous drilling, the 3,060 strings available at the start of 1989 would enable the industry to drill about 4 million additional drilling days if all those strings were new. However, only a small amount of newly made drillstrings have been purchased for use in the U.S. since the early 1980s. Thus, a safer assumption is that the average 1989 drillstring had less than 2 years of drilling days left, giving the industry about 2 million drilling days before most of the vast pool of drill pipe finally wears out.

Then, from the available supply of drillstrings, one has to subtract the pipe from about 300 rigs that have left the U.S. for foreign work. The adjusted starting supply is therefore 1.5-1.9 million drilling days before the available pool of quality drillstrings has been exhausted. Since the beginning of 1989, the industry has used about 1.4 million of these drilling days, which indicates the industry is rapidly nearing a point where the supply of high quality drill pipe will be gone.

When new drill pipe is needed on a wide-scale, most contractors will have to spend $200,000-300,000 per rig just to keep the current low number of rigs still drilling. When this occurs, a capital call will be thrust on an industry where most participants currently have virtually no access to external capital of any kind (debt or equity).

MANPOWER

The other problem facing the land drilling contractors is a shortage of trained personnel. Contractors have difficulty attracting quality workers to an industry with both low levels of pay and unpredictable prospects for work. In most regions of the U.S., the average drilling crew pay scale is now 50% that of an average automobile worker or coal miner.

Compounding this problem is the small number of young workers who have entered the drilling business since the collapse began in 1982. Thus, the total labor pool for the drilling business has aged considerably during the past 12-13 years of the industry's decline. With so few new entries into the drilling industry labor pool, the total number of trained workers is shrinking through attrition and retirement. This attrition may place a burden on the industry merely to keep the current rigs working.

CHALLENGES OFFSHORE

Drill pipe and manpower problems will not be as pronounced for offshore drilling contractors since the top quality contractors are now generating ample cash flow to keep equipment in top condition and to retain experienced personnel. The offshore contractors' problems will center around ultimately having to begin replacing the current drilling fleet.

In the past decade very few offshore rigs have been ordered, excepting several deepwater jack up rigs and fourth-generation semisubmersibles. Few contractors have had cause to seriously estimate how much a new 300-ft jack up or medium-water-depth semisubmersible would cost.

The cost of building a fourth-generation semisubmersible has jumped from $80-100 million to more than $200 million. If this escalation in cost of a new semisubmersible is indicative of future trends, all types of new offshore rigs will cost twice as much as they did in the early 1980s.

Many offshore contractors have corrected their highly leveraged balance sheets during the last few years, and several are almost debt free. However, none could begin to significantly expand their fleets or even replace several older drilling units without suddenly inheriting a highly leveraged balance sheet once again.