How Do Offshore Drilling Companies Make Their Money?

Offshore drilling is a booming market in the U.S. and around the world, despite bad press from the Deepwater Horizon spill. Oil is becoming harder to find on land and explorers are moving to places like shale, or tight oil, and into ultra-deep water to find new reserves.

This expansion of drilling has led to a boom in rig construction and a sharp rise in revenue per rig. So, how exactly does an offshore drilling company make money and what should investors be watching for to see if the long-term thesis is intact?

Building an apartment on the ocean
An offshore oil rig can be viewed somewhat like a real-estate investment. You build a rig for an upfront cost and then someone rents that property for a fixed monthly or daily fee. There are some operating costs to go along with owning the rig, and some costs fall on the renter, but in the end the big numbers to watch are what the rig costs and how much rent is.

Here is where rig owners really differentiate themselves. Not all rigs are built at the same time, with the same specifications, and not all companies own the same number of rigs in each segment of the market. In general, older rigs don't command the same dayrates as a new rigs, particularly as high specification floaters and ultra-deepwater drillships have grown in popularity. At the same time, ultra-deepwater rigs can command dayrates in excess of $600,000 while jackups (shallow water) are considerably less.

You can see in the dayrate table below that these trends play out in last quarter's rates. Floaters (deepwater) have higher dayrates than jackups, which operate in shallow water and don't have high demand right now.

Note: The number in parentheses is the number of rigs owned and built (excludes under construction).

You can see that SeaDrill (SDRL) has a high dependency on deepwater rigs and since it has a relatively new fleet it also commands high dayrates. Transocean (RIG -2.29%) recently sold most of its shallow water fleet to focus on the deepwater market, which is why its rig numbers skew heavily toward floaters. Ensco (VAL) and Noble (NEBLQ) are more dependent on jackups but have three drillships under construction in an effort to capitalize on the deepwater market.

Investors who have followed these trends have outperformed the market. SeaDrill is the clear winner because of higher returns on ultra-deepwater rigs, while Ensco and Noble have struggled to make money on shallow-water rigs. Transocean is well set up for the future but the Deepwater Horizon spill took a bite out of past returns. 

SDRL Total Return Price data by YCharts

Foolish bottom line
When looking at offshore rig owners you can view them somewhat like a real-estate investment. Right now, new ultra-deepwater rigs are like the luxury apartments in Manhattan that keep being built and keep being in high demand. Considering the fact that an ultra-deepwater rig costs around $600 million and commands $600,000 per day, the payback is less than two years -- something older jackup fleets can't match. 

Look for new, ultra-deepwater exposure in offshore drilling. It's where the profits are and there's no end in sight to industry demand.