Conventional wisdom says that offshore drillers will have several lean years ahead of them because of oil-price volatility and investment cutbacks. As the theory goes, oil companies will first invest in onshore drilling, as it's far cheaper than offshore drilling, which will lag behind the oil recovery. Yet The Wall Street Journal just released a report that says crude oil production from the Gulf of Mexico is expected to increase by 500,000 barrels a day by 2017.
Which of course begs the question: how is this production increase possible under the current market conditions, and does this mean the tides might be rising for offshore drillers?
The production increase
According to the report, producers are expecting to pump 1.91 million barrels of oil equivalent per day (BOE/D) in the Gulf of Mexico by the end of 2017, up from 1.54 million at the end of 2015. The added production would help offset expected decreases nationwide, with production expected to fall from 8.7 million barrels a day to 8.5 million barrels later this year.
There are two primary reasons driving this increase. The first is that discoveries and oilfield development dating all the way back to 2005 are finally coming online. For example, Freeport McMoran (NYSE:FCX) and BP (NYSE:BP) will both begin pumping oil this summer from oilfields they've been developing for several years.
The second reason behind the increase is a process known as tiebacks, when one company connects smaller offshore wells to pre-established oil rigs. A prime example of this practice is ExxonMobil's (NYSE:XOM) 13,000 BOE/D from a well it connected back to a Chevron (NYSE:CVX) rig. Exxon expects this tieback to eventually increase to 34,000 BOE/D. Companies such as BP, Royal Dutch Shell, and Noble Energy are also expecting to utilize these cheaper production techniques .
How offshore drillers will benefit
You shouldn't bank on this production increase yet as a reason to bet on offshore drillers. As mentioned, upstream oil producers are seeing the fruits of past investments or utilizing cheaper alternatives, as opposed to establishing new rig positions. While this trend could theoretically prolong existing offshore contracts, you shouldn't yet feel confident that idle rigs will be scooped up.
This is, unfortunately, bad news for offshore drillers such as Atwood Oceanics (NYSE:ATW), Seadrill (NYSE:SDRL), Transocean (NYSE:RIG), and Diamond Offshore (OTC:DO) all have rigs in the Gulf of Mexico. Diamond Offshore currently has six in operation, but two of those have contracts that expire this year, and an additional seven have been cold-stacked, which is driller parlance for long-term idle storage. And both contracts for Atwood's rigs in operation in the Gulf will expire by 2017. The point is that rigs that are in operation are operating on developments and contracts that were planned several years prior and have already been contracted out. New contracts are not yet becoming a trend.
Will production even increase?
To make matters worse, it's possible that new regulations will counteract any future increases, further quelling demand for offshore drilling contracts. Offshore producers with a large Gulf presence have recently claimed that a new U.S. plan to strengthen offshore drilling regulations will cost them $25 billion over 10 years and counteract the potential profits from future discoveries.
A report from consulting firms Quest Offshore and Blade Energy Partners, which admittedly came on behalf of the industry-funded American Petroleum Institute, puts these costs at $31.8 billion and results in a loss of -- you guessed it -- 500,000 BOE/D by 2030. While the government puts the expected costs at less than $1 billion, there is undoubtedly some serious concern from oil producers.
And that brings us back to the original point. Whether or not oil production does in fact increase in the Gulf of Mexico, that production will be based on pre-existing discoveries or cheaper alternatives than submitting contracts for new rigs.
It's tempting to buy into the hoopla over large near-term increases in Gulf of Mexico crude oil production. But conventional wisdom is usually conventional because it's based on the known fact. Any increases could quickly be reversed by new regulations and will almost certainly utilize the cheapest possible methods of drilling. If you're tempted to invest in an offshore driller operating in the Gulf of Mexico, just remember that new contracts will remain difficult to come by for several more years.