Following my recent praise of Noble's (NYSE:NE) 2009 results, a reader asked about the risk of long-term rig overcapacity in the deepwater drilling market. It's an important question, and I'm happy to take a crack at it.

First, let's establish some terminology, which we'll borrow from Transocean (NYSE:RIG). When we talk about deepwater rigs, we mean either drillships or semisubmersibles that are able to operate in more than 4,500 feet of water. Ultra-deepwater rigs, a state-of-the-art subset, have a rated water depth of 7,500 feet or more. We'll later see that this is an important distinction.

Oil: Who needs it?
Let's start with demand for these drilling leviathans, which is ultimately driven by oil fundamentals. The dynamics of the oil market extend well beyond the scope of this article. But at a minimum, you need to believe two things in order to have confidence in the demand picture:

  1. Oil and its fellow hydrocarbons will power the global economy for decades to come.
  2. Oil prices will be high enough (call it $60 and up) to justify multibillion-dollar deepwater projects.

If you believe that resource access will remain an issue for international oil companies like ExxonMobil and Chevron (NYSE:CVX), that should further support your long-term outlook for deepwater rig demand. The industry's growing exploratory success, with a record-setting 23 deepwater discoveries in 2009, is also encouraging.

Let's get granular
On the supply side, we can drill down to a more detailed level, thanks to the disclosures of publicly traded drilling contractors.

In July 2008, Schlumberger's CEO noted that there were 68 deepwater rigs under construction around the world, which would double the world's fleet. That was the frothiest point in the market, when oil prices approached $150 a barrel and Transocean landed a five-year, $650,000-per-day contract with Eni. You know what happened next.

There's a multiyear lag from order to delivery, given the scope of these massive construction projects. Since orders for these rigs were piling up until the crash in 2008, we've still got two years of fairly heavy additions to the global fleet. In 2010 and 2011, a combined 53 "newbuild" ultra-deepwater rigs are hitting the water. If the market can digest this proverbial lump in the python, I think we can be pretty comfortable about the longer-term rig supply situation.

This is where the distinction between deepwater and ultra-deepwater (UDW) rigs is so important. Since last August, Transocean has been describing a bifurcation in the market. Back then, it seemed likely that some less capable deepwater rigs wouldn't find work as they rolled off contract. In the case of the two rigs Transocean highlighted, that's exactly what's happened. In addition, rigs like the GSF Celtic Sea, a moored deepwater semisubmersible, have repriced at significantly lower dayrates.

Fortunately, the freshly arriving UDW rigs aren't competing with the less capable crowd. In this area, there are few uncontracted rigs in 2010. Seadrill just signed a contract for the newbuild West Gemini at $473,000 per day, which arrives in July. That leaves Diamond Offshore's (NYSE:DO) Ocean Valor as the only other uncontracted newbuild arrival that I'm aware of among the publicly traded drillers. As far as existing UDW rigs coming off contract this year, Ensco (NYSE:ESV) has one finishing up work in September, while a few other operators' rigs come available in December.

When the storm blows in
In 2011, things get a bit dicier. This is when the most speculative late-cycle rigs arrive. In addition to one delivery each between established players Pride International (NYSE:PDE), Ensco, and Seadrill, a slew of uncontracted rigs are being delivered to newer entrants like DryShips' (NASDAQ:DRYS) deepwater drilling subsidiary. At the same time, around 20 operating rigs are coming off contract.

The world's oil majors won't be so hard-nosed that they break the economics of the contract drilling business, but they will extract meaningful concessions when this short-term oversupply takes hold. Dayrates could easily break below $400,000 per day in this period. This softness may extend through 2012, as a large number of contract rollovers offset an ebb in newbuilds. Oil prices and exploration/development budgets will be a key swing factor in just how rough this period gets for the contract drillers.

A Foolish final word
While I would expect business failures among the more leveraged (and generally private) outfits, most of the public companies we're concerned with have very strong balance sheets. They should be able to not only weather the storm, but pick up some shiny new rigs at fire-sale prices. As far as current valuations, a 2011 downturn is already priced into the shares to some degree. I would view a deep sell-off in the group sometime later this year or in early 2011 as a very interesting long-term opportunity.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. The Motley Fool has a disclosure policy.