Source: Transocean.

On Halliburton's (NYSE:HAL) third-quarter conference call, the company pointed out a key problem facing offshore drilling contractors such as Atwood Oceanics (NYSE:ATW) and Transocean (NYSE:RIG): Because the services provided by drilling contractors make up such a large percentage of the costs of an offshore well, they're easy targets for oil companies looking to reduce costs. It's a factor that could hold back the profitability of offshore drillers for years to come.

The biggest slice of the pie
Halliburton President Jeff Miller noted on the call that much of the profitability from offshore development was "stressed even at $100 [oil] in deep water." Needless to say, the stress has only gotten worse now that oil is half that price. This is forcing oil companies to put pressure on service providers and suppliers to cut them some slack by reducing pricing. However, because of the cost structure of a well, there's one cost, in particular, that oil companies are targeting.

That cost is detailed below by Halliburton CEO Dave Lesar, who added some background color by saying:

I think it's important to sort of sit back and understand where does the customer have a leverage point in these negotiations. So if you go back to a -- let's say U.S. horizontal unconventional well, and it costs a dollar, about -- say about $0.70 of that dollar is focused on the completion, particularly the frac. So that's naturally where customers have gone in terms of the pressure to reduce cost.

Lesar takes a step back to point out that, when it comes to drilling a well, there are certain pieces of the cost pie that are bigger than others. In unconventional drilling, it's the frac job, which is typically 70% of the overall cost. Oil companies are targeting this cost, in particular, because it's such a large portion of the overall well cost. He then took this analogy offshore by saying:

If you go to an offshore kind of a project, the cost is really in the E&C [i.e. engineering and construction] cost, it's in the day rate and the drilling rig [that make up the biggest slice of the pie], and [the] other services work that we do is maybe 20% of that. And so, the leverage point that customers have gone for there... has been to the day rates on the drilling contractors... that's really where the pricing leverage has been directed initially.

In other words, because 80% of the cost of an offshore well is in E&C and the dayrate on the drilling rig, it's the easiest cost for an oil company to target in order to make a meaningful reduction in its costs. That's important for Halliburton because customers haven't been putting as much pressure on it to reduce its costs because the services it provides are only about 20% of the cost equation.

 

Source: Atwood Oceanics 

Feeling the pressure
Offshore drillers haven't been quite so lucky, which is evident by the fact that drilling rig dayrates have been falling like a rock. With fewer contract awards available, it's forcing offshore drillers to either accept a very-low rate, or idle their rigs and receive nothing at all.

Transocean is among the many to feel the brunt of this pressure. It was recently awarded a three-month extension for work on one of its drillships at a dayrate that was $100,000 less than its previous rate of $395,000. Meanwhile, another Transocean rig saw its dayrate fall from $547,000 all the way down to $300,000 on a one-month contract.

Atwood Oceanics, on the other hand, recently agreed to rate adjustments for current contracts that also extend the term of the contract. In one case, the company added four months to the contract of one of its ultra-deepwater drillships in exchange for lowering the dayrate from $584,000 to just $240,000 for those four additional months. This was due primarily to the specific project it would complete during that term. In addition to that, Atwood Oceanics agreed to an extend-and-blend contract with another customer, which lowered the dayrate on another rig from $165,000 down to $85,000, but extended the contract by nine months.

There have been some cases where drilling contractors have been willing to accept break-even dayrates just to keep their rigs working. While that's not sustainable, meaningfully lower dayrates appear to be here to stay. Further, it would require a very significant boost in both oil prices and offshore drilling activity before dayrates were to improve. 

Investor takeaway
Halliburton points out a big problem facing offshore drillers: Dayrates make up such a huge portion of the costs of drilling an offshore well that it makes them an easy target for oil companies looking to cut costs. Worse yet, given the number of rigs currently out of work, and the number with looming contract expiration dates that will be looking for work, offshore drillers could continue to see significant reductions in dayrates. That really dims the near-term outlook for the industry, especially until oil prices improve to the point where oil companies start to increase investments in offshore drilling.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Atwood Oceanics and Halliburton. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.