Oil companies began venturing offshore in search of new sources of oil and gas more than a century ago. They started in shallow waters near the coast by building piers out into the sea that could hold a drilling rig. Companies soon moved farther away by constructing drilling platforms in the water. Eventually, they developed vessels capable of tapping oil and gas resources far offshore.
In recent years, offshore fields supplied 37% of global oil production and 28% of gas supplies. Those numbers rose steadily for years as energy companies invested more money in offshore drilling projects. However, the collapse in oil prices starting in mid-2014 took offshore-focused spending with it.
The offshore drilling market finally began rebounding in 2019. Most industry forecasters anticipate this will continue for several years. Fueling that view is the world's unrelenting thirst for oil and gas as well as a significant decline in costs. That uptick in spending should benefit offshore drilling contractors. This guide can help you better understand how to potentially profit from the sector as spending rises.
What is the offshore drilling industry?
Offshore drilling is the process of drilling oil and natural gas wells off the shores of oceans, lakes, and inland seas. The offshore drilling industry supports exploration and production (E&P) companies in finding and producing oil and gas from reservoirs below the surface of the world's oceans and seas. That makes it a part of the upstream segment of the oil and gas market and places it in the oilfield service and equipment subsector. Several leading oilfield service companies provide offshore services and equipment. Meanwhile, many smaller companies build and operate specialized equipment and products or provide specific services to support offshore oil and gas development.
However, when most investors talk about the offshore drilling industry, they're typically referring to companies that own and operate the drilling rigs leased to E&P companies.
What are the types of offshore drilling rigs?
The oil and gas industry requires very specialized equipment to safely and efficiently drill offshore wells. The sector uses three main types of rigs:
Jack-ups: These drilling rigs consist of a mobile platform that includes a floating hull and several adjustable legs that raise the drilling platform above the surface of the water. Jack-ups get their name from the moveable legs that can be extended or jacked above or below the hull. Once in position, a crew jacks the legs down into the seafloor, which anchors the rig above the waves so that it can drill into underground reservoirs. Oil companies primarily use jack-up rigs in shallow water of up to 400 feet.
Semi-submersible rigs: As the name suggests, these rigs are partially submerged underwater. The top of the vessel remains above the water. Structural columns connect it to watertight pontoons moored to the seabed that stay below the surface and help keep it very stable. The industry uses semi-submersible rigs in deeper waters (up to 12,000 feet) because of their stability, especially in harsh environments known for rough waters like the North Sea.
Drillships: These boat-like vessels have a drilling rig installed on a deck that operates through an opening on the ship. Drillships are also capable of drilling in ultra-deep waters of up to 12,000 feet, though they're not as stable as semi-submersible rigs and therefore not ideal for drilling in harsh environments. The industry primarily uses these vessels for oil and gas exploration since they're much more mobile than jack-ups and semi-submersibles. That makes it easier to move them to new prospects quickly.
What are the key terms of the offshore drilling industry?
The three most critical terms that companies highlight are:
- Dayrates: The rate per day that an offshore drilling contractor charges an oil company to use its rig.
- Utilization rates: The percentage of an offshore drilling contractor's fleet that's actively working on behalf of customers.
- Contract backlog: The value of outstanding customer contracts remaining.
Dayrates tend to ebb and flow with demand for drilling rigs. For example, the dayrates for drillships and semi-submersibles capable of working in ultra-deepwater were above $600,000 per day from 2012 to 2014, as high offshore spending levels by oil companies fueled triple-digit oil prices. However, they plunged along with crude prices in the following years -- to an average of around $150,000 per day in 2018. That slump in dayrates hit the profitability of offshore drilling contractors, forcing them to retire older rigs while idling higher-cost ones that couldn't find profitable work.
Offshore drilling contractors aren't making money unless customers utilize their rigs. That's why the industry focuses on utilization rates. This metric can be a leading indicator for investors since an improvement in utilization suggests higher future profitability, while a drop hints that troubles could be coming.
Offshore drilling contractors tend to sign long-term contracts with oil companies for drilling projects. Sometimes these agreements last a few months and cover drilling one well, while others can last five years or more. These contracts typically lock in the dayrates of the drilling rig, providing revenue visibility for the offshore driller and cost certainty for the oil company. The future value of these contracts forms an offshore drilling contractor's backlog, giving investors a glimpse of how much revenue the company will likely collect in the future. A rising backlog suggests future revenue growth, while one in decline hints that rough seas could be ahead.
The rise and fall of the offshore drilling market
While companies have been drilling offshore wells since the 1890s, the industry's importance has increased along with the price of oil because of the high costs of drilling deepwater wells. After spending many decades below $40 a barrel, crude prices started soaring in 2005 because of concerns that there wouldn't be enough of it to meet demand. Oil peaked in mid-2008 at more than $140 a barrel. While it collapsed during the global financial crisis, crude quickly rebounded back into the triple digits. Those high oil prices encouraged oil companies to invest more money offshore. That gave offshore drilling contractors the money to build more rigs so they could drill additional wells. This boom resulted in the industry discovering nearly 500 large offshore fields between 2007 and 2012.
Investment spending on offshore drilling projects peaked at $329.2 billion in 2014, according to data by industry consultant Rystad Energy, fueled by triple-digit oil prices. However, crude prices started selling off in late 2014 as supplies began outpacing demand. That plunge forced oil companies to cut capital spending, especially on higher-cost offshore projects. As a result, investment levels tumbled, falling more than 50% by 2018, when the industry only spent $150.3 billion on offshore oil and gas projects, according to Rystad.
This slump in offshore-focused spending hit drilling contractors hard. The sector had significantly more rigs than it needed to meet demand from oil companies, which caused dayrates to collapse. Most offshore drillers had to idle rigs as well as sell older ones for scrap. That helped reduce costs and the supply of available rigs, which improved utilization rates. However, market conditions got so bad that several offshore drilling contractors declared bankruptcy. The biggest was Seadrill (NYSE:SDRL), which collapsed under the weight of the $10 billion in debt that it took on to buy new drilling rigs.
The 2019 offshore drilling recovery
Market conditions finally started improving in early 2019. Rystad Energy anticipates that after a five-year slump, offshore spending will expand at a 9% compound annual growth rate through 2025. Two factors drive that view. First, the oil market stabilized. That's because major producers like the members of OPEC, as well as Russia, banded together to keep supply and demand closely balanced. These efforts helped boost prices back above $60 a barrel.
In addition to that, the cost of developing offshore oil and gas projects declined significantly. Breakeven levels -- the oil price needed to keep investments from losing money -- dropped from $64 a barrel in early 2016 to $43 a barrel by early 2019, according to Rystad Energy. Some projects, meanwhile, had breakeven levels well below that price point. In offshore Guyana, for example, ExxonMobil expected a $35 a barrel breakeven price for the first phase of its Liza discovery and $25 a barrel for additional ones.
The combination of stabilization in the oil market and low oil breakeven levels led oil companies to ramp up their approvals of major projects. By 2018, the industry had sanctioned two-and-a-half times more projects than it did at the low point in 2016. Many industry forecasters expect continued growth in new offshore drilling projects through at least the mid-2020s.
Risks of offshore drilling
While the offshore drilling industry has returned to a recovery and growth mode in 2019, it still faces several threats that could sink an investment in the sector. Three of the biggest are:
- Oil prices: As noted throughout, oil prices have a direct impact on the offshore drilling sector. When they plunge, investments in the sector dive, which cuts into dayrates and utilization, hurting drillers' bottom lines.
- Overcapacity: Dayrates not only ebb and flow with oil prices, but with supply and demand for drilling rigs. The industry often has more rigs than it needs because it builds too many during the boom years. That can put downward pressure on dayrates even during periods of higher oil prices.
- An oil spill: Offshore wells are much more challenging to drill than onshore ones, owing partly to the intense pressure of not only the water, but also subsea reservoirs. Because of that, a mechanical malfunction that causes an oil spill can have catastrophic and costly consequences. In 2010, for example, Transocean's Deepwater Horizon semi-submersible rig exploded following the blowout of a well it was drilling, causing a massive oil spill. Transocean agreed to pay $1.4 billion for its role in the disaster.
The largest offshore drilling contractors
Dozens of companies own and operate offshore drilling rigs. However, five companies publicly traded on U.S. exchanges dominate the sector:
Offshore Drilling Contractor
Area of Focus
Ultra-deepwater floaters and harsh environment
Modern floaters and ultra-harsh environment jack-ups
Modern vessels and managed partnerships
Ultra-deepwater and high-specification jack-ups
To give investors a flavor of this group, we'll look a bit closer at the top three offshore drilling contractors.
Transocean: Focused on harsh environments and ultra-deepwater
Transocean undertook a significant fleet transformation as a result of the oil market downturn. In January of 2014, the company had 91 offshore drilling rigs. Though only about 45% were capable of operating in ultra-deepwater or harsh environments, which tend to fetch higher dayrates. Fast-forward to January of 2019, and Transocean had slimmed down its fleet to 53 rigs; 93% of them could operate in ultra-deepwater and harsh environments.
The offshore drilling contractor took a multipronged approach to reposition its fleet. It has sold or scrapped 64 vessels from 2014 through early 2019, including selling its entire jack-up fleet to Borr Drilling. It partially replaced the jettisoned rigs by acquiring seven harsh-environment semi-submersibles and 10 ultra-deepwater drillships in three transactions in 2017 and 2018. The company acquired rival offshore drilling contractors Songa Offshore and Ocean Rig for a combined $6.1 billion, and it also partnered with a private-equity fund to buy a 33.3% interest in another vessel for $160 million.
As a result, Transocean controls one of the largest and youngest floater fleets in the industry. It's highly concentrated on rigs that can drill in the harshest environments or deepest waters. Those rigs tend to be in greater demand by larger oil and gas companies, which want to work with the best equipment since they're the most efficient at drilling wells. That should enable Transocean to earn higher dayrates and enjoy a better utilization rate than rivals with less desirable rigs.
The numbers seemed to bear that out, as Transocean's revenue backlog stood at more than four times that of its nearest competitor in early 2019, with some of its contracts not set to expire until 2028. Because of that, the company should generate more predictable revenue than rivals in the decade ahead.
Ensco: The world's largest offshore drilling contractor
Transocean's decision to pivot away from the jack-up market by retiring its oldest rigs and selling the rest opened the door for Ensco to assume the title as the largest offshore drilling contractor. As of early 2019, the company had the second biggest floater fleet and the largest portfolio of jack-ups. Ensco, like Transocean, took advantage of the market downturn to acquire rivals, including buying Atwood Oceanics for $839 million in 2017 and Rowan for $2.4 billion in 2018.
Ensco, however, hasn't sacrificed fleet quality for quantity. That's evidenced by the fact that the vast majority of its rigs are sixth-generation or better, built before 2010. Meanwhile, most of its jack-ups are either capable of operating in ultra-harsh environment locations like the North Sea or are modern vessels less than 20 years old. This focus on owning the newest and most sophisticated rigs should enable the company to command higher dayrates and enjoy better utilization rates. Utilization for ultra-harsh environment jack-ups, for example, was around 80% from 2016 through 2018 compared to less than 50% for other jack-ups.
The company also has a unique drilling joint venture with Saudi Arabia's national oil company Saudi Aramco thanks to its acquisition of Rowan. Those two companies created ARO Drilling in 2017, which is a 50-50 partnership that operates jack-ups to drill wells in places like the Safaniya oil field in the Persian Gulf, which is one of the world's largest offshore oil fields. The two companies had contributed seven jack-ups to the joint venture by early 2019 and agreed to buy 20 newbuild jack-ups that Saudi Aramco's manufacturing joint venture will build and deliver between 2021 and 2030. Each of the newbuild jack-ups will have a 16-year drilling contract with Saudi Aramco, providing strong revenue visibility and growth for Ensco.
Ensco's fleet size and global scale give it a competitive advantage over rival drillers because it has the most versatile fleet in the industry. That positions it to meet any customer need. Add that to its relationship with Saudi Aramco, the largest customer for jack-ups in the world, and the company has put itself in a strong position for whatever lies ahead in the offshore drilling market.
Seadrill: Rising from the ashes of bankruptcy
Seadrill was one of several offshore drillers that declared bankruptcy following the crash in oil prices. The company had borrowed heavily to fund the purchase of several newbuild drilling rigs during the boom years. However, when crude prices crashed, oil companies canceled and postponed offshore drilling projects, which negatively affected demand for drilling rigs. That hurt dayrates and cut into Seadrill's cash flow, making it hard for the company to pay back its debt. Seadrill reemerged from bankruptcy in 2018 with a much stronger financial and cost profile.
Before going bankrupt, Seadrill was in the process of building one of the most modern drilling fleets in the offshore drilling industry. The company bought several newbuild drillships made for ultra-deepwater drilling as well as semi-submersibles and jack-ups designed for handling harsh environments. That young and highly capable fleet should be in high demand during normal offshore market conditions.
Aside from its modern fleet, another of Seadrill's competitive advantages are its relationships with several other offshore-focused companies:
- Seadrill Partners, an offshore driller formed by Seadrill to operate and acquire floating drilling rigs under long-term contracts with major oil companies. Seadrill held a majority stake in Seadrill Partners in early 2019.
- SeaMex, a 50-50 joint venture with Mexico's national oil company, PEMEX, that owns several jack-ups.
- Northern Drilling, an offshore driller formed by Seadrill's founder to buy floaters under construction that Seadrill had canceled. Seadrill didn't have any ownership interest in Northern Drilling as of early 2019 but will manage the rigs.
- Sonadrill, a 50-50 joint venture with the national oil company of Angola, Sonangol, to operate floaters for that high-growth market.
- Seabras, a 50-50 joint venture that owned pipe-laying support vessels under long-term contracts with Brazilian oil giant Petrobras.
- Archer, a global oilfield services company specializing in drilling and well services. Seadrill held a minority stake in Archer as of early 2019.
Seadrill's relationships with these various entities provide it with additional diversification, deeper relationships with key customers, and revenue for managing the vessels. Add that to its modern fleet, and the company is solidly positioned to benefit from a strengthening offshore drilling market.
Offshore drilling: Volatile but vital
Global oil demand growth isn't expected to peak anytime soon. Because of that, the industry will need to continue drilling more wells. That bodes well for the offshore industry since it suggests oil companies will need to keep pouring money into the sector. Those investments should enable offshore drillers to make money, which should boost their stock prices.
However, with that potential reward comes significant risk. The sector not only needs to maneuver through oil price volatility, but also the potential for overcapacity if drillers don't properly manage their fleets. On top of that, there's always the risk for another major offshore disaster, which could cause a significant setback. Investors need to be comfortable with the sector's added risk before jumping into an offshore drilling stock.