Over supply of oil, diminishing returns and an increasing rig fleet will challenge rig operators in 2015. Rystad Energy’s Joachim Bjørni and Oddmund Føre look for a ray of light.
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Graphs from Rystad. |
Throughout 2014, drilling companies were punished in a bearish market where few fixtures and downward pressure on rig rates was the reality. Following the post-summer crash in oil prices, share prices have dropped accordingly (Figure 1). Due to diminishing margins, free cash flows have been key to the oil companies’ performance for a while, and with an oil price scenario resembling that of 2008, we now expect to see further reduction in investments and an ever increasing focus on capital allocation. As a direct result, an increasing number of rigs without contracts have been stacked; simultaneously, we expect the entry of newbuilds to worsen an already oversupplied market.
In the short-term, drilling companies will face some rough waters. Predicting the future of the drilling markets is right now almost the same as predicting the future of the oil price, and therefore we turn to fundamentals of oil supply and demand to find answers. Our analysis suggests a recovery of the deepwater drilling space into a healthy market in the longer run.
Oil supply and demand
The oil market has experienced the largest supply shock ever seen over the past four years. US shale oil production alone has added more than 1 MMb/d each year on average – more than the growth of global oil demand over the period. Nevertheless, oil prices remained high, mostly as a result of record-high production outages following the Arab Spring. Surprisingly, demand growth weakened during 2014, US shale production accelerated, outages fell and additions from other projects came onstream. The result was an over-supplied situation, which came sooner and more forcefully than the market had anticipated (Figure 2).
On 27 November 2014, OPEC refrained from cutting production despite projections showing a need for a cut of 1.5-2 MMb/d in 2015 to balance global supply and demand. The global oil market is now in uncharted territory as it has lost its traditional swing producer, and oil prices are left to balance supply and demand.
Following the cash flow squeeze for exploration and production companies, we expect 2015 to be an extraordinarily tough year for international oil companies. The global oil supply response will come from a combination of the following: Lower North American shale activity, reduced infill drilling offshore, shut-in of tail-end fields, delays in sanctioning greenfield projects and possible delays in sanctioned projects already under development. Aggregating 2015 budgets, we find that global exploration and production activity is expected down by about 10% in 2015. The budget cuts highlight the challenges expected for 2015, and the scene is now set for further offshore exploration and production cuts. The question is: where will it end?
Industry opinions differ, our analysis shows that we could still see a worsening in 1H 2015; however, we expect oil prices to turn around when seasonal demand picks up. If oil supply and demand is going to balance in 2020, at the US Energy Information Administration’s (EIA) estimated demand at 98.1 MMb/d, supply will need to grow with 6 MMb/d from today’s production levels. To achieve this, we need to see an oil price of above US$100/bbl, based on individual field-by-field analysis by 2020.
Short term perspectives
Offshore drilling is one of those capital-intensive activities that will be victims of the capital discipline to be exhibited by exploration and production companies in the short term. Our analysis suggests that exploration and production companies will reduce drilling activities in deepwater areas by 2% in 2015. This trend has been evident in the past quarters, where we have seen low contracting activity from exploration and production companies, and significant decrease in day rates from the new mutual contracts that have been realized due to current oversupply in the floater space. The current market situation is challenging for the rig owners, which are expected to face troublesome years to come. In terms of survival, rig owners with solid backlogs will be best equipped to ride the passing storm (Figure 3).
In late 2014, we have seen increased attrition activity of older low-specification units from rig owners, including majors such as Diamond and Transocean, which are in the process of scrapping a total of 18 floaters. This trend will continue as exploration and production companies high grade their operating fleet. This selective behavior emphasizes the current market situation, where supply growth is outpacing demand and is expected to result in further attrition pressure on low-specification units. A large number of newbuilds are expected to hit the market within the next two years, adding distress to an already challenging market. Already rig owners are trying to counteract the effects on utilization levels of this influx by postponing planned newbuild deliveries.
A vital question for the rig market exists: how long will this downturn continue? Our analysis suggests we will see an oil market return to balance in 2017-18. Combining the expected oil market balance with rig market supply side actions, we anticipate brighter days to come for the deepwater drilling market. The latest EIA oil demand estimate for 2020 is 98.1 MMb/d, up from~92 MMb/d today. To meet these production levels, it is pivotal for the oil market to see an increased contribution from deepwater production. The past years’ shale production has demonstrated tremendous year on year (YoY) growth numbers of 72%. However, future growth levels for shale production are estimated to slow to around 9% YoY. Coupled with an expected decreasing trend from other onshore production at -1% YoY, the need for growing deepwater contribution is justified. Deepwater production needs to achieve a 9% YoY growth by 2025 (Figure 4) for the oil supply market to deliver on expectations.
During the past decade, about 50% of the deepwater fleet has been focused on exploration activities, an activity that has proven fruitful. With a balancing oil market and resulting increase in oil price, there are numerous high quality deepwater projects with competitive break-even prices lined up to be developed to support the increasing global oil demand. As a result we see the offshore fleet allocation increasingly weighted towards development drilling. This call on deepwater production and expected oil price increase will further provide incentives for increased infill drilling on already producing fields as the economic benefit of keeping the infrastructure alive is added to the value analysis. With the expected oil price increase our analysis suggests, as a result of exploration and production companies benefiting from better cash flows and increasing oil demand, exploration activity will again be deemed attractive.
Darkness before dawn
Adding an oil market oversupply situation on top of an E&P industry working against diminishing margins and a rapidly increasing rig fleet, market drivers indicate a continuation of the market cool-down we are experiencing.
However, with an expected slowdown from shale and onshore oil supply, the oil market will need to turn to deepwater production to meet the expected long term oil demand growth. Our analysis tells a challenging story short term in the deepwater drilling space, and sees the rational in increased attrition activity and newbuild delays from rig owners.
It is always darkest before dawn; the long term, triggered by balancing oil market driving increasing oil prices, will again provide a scenario with market fundamentals pointing towards increasing utilization levels.
Joachim Bjørni is an analyst in Rystad Energy’s global oilfield service team. His experience includes rig supply and demand, and global exploration and production spending. Joachim holds an MA in international business from the University of Edinburgh.
Oddmund Føre is an analyst in Rystad Energy’s global oilfield service team – with focus on rig markets and operator spending outlook. Føre holds an MSc in finance from the Norwegian School of Economics and a bachelor’s from the Norwegian Naval Academy.
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