Low oil prices pushing offshore rig owners towards innovation
April 2016 | William Wu and Ryan Peacock
In the face of declining revenue and maturing debt, struggling drilling rig owners are innovating to increase liquidity by using new operational and financial solutions.
By doing this, owners are able to buffer against further downturns, pay off maturing debt, and take advantage of undervalued opportunities. Going forward, these solutions are likely to become widely adapted as rig owners and operators reset their costs to operate in a prolonged lower oil price environment.
Number and length of rig contracts fallen drastically since 2013
As a result of the widening gap between rig supply and demand, the number of new rig contracts fell approximately 65% for floaters and 50% for jackups between 2013 and 2015. In the same period, total contract length fell approximately 75% for floaters and 50% for jackups. Further, in what has quickly become a common practice, operators are deferring or cancelling contracts despite legal, reputational, or financial consequences. The resulting shrinkage in revenue backlog has exacerbated liquidity issues, especially in the short term as large debt payments become due (figure 1).
To improve liquidity and survive the downturn, owners have started to look beyond the standard cost-cutting measures of controlling overhead costs and maximizing efficiency and combined these efforts to simplify and cut costs with novel operational and financial solutions.
Owners retiring rigs and renegotiating contracts to cut costs
On the operational side, large owners such as Transocean are transitioning their fleets to a higher specification by retiring older idle rigs that are not expected to return to work, with 7 rigs retired in 2013 compared to 41 in 2015, and 73 are expected to be retired in the next 3 years. At the same time, contracts have been renegotiated to extend terms and avoid outright cancellation, with many being renegotiated in “blend-and-extend” agreements with term extensions of up to 2 years for a 10-40% decrease in day rate (figure 2).
Uncontracted new builds leading to cooperation between rig owners and shipyards
New builds without contracts have also been deferred, with Seadrill and Transocean leading the way having delayed their rigs a total of 20 and 17 years respectively, or in some cases have been outright refused (for example, the original arrangement for the almost completed Pacific Zonda was cancelled with only ~30% of the $634 million instalment paid). The number of uncontracted new builds has led to cooperation between rig owner and shipyard; for example, in December 2015, Seadrill and Jurong Shipyard agreed to a joint venture to sell or otherwise contract the uncontracted West Rigel, with Seadrill owning 23% and Jurong owning 77%.
Industry-first performance-based agreement entered between Diamond Offshore and GE
On the financial side, in what has been an industry first, Diamond Offshore has entered a performance-based subsea blowout preventer agreement. Under the agreement, Diamond sold 4 subsea blowout preventer (BOP) systems back to the OEM GE for $210 million. In return, Diamond has leased back the BOPs under a performance-based contract tied to total hours of pressure control provided. This novel partnership can provide mutual benefits for both parties: Both Diamond and GE have incentives aligned to minimize downtime and maximize operational efficiency. GE is able to capture a larger share of the Diamond spend on BOP operation and maintenance as it provides full support for the systems. Expansion of the program could provide additional upside as GE is able to decrease maintenance costs through shared resources across a larger pool of units and improved preventative maintenance programs. Diamond receives an immediate infusion of liquidity during the current down cycle as it effectively borrows off-balance sheet (OBS) debt using the BOP systems as collateral. In return for a lump cash flow today, Diamond will now make regular payments for the next ten years.
Several players resorting to bankruptcy as a financial restructuring tool
At the extreme end, several players have used bankruptcy as a financial restructuring tool rather than protection from creditors, where bankruptcy only lasts one to two months and operations are not halted. For example, Vantage entered bankruptcy in December 2015 only to re-emerge a month later with $1.6 billion debt converted into equity and senior notes. As part of the restructuring, the new senior notes pay interest in the form of another set of notes, thereby eliminating an additional $152 million in annual interest expense.
Opportunistic strong players buying back discounted equity, debt, and assets
Players with relatively strong balance sheets will be able to take advantage of depressed oil prices by opportunistically buying back heavily discounted equity, debt, or real assets. This is already beginning to happen, with Diamond recently repurchasing $211 million of its near-maturity debt securities and, therefore, saving $84 million in interest over the next 3 years. At the same time, acquiring distressed and undervalued rigs will become feasible if near-term liquidity remains strong, rigs are of high quality, and prices are sufficiently discounted.
Innovative solutions becoming commonplace as 2014 rig utilization levels not expected to recover until 2020
Going forward, we estimate that rig utilization will not recover to 2014 utilization levels until 2020 due to demand recovering at only 5% p.a. through to 2020 and short-term supply continuing to increase as the 160 rigs in the current order book are delivered. As such, expect these solutions to become more commonplace as rig owners adjust to a prolonged downturn.
About the authors
William Wu is an analyst with Energy Insights in McKinsey's London office and Ryan Peacock is a solution manager with Energy Insights in McKinsey's Houston Office.