Fewer projects have been sanctioned since the precipitous drop in oil price in 2008. (Images courtesy of Wood Mackenzie)

The relentless rise in oil prices between 2004 and 2008 led to a large increase in new deepwater projects. These were driven, at least initially, by attractive project economics and underpinned by the availability of accessible project finance. Previously marginal deepwater projects suddenly became not just economically viable but financially very attractive.

Increased exploration activity naturally followed, leading to a raft of new deepwater discoveries, all of which increased demand on the limited deepwater rig fleet.

Despite the clear market signals, it took a while for this traditionally cautious industry to become comfortable enough with the long-term upward trend in demand to consider new investment in the deepwater fleet.

Changing dynamics

The first new-builds by Seadrill and others were built on spec, but were awarded contracts long before leaving the shipyards. As other established players followed suit, the investment community took notice. Many new players with little or no experience rushed into the space as deepwater demand, led by spectacular discoveries in Brazil, promised high day rates on long-term contracts. The deepwater rig market experienced the biggest construction boom in its history.

At the same time, rapid global economic development, led by the expanding Asian economies, pushed up the price of raw materials and exacerbated inflation in offshore costs, leaving operators facing challenging economics, even with oil selling at a price in excess of US $100 a barrel. Consequently, annual Final Investment Decision (FID) activity slowed in 2008, dropping to its lowest level since 2003 and down one-third on 2007 levels.

Just when it seemed that $200 a barrel was in sight, the unstoppable finally stopped. The crisis on Wall Street was felt on Main Street, and institutional investors moved out of oil commodities and back into equities, which led to sustained downward price pressure.

Oil prices dropped sharply between July and December 2008 as the market corrected in the face of rapidly falling global demand, creating low oil commodity prices and high capital costs.

In early 2009, Wood Mackenzie expects that the level of FIDs will fall further as energy companies delay development projects until costs and commodity price come back into alignment.

In the face of falling demand, rig construction activity is showing signs of easing. Yard options are not being taken up, and some construction contracts have been cancelled. The absence of available financing has meant that some rig contractors (particularly those new to the sector) are struggling to find ways to pay their bills for rigs already under construction.

Using semisubmersible rig rates as a proxy for deepwater costs and relating this to oil price change clearly demonstrates the relationship. Until the cost environment is brought back into alignment with the prevailing oil price (assuming of course that they were in alignment in 2004) new project development activity in the deep water is likely to weaken further.

Service sector challenges

As energy companies vied to develop their discoveries during the deepwater boom, demand for specialist deepwater supply chain services rapidly outstripped supply. This was largely due to reluctance among service companies to create new capacity and expose themselves to sudden and rapid declines in demand — as seen in previous downturns. With high technical barriers to entry, the market was firmly in the hands of the specialist equipment manufacturers and service providers who were able to grow their margins rapidly.

As soon as a demand response was established, service sector companies and EPC-related contractors adjusted their fees upward to test the new demand level. At the top of the market, it was the specialist equipment sector that was at the vanguard of pricing increases. Manufacturing lead times had grown to well over a year in some cases (e.g., for high-pressure/high-temperature wellheads and large steel bearings). As their order books overflowed, EPC contractors also increased their rates and moved away from turnkey contracts to “open book” or reimbursable contracts in a bid to shift cost risk to the operators.

Service sector companies’ revenues rose rapidly from 2005 as they benefited significantly from the rising price of oil, leaving energy companies facing reduced margins — despite record-breaking short-term revenues — and a high level of exposure to construction cost risk.

The convoluted relationship that exists between the E&P and service sectors invariably means that only one or the other is in the ascendancy at any given time. The contracting structures employed, in addition to investor expectations, lead to corporate behaviors that result in the inevitable short-term boom and bust cycles, where arguably nobody wins over the long term.

In a bear oil market, energy companies are initially hit the hardest, facing lower oil prices and high residual capital costs.

Demand will soften eventually, as outstanding projects are completed and service sector costs fall. Remaining existing contracts will be renegotiated sooner rather than later, as the service sector comes under intense pressure to cut costs or lose business. And as costs re-adjust downward, operator margins will be somewhat restored, although perhaps not to the same level seen in 2004.

Can the cycle be broken?

Can supply chain risks be mitigated jointly across the deepwater sector, or will the seemingly endless cycle of either energy companies or service sector firms being in the driving seat at any one moment continue to repeat itself?

Is greater cooperation required between energy companies and their supply chain for the good of the industry as a whole? Or is this simply the sharp end of capitalism?

Certainly, there needs to be a more finely tuned understanding of the factors that make deepwater very different than other E&P sectors. Deepwater is characterized by large-scale, technically challenging projects with 20- to30-year life cycles and 5- to 10-year development phases that require large capital commitments. The scale of the work commitments naturally requires longer supply chain contracts. Investment decisions are made on the basis of a long-term oil price assumption over a project’s life cycle. The combination of these factors means that, once begun, it is difficult to put a deepwater project on hold.

Perhaps service sector firms could take a proactive stance on breaking the cycle of boom and bust and look to drive the lateral thinking around deepwater supply chain risk mitigation that is so sorely needed. This would arguably help to improve the longer term outlook for all deepwater players.

Deepwater outlook

Many companies were rewarded by the market for their aggressive development positions, but now find themselves saddled with high gearing levels. Following the fall in oil prices, all companies are facing a shortfall in cash flow, which for many smaller or aggressively investing companies, raises the prospect of negative cash flow. The combination of these factors will leave many companies potentially unable to deliver key growth projects, or worse, struggling to cover their cash costs.

Where floating assets are concerned, companies with strong balance sheets and reliable contracts will be well positioned to ride out the storm and even grow through picking up partially completed new rigs. New entrants to the market (both rig contractors and yards) that have suffered from poor timing are likely to struggle in the downturn due to a combination of their being new to the market, suffering a lack of cash flow, and having poor access to project finance.

Now is an ideal time to be investing in the deepwater for energy companies that have a strong balance sheet, take a bullish view of the long-term oil price, and can drive down costs.

Energy companies that meet these criteria and are willing to make bold deepwater investment decisions will be able to ensure long-term value creation.