While Wall Street frolicked as equity prices reached record highs in 2013, a different story unfolded for publicly held offshore drillers who began taking on water in mid-2013 as part of a stunning reversal of fortune.

Offshore drillers finished the year as one of the worst performing sectors in a broader market that featured bull runs for nearly every other economic segment.

And the rollover in offshore drilling equities is not over.

“We remain on the sidelines for all of the offshore drillers and believe the stocks will be underperformers in 2014 and have absolute downside even from today’s levels,” said Angie Sedita, an oil services analyst with UBS Securities LLC.

Separately, Barclay Capital’s oil services analyst James West published a model that suggested another 30% downside in offshore drilling stocks if current trends hold – and larger if market conditions worsen.

The bottom line is that offshore drillers have walked the plank to the lowest valuation levels since Macondo and the financial industry collapse in 2009. Unfortunately, when the sell side community on Wall Street is even more bearish than the buy side, the outlook can’t be good.

If anything, the offshore drilling sector seems to be snakebit. Pessimism has increased recently either because no new contracts have been announced during monthly fleet status updates, or contractors are reporting more fleet downtime. Noble Corp. spooked the market during its 4Q earnings call with a tepid market outlook and expectations of lower utilization on commodity floaters.

Additionally, Noble, which is spinning off its standard jackup fleet in 2014, pointed to slowing demand for jackups in the formerly high-flying Middle East and Southeast Asia. That was not good news in a market that anticipates another 80 newbuild jackups over the next two years, none of which have contracts.

Last year started out promising for offshore drillers. The sector set an early pace for what turned out to be one of the great bull runs in modern history. The main issue offshore drillers faced in early 2013 was pressure from shareholders about how to start distributing the bounty of anticipated free cash flow from rising demand and rig rates in an expanding market to investors, either in the form of larger dividends, which most enacted, or through creating master limited partnerships. With strong, commodity-induced demand for offshore assets and a barrage of new rig orders, it looked as if new rig construction would be challenged to keep pace with an expanding global offshore market.

And then, out of the blue, sentiment changed in mid-summer as worries grew about an oversupply of equipment. The offshore drilling stocks rolled over in 3Q and have been sinking ever since.

There are several trends that make the malaise for offshore drillers chronic, at least in the “what have you done for me lately” mindset on Wall Street.

Short term, the basic story line is that the offshore drilling sector is facing declining utilization, especially for older equipment in the mid-water and commodity deepwater floating segments, a potential for declining rig rates across most rig classes including the higher spec ultra-deepwater (UDW) class, and finally an apparent slowdown in capital spending as the largest E&Ps quietly reassess programs.

After nice runs in 2013, markets such as the Middle East and Southeast Asia appear to be softening for jackups. Momentum has matured in the US Gulf of Mexico (GoM) following the strong run-up in rig employment in 2013 – from 38 to 52 units. Rig count is likely to plateau through 2016. Deepwater Brazil is not developing as fast as anticipated and some mid-water floaters are going to be set adrift when current contracts expire.

Even the bullet-proof UDW segment has seen a reversal in fortune on rig rates. Remember those illustrious days of $600,000 rig rates for newbuild UDW equipment in mid-2013? Now some higher spec UDW rigs are being sublet in the mid-$500,000 range with fears UDW rates could sink below $500,000 before the cycle runs its course.

Meanwhile the conveyor belt of newbuilds, many without contracts, continues to move inexorably with a large volume of floaters and jackups headed to market this year. The industry has seen almost 100 UDW rigs delivered over the last half decade during the deepwater renaissance in the GoM, West Africa, and Brazil. But another 88 are under construction, and those units are coming to market faster than the equipment can be absorbed, especially with larger operators slowing capital investment in the next few years as exploration turns to appraisal and development. It means contracts of shorter duration, more idle time and pressure on smaller contractors to cut rates to keep their own equipment busy. The story is the same whether it involves floaters or jackups.

Add it all up, and the offshore sector is facing a 12- to 18-month sail through some very choppy market waters.

However, fears that the selloff in equities for offshore drillers presages a weakening macro environment for other oil services may be premature. The more sobering interpretive framework is that the offshore scenario is a temporary hiccup that worsens in 2014 and before demand once again catches up to supply in the out years of the decade.

Contact the author, Richard Mason at rmason@hartenergy.com.

Offshore