Deepwater Rig Overhang Hurts Drillers

Three canceled contracts could signal more downward pressure on rig rentals.
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Firm long-term contracts between oil companies and drillers may not be so firm after all.

Three contract terminations by major oil companies in as many days have analysts scrambling to cut earnings estimates for the drillers once again, as the cancellations look set to drive deepwater rig rental rates lower.

Just Wednesday morning

Diamond Offshore

(DO) - Get Report

announced that

BP Exploration

, a unit of

British Petroleum

(BP) - Get Report

, terminated its contract with Diamond's deepwater rig

Ocean Clipper

due to mechanical failures.

Mechanical failures are part of life. Just deal

These problems, related to the rig's blowout prevention system, have plagued the Clipper since its conversion for operations in ultra-deep water last year.

Only Tuesday,

Transocean Offshore

(RIG) - Get Report

announced the cancellation of a not-yet-begun two-year contract for its

Transocean Explorer

semisubmersible rig. The rig had been contracted by a consortium of five oil companies operating a large oil and gas field off the shore of Newfoundland. The group will pay Transocean a $40 million cancellation fee for a contract reportedly worth $105,000 per day, or $76.6 million in total.

And late Monday

R&B Falcon

(FLC) - Get Report

announced the early contract termination for the

Jack Bates

, a later-model semisubmersible rig contracted to

Mobil

(MOB)

in the North Sea, also due to equipment troubles.

While these three cancellations are for different reasons, and contract cancellation clauses for nonperformance of equipment are routine, they are still a blow to the sector roiled by a 40% year-over-year slide in oil prices. Industry observers are now trying to discern if these contract cancellations are isolated incidents or if they signal a broader trend toward deepwater dayrate deterioration.

Multiyear fixed contracts are the one secure source of revenue for rig contractors with large deepwater fleets and often entail intense capital investment before contracts begin. If more oil companies seek to shed long-term contracts, it could have disastrous results for companies that have taken on debt to build or upgrade rigs. Already this year, the shallow-water rig rates in the Gulf of Mexico plunged to under $20,000 a day from an average of $50,000 in a matter of months. But the deepwater market was supposedly immune.

"Our fear is that major oil companies will seek to find a loophole or contract breach wherever they can to give legal justification to breaking contracts," says Matthew Conlan, an analyst at

Prudential Securities

in Houston who follows Falcon and Transocean. He has an accumulate rating on Transocean and a hold on Falcon; Prudential has not performed underwriting for either firm.

The oil-price slide -- from near $20 per barrel a year ago to Tuesday's close of $10.88 per barrel -- has caused oil companies to rethink drilling project economics. A project deemed profitable at $16 per barrel is much less attractive with oil selling at about the same price as a Beverly Hills manicure.

Right now it's a buyer's market; oil companies can basically pick and choose the rigs they want. There are currently 40 rigs worldwide (many are shallow-water rigs) that are contracted yet have no work, according to industry tracker and publisher

Offshore Data Services

. This is in addition to a plethora of uncontracted rigs. A large number of contractors will be forced to drop prices in order to bid competitively for work.

A Mobil spokesman cited a problem with the Falcon rig's mooring system as one reason for the termination; Offshore Data confirms that the rig is in a shipyard getting a damage assessment after it broke loose from its mooring lines. It has not been on location since Dec. 10.

However, Mobil's contract with Falcon was set to roll into a much higher dayrate in January. Mobil was under contract to start paying $196,000 per day for the Falcon rig at a time when new contracts for similar rigs are being signed for $115,000 per day, according to Offshore Data. Observers say no operator in his right mind would pay above-market rates for drilling services in today's environment.

Falcon did not return calls seeking comment, but said in a press release that it will pursue legal recourse over the termination.

Falcon's publicized contract termination illustrates the wiggle room available in terms of performance and safety measures, according to an analyst who spoke on the condition of anonymity. Also, the deepwater market is not as tight as some would like to believe. If Mobil thought a comparable rig would not be available, it would have kept the Falcon rig, he adds.

The

Terra Nova

group, the consortium working off the coast of Newfoundland, is confident it can secure a newer, more capable rig and on better terms than its Transocean contract, which had called for a costly and time-consuming upgrade. An upgrade can stretch into months, delaying a project's start. The total upgrade cost for the Explorer is unclear, but Offshore Data estimates it to be about $38 million. The consortium is betting on the competitive environment in the drilling industry to secure a lower dayrate.

But fostering competition will only serve to further pit contractors against each other, says Tom Marsh, an editor and drilling industry analyst at Offshore Data. "There is already name-calling and finger-pointing

among the drillers," Marsh says. "Tensions are running high."

Over the next 90 days, 130 rigs are coming off contract. Undoubtedly, some will go right to work, he says, but the danger to dayrates is posed by the ones that will not find work. "Dayrates are so sensitive to utilization," he says. "They fall faster than anybody can believe. All it takes is one bid."