The offshore industry's 2Q: A slow-motion decline

Stephen Ellis 24 August, 2009 | 3:09PM
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Near-term opportunities for Brazil suppliers and jackup drillers?
We think Brazil continues to be a positive story for offshore drillers. Petrobras is ready to issue a second tender for eight to 12 deep-water rigs very shortly, and potentially another 20 before the end of the year. Unfortunately, we still do not know the exact local content requirements, but we do know the country and Petrobras are under immense pressure for nationalistic reasons to build the rigs in Brazil. Therefore, we may see more rigs tenders awarded to Brazilian contractors, despite the disappointing results from the first tender of 12 rigs last year. Transocean stated that at least one rig has been canceled, and six or seven other rigs are struggling to obtain construction financing and have not yet submitted a shipyard order. The delay in rigs could be very costly as it will delay oil- and gas-production efforts. If Petrobras wants to meet its aggressive oil-production goals, we believe it will eventually need to outsource rig construction to the more experienced South Korean shipyards (it met with the shipyards to discuss rig construction plans in April) and hand out rig contracts to established drillers such as Noble, Pride International, Transocean, and Diamond Offshore.

Brazil also continues to be a growth story for the equipment providers. Petrobras needs around 200-300 subsea trees a year for the next few years and plans to award about 300 trees to equipment suppliers by the end of 2009. FMC Technologies mentioned that it was the leader to win an award of 107 subsea trees for presalt work. The trees cost about $3 million-$5 million each because of Petrobras' custom design, and are fairly low-margin compared with the industry's more typical $15 million-$20 million a tree. Our expectations last quarter were that FMC may skip the low-margin work and focus on the more profitable-related equipment such as manifolds. However, it looks like FMC wants a portion of the low-end tree work to better position itself versus competitors and perhaps curry favor with Petrobras for the more profitable manifold awards. Petrobras plans to award 12 manifolds for around $30 million-$35 million each, but the cost can be up to $80 million per manifold. The additional costs reflect the complex requirements Petrobras has specified for the equipment. We expect FMC to win at least one of the two tenders for the manifolds and Brazil to be a lucrative source of work for the company for years to come.

National Oilwell Varco is another key equipment supplier to Brazil and Petrobras that has performed well year to date. Equipment margins have held up despite a significant slide in demand because of high equipment prices coming out of the firm's backlog. However, favourable currency shifts, National Oilwell Varco discounts, lower steel prices, and aggressive shipyards are cutting the all-in price of a rig by about 15%-20%. This points to lower equipment margins in the second half of 2009, but we think more cost-cutting by the company may limit the impact. Also, National Oilwell Varco has only experienced about $235 million in order cancellations so far, out of a backlog that peaked at $11.8 billion late last year. This compares favourably with our earlier estimate of $750 million in possible cancellations that could occur over the full down cycle.

We're more concerned about future equipment orders than order cancellations, as the company has collected far more in cash than it has spent on its equipment orders at risk. For its part, we think National Oilwell Varco is still well positioned in the red-hot Brazilian market. For example, the company can still win more of the 12-rig tender issued by Petrobras last year, as some of the rigs are still searching for financing and haven't even ordered equipment yet. Furthermore, comments from offshore drillers indicate that Petrobras currently plans to issue a second eight- to 12-rig tender shortly, and possibly tender for a total of 30-plus deep-water rigs by the end of 2009. All of the orders are potential wins for National Oilwell Varco, even if the actual timeline remains murky and somewhat undefined.

Facing setbacks
Unfortunately, Petrobras' rig needs for the development of the firm's massive Tupi discovery and related finds do not include jackups. Still, it is possible that jackup rig delays and cancellations could help the rig-supply picture. The 13 jackups delivered so far this year have been delayed an average of 75 days, and several rigs have been canceled. For example, two of Noble's jackup rigs have been delayed a few months, but the company has managed to escape with minimal financial penalties, as its customers value its drilling expertise and are willing to cut Noble some slack.

We may not see such a happy ending for some of the remaining 60 jackups due to be delivered by 2011. Many of the jackups are being financed by speculative builders, and have a much higher cost of capital, which is unlikely to be met in a weak day rate environment. Other rigs are unlikely to be competitive in the global rig market because they were built in Iran and China, where operations have a poor reputation for quality. We believe many of the rigs will eventually be canceled, and it looks like our previous estimate of 20-30 rig cancellations remains reasonable. Whether the canceled rigs have a significant impact on fleet utilization and day rates depends on customers' demand and expectations surrounding commodity prices. Many drillers are indicating that customer tenders are increasing with oil trading in the $60-$70 range, which implies that a high rate of rig cancellations in 2010 may lead to an improving jackup market. For now, we think that the overwhelming number of jackup deliveries without a contract in place will keep the rig market oversupplied, and it may not recover until well into 2011.

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Stephen Ellis  Stephen Ellis is a senior stock analyst on the Energy Team.