Industry Implications of Oil Spill

We assess three scenarios to range the potential industry impacts of the Deepwater Horizon failure

Stephen Ellis 20 May, 2010 | 10:34AM
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After following congressional testimony and news reports, we're trying to get our arms around potential impacts to offshore drillers and service companies. While it seems certain that the regulatory environment will tighten, we also expect the industry to reevaluate the equipment and procedures currently in place for deep-water drilling. One critical area of focus will likely be blowout preventers (BOPs), as the BOP used on Deepwater Horizon has not functioned properly. We expect reviews driven by both industry and government to result in a slowdown of drilling activity; the question is how much of a slowdown, and for how long. To range potential industry impacts, we've thought through three scenarios of increasing severity.

Scenario #1
In the first scenario, we assume operators are satisfied with existing BOP technology, despite the catastrophic blowout. In this scenario, oil and gas companies will only require a detailed review and updating of safety and cementing practices in the Gulf of Mexico, and offshore drilling can fully resume. We expect this process to take two to three months. During this time period, we expect offshore drilling to mainly target shallower wells where the well pressures can be easily managed with existing technology or the basins' geological pressures and structures are already well understood. Deeper wells with corresponding higher pressure and higher profits for the services companies and drillers could be delayed. The impact on valuations in this scenario would be immaterial, as the delay is essentially the time it would take to drill a single deep-water well.

Scenario #2
The second scenario we contemplate would result in a six to nine month slowdown in deep-water drilling, by our estimation. In this scenario, we would expect a detailed review and updating of safety, cementing, and BOP practices globally, not just in the Gulf. Further, we believe BOPs will need to be upgraded mainly on older midwater rigs and some deep-water rigs to the latest BOP technology, which ultra-deep-water rigs already use. The need to upgrade the midwater and selected deep-water rigs forces operators to hold off on drilling ultra-deep wells and instead target shallower wells. Some operators may choose to idle the rig and pay the day rate until the upgrades can be completed. In any case, the delay in drilling deep wells will create an oversupply of midwater rigs and selected deep-water rigs, which will cause a decline in day rates of around 15%. However, once the rigs are upgraded, we expect the drilling industry to snap back and resume its favourable long-term trends. We think this scenario could be more painful for the services firms, as the services industry's pricing power can disappear very rapidly in a downturn, and the sudden nature of the slowdown in deep-water drilling will recreate conditions similar to those that crushed the North American market in 2009. We'd expect to see a sharp drop in services profitability within a few months, followed by a year-long recovery to prior margins as drilling activity ramps back up to resume its long-term trend.

Scenario #3
Our third and worst-case scenario envisions an offshore drilling slowdown of about two years. In this case, we believe oil and gas companies and drillers will postpone further deep-water drilling until BOPs capable of handing 30,000 psi are widely available. Today's best-in-class BOPs can only handle about 20,000 psi, and we think it will take some time for the industry to be able to develop and mass-produce more powerful BOPs. The time period is long enough for a significant amount of the industry's rigs to come off contract, and therefore we expect substantial levels of oversupply in the midwater and deep-water rig markets. Ultra-deep-water rigs will be relatively less affected as we expect the more powerful rigs to be better-equipped to handle the upgraded and heavier BOPs without too many changes to the existing rig's structure. Ultra-deep-water rigs will also benefit from lengthy contracts that will still be in place during this period of uncertainty, which should ensure a steady stream of income for the driller. Industrywide, we expect spot day rates across midwater, deep-water, and ultra-deep-water rig classes to decline about 25% in the near term, but day rates should return to a strongly positive long-term trend once the industry has upgraded its BOPs. The exception to this case will be Diamond Offshore, as we think the company will be reluctant to invest more into its aging midwater fleet, and therefore its rig rates are unlikely to recover completely from the downturn. For the services companies, we expect profitability to sharply decline within a few months and remain depressed for another year, followed by a year-long recovery process.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
BP PLC394.70 GBX1.54Rating

About Author

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