Weekly Offshore Rig Review: Day Rate Divergence

Contract Lengths and Day Rates
For this week's rig review, we set out to examine the relationship between contract lengths and the day rates for those contracts. Specifically, the goal was to determine if longer contracts generally carried lower day rates. The guiding theory was that if an operator could contract a rig for a longer length of time, the rig manager would provide a more favorable rate since the value of the contract would be higher than on a shorter contract. In other words, we were looking for a volume discount on rig time.

What we found both confirmed and upset portions of our assumptions and was surprising in more ways than one. Read on to learn about the results for the worldwide competitive jackup fleet. Next week we'll examine the semisub and drillship fleet in detail.

Jackups < 300' WD
In 2004, 83% of the contracts awarded to competitive jackups rated for less than 300 feet of water were for 360 days or less. Amongst these contracts, the average day rate was $44,511. Contracts with lengths of 361 to 720 days accounted for just 15% of the contract awards, but the average day rate for these contracts was $54,281 (22% higher than the average for the shorter contracts).

In 2005, a shift towards longer contracts began. In that year, 70% of the contracts for less than 300' jackups were 360 days or shorter, with average day rates of $78,131. For contracts lasting 361 to 720 days, the share increased almost 50% from the year before to reach 23% of contract awards in 2005. This group of contracts continues to see significantly higher day rates than the shorter term contracts with day rates averaging $91,424 (17% higher than the average for the shorter contracts). A further 8% of the contracts awarded were for contracts lasting 721 or more days, for which the average day rates jumped down to $71,083.

In 2006, the trend towards longer contracts continued and seems to have peaked. Contracts of 360 days or less constituted 65% of the contract awards for < 300' WD jackups. These contracts were awarded average day rates of $98,698. The contracts with lengths of 361 to 720 days constituted a smaller percentage of the awards than in 2005, accounting for 18% of the contract awards, but still maintained a very large lead in terms of day rates, with an average rate of $143,392 per day (45% higher than the shorter contracts). The other 17% of contract awards were for contracts of more than 720 days. As in 2005, these contracts pulled in lower day rates than the 361 to 720 day contracts, with an average day rate of $104,393.

Thus, in terms of contract lengths and day rates for these lower specification jackups, the trend is not what we expected. The shorter contracts, up to 360 days in duration, constituted the largest portion of contracts but had lower rates than contracts that lasted 361 to 720 days. The group of contracts that lasted 361 to 720 represented a peak in day rates earned over the shorter and longer contracts. So, where we expected to find a steady decline in day rates as contract lengths increased, we instead found a very pronounced increase in day rates for contracts between one and two years in length, followed be a similarly sharp decline in day rates for contracts longer than two years.

Jackups 300'+ WD
In 2004, the trend that we expected to see across rig types and specifications was clearly present for 300'+ jackups, with day rates declining steadily as contract lengths increased. For these rigs, 58% of the contracts awarded in 2004 were for 360 days or less earning average day rates of $73,775. A further 26% of the contracts were for 361 to 720 days in length, with day rates averaging $71,228. Only about 17% of the contracts awarded were for two or more years, and the day rates for these contracts dropped to $58,883.

In 2005, this linear decline was disrupted as a slight shift to longer contracts occurred. Contracts for 360 days or less accounted for 55% of the awards with average day rates of $93,449. As we saw with the < 300' WD jackups, the rates for contracts of 361 to 720 days in length were notably higher for these jackups as well. The 361 to 720 day contract awards accounted for 25% of the contract awards in 2005, and the average day rates for these contracts stood at $108,604. The day rates for contracts longer than two years, which accounted for 20% of the contracts for these rigs, came back down to $89,572.

In 2006, we saw the first and only year in which there were more contracts longer than a year awarded than contracts shorter than one year in length. Just 43% of the contract awards in 2006 were for 360 days or less. The average day rate for these contracts was $151,328. Contracts of 361 to 720 days in length constituted 26% of the awards for 300'+ jackups in 2006, with average day rates of $156,476. A further 18% of contract awards were for 721 to 1,080 days in length, for which the average day rate was $157,714. The final 13% of contracts were for longer than 1,080 days, with day rates averaging $180,765. In this year, the trend that we saw was the opposite of what we had originally expected, with day rates climbing as contract lengths increased.

Over the three years from 2004 to 2006, the trend of contract lengths compared to day rates changed noticeably from year to year. In 2004, the trend was as we had expected with longer contracts paying out lower day rates. In 2005, the trend changed with one-to-two year contract paying out significantly more than either longer or shorter contracts. Then in 2006, the trend was completely reversed with the day rates increasing as contract lengths increased.

The Big Question - Why?
In looking at these trends among the two groups of jackups examined, we cannot help but wonder why the discrepancy between the expected results and the actual data. Clearly, at least some aspect of the initial assumption was incorrect.

As a general business rule, it makes sense to secure revenue in as large of chunks as possible by establishing longer term contracts, since this reduces uncertainties about future income. However, from the customer's perspective, an incentive generally needs to be provided for locking into longer contracts. If it will cost the same to purchase now as it will a year from now, it does not make sense to "pre-purchase" unless a better deal is offered. Thus, the "volume discount."

In the case of offshore rig time, it quickly becomes apparent where the logical error lies in assuming that rig time will be less expensive the more you buy.

When the overall demand for rigs of a given type is not particularly strong or declining, rig managers will have an incentive to discount day rates for longer contracts. This locks in revenues and keeps the rigs working where they otherwise might sit idle. This is more the situation we saw from 2001 to 2004, and it is clearly indicated by the presence of the expected trend amongst the higher specification jackups in 2004.

However, when the demand for rig time is strong and increasing, it makes much less sense for rig managers to offer discounts for longer contracts. On the contrary, when rates are increasing and the market is tight, rig managers can charge higher day rates for longer contracts (to a certain extent) because the future value of the rig time is likely to be greater than it is at that moment. There is less incentive to sign a longer-term contract at a lower day rate because more revenue could be earned through several shorter contracts each at a higher day rate than the previous one. This has been the case for much of the last three years, particularly 2005 and 2006. Yet with high oil and gas prices, operators have been anxious to secure rig time, and have thus signed longer contracts for higher day rates than they would have paid for shorter contracts.

The Big Surprise
The most surprising aspect of the data that we culled through for this research was the clear indication that the boom is over, at least for jackups. Thus far in 2007, the contracts that have been awarded have generally been shorter than in the previous two years. In fact 74% of < 300' WD contracts and 63% of 300'+ WD contracts have been for 360 days of less. For 300'+ jackups, that is the highest proportion of less-than-one-year contracts in any of the last three years, and for < 300' jackups it is the highest level since 2004.

In addition, those new, shorter contracts are paying less than last year's contract awards. In fact, for contracts less than one year in length, average day rates are about 10% less than last year's awards across all jackups. Part of the reason for the decline in day rates is a lessening in demand, which has seen the number of jackup contract awards drop almost 50% from the same period last year and more than 65% from the same period in 2005.

So, times are changing. The market for jackups appears to be on the brink of a change from a "seller's market" that favors rig managers and drives higher day rates to a "buyer's market" that favors operators. If that is truly the case, we could see the economics of rig contracts begin to swing back in line with our initial expectations whereby longer contracts do entail lower day rates.

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