Weekly Offshore Rig Review: More Day Rates & Durations

More On Contract Lengths and Day Rates
In last week's rig review, we examined the relationship between contract lengths and day rates, specifically for the competitive jackup fleet. At the beginning of this process, we expected to find that day rates would decrease for longer contracts, a sort of "volume discount" on rig time. However, in our examination of the jackup market, we found that over the last two to three years the opposite relationship existed between contract lengths and day rates. Instead of day rates declining with longer contracts, the rates were actually higher for longer contracts than for shorter ones.

This week, we will continue our examination of the correlation (or lack thereof) between contract lengths and day rates by looking at the worldwide fleet of competitive semisubmersibles and drillships. Based on the findings from last week's rig review, we expect to see a similar pattern among the deeper water rigs whereby longer contracts command higher day rates, given that largely the same supply and demand factors are at play among these rigs as well.

Semis and Drillships < 4,000' WD
In 2004, nearly two-thirds of the contracts awarded to semisubmersibles and drillships rated for 4,000' of water or less were for 360 or fewer days. The average day rate for these contracts was $80,470. Contracts running 361 to 720 accounted for 30% of the contract awards in 2004, earning 50% higher day rates of $123,563. Contracts of more than two years in length accounted for just under 6% of the contract awards in 2004, and none of them was for longer than three years. Interestingly, these contracts averaged a 50% higher day rate than the 361 to 720 day contracts, coming in with average day rates of $183,368. This year marked the broadest separation and the steepest rate of increase in day rates across the contract lengths.

For the contracts awarded in 2005, the shift towards longer contracts was clearly evident as was the reduction of the differential between day rates earned for different contract lengths. Just 51% of the contract awards were for 360 day or less, but average day rates for this group of contracts increased more than 50% from the previous year to $127,967. For contracts lasting 361 to 720 days, the proportion of all contracts awarded also fell, dropping slightly to 26% of the awards that year. Day rates for this group of contracts increased 36% from 2004 to $167,534, thus reducing the premium on these contracts over the shorter contracts of 360 days or less (from 50% higher in 2004 to 31% higher in 2005). Among contracts 721 to 1080 days in length, the proportion grew from 6% in 2004 to 9% in 2005, while day rates for these contracts held basically steady. Among the longest contracts, 8% of the awards were for 1,081 to 1,440 days, where the average day rate peaked at $306,165. A further 6% were for more than 1,440 days. In line with our original expectation, day rates did come back down very markedly to an average of $134,363 for these 4+ year contracts.

In 2006, the trend toward longer contracts continued unabated as did the concentration of day rates towards a similar level. For the first time in our sample, contracts of less than 360 days were not a majority of the contracts awarded, constituting just 46% of the contracts. The average day rate for these contracts was $294,299, a 130% increase over the 2005 rates. Contracts ranging from 361 to 720 days in length again constituted a smaller proportion of the contract awards than in the previous year, accounting for 21% of the awards and averaging $295,296 per day in day rates (a 76% increase over the previous year). The proportion of 721 to 1,080 day contracts grew the most of any contract length, jumping from 9% in 2005 to 19% in 2006. The average day rates for these contracts was $303,596, which marked a 65% increase over 2005. Contracts 1,440 days or more accounted for just 4% of the contract awards, but as in the previous year, day rates jumped down very prominently to $213,420 making these the lowest-paying contracts awarded in 2006.

The shift in average day rates from 2005 to 2006 was remarkable for two main reasons. Firstly, the average day rates for contracts of less than three years in length jumped more than 100% year over year. In 2005, the average day rate for contract awards of less than 1,080 days in length was $145,831. In 2006, that average jumped to $296,618! Secondly, the difference between the day rates for the shortest contracts and longer contracts almost entirely disappeared in 2006. Specifically, the difference between contracts of 360 day or less and those of 1,081 to 1,440 days dropped from $178,198 (140% higher) to just $15,451 (5% higher) from 2005 to 2006.

Amongst the fleet of competitive semisubs and drillships rated for less than 4,000' water depths, we found both the steadily increasing day rates for longer contracts that we had seen among jackups as well as the "volume discount" on the contracts over four years in length. Thus, rather than steadily declining the longer the contract length, day rates increased up to a maximum on 1,081 to 1,440 day contracts before jumping back down for contracts longer than 1,440 days.

Semis and Drillships 4,000'+ WD
The day rate and contract length trends for premium deepwater semisubs and drillships were very similar to those of the lower specification floating rigs. In both cases, day rates have increased across the board each year, longer contracts have commanded higher rates to a point, and the difference between rates on shorter contracts and longer contracts has shrunk over the last three years.

In 2004, 66% of the contracts awarded were for 360 day or less, with average day rates of $121,092. Contracts ranging from 361 to 720 days constituted 26% of the awards and had average day rates of $158,754, about 31% higher than the shorter contracts. A further 8% of the contract awards were for more than 720 days, although as with the lower spec rigs, no contracts lasting more than three years were awarded. Average day rates for this group were $220,373.

In 2005, a notable shift occurred and the majority of the contracts awarded were for more than 360 days. Contracts for 360 or fewer days dropped to just 37% of the awards, with average day rates of $210,672. Contracts for 361 to 720 days moved up to a larger proportion of the contracts awarded, grabbing 27% of the awards and averaging $237,454 per day. Contracts lasting 721 to 1,080 days increased to 16% of the awards, grabbing average day rates of $256,862. For contracts of 1,081 to 1,440 days, the average day rates fell lower than any of the shorter segments, dropping to $205,264 and accounting for 7% of contract awards. The biggest change occurred among contracts lasting 1,440 days or more, which accounted for 13% of the awards in 2005 and saw the lowest day rates of any contract length group with an average of $173,506. Clearly, in 2005, the expectation was that day rates would be increasing over the next three years, but would likely be steady or declining after that.

In 2006, contract awards were more evenly split among the different lengths than in any other year as the two shortest groups (360 or less, 361 to 720, and 721 to 1,080 days) each saw their share of contracts decline from the previous year. Contracts of 360 days or less were 25% of the awards (down from 37% in 2005), with day rates of $310,987. Contracts of 361 to 720 days in length were 15% of awards (down from 27% in 2005), with average day rates of $397,040.

Contracts of 721 to 1,080 days in length basically maintained their overall percentage of the contract awards. In 20006, these accounted for 17% of awards (on par with 16% in 2005), with average day rates of $370,905.

While the shorter contracts' proportion of awards shrank, the two longer contract groups saw marked increases in their share of contracts awarded in 2006. For contracts 1,081 to 1,440 days in length, the share grew from 7% to 21% and day rates soared 125% to $463,926, the highest for any contract length in 2006. For contracts longer than 1,440 days, the share of awards grew from 13% to 22% and day rates jumped 132% from $173,506 to $402,393. This was a departure from the previous year as well, since in 2005 1,440+ day contracts earned the lowest average day rates whereas in 2006 these contracts were the second highest paying group of contract awards.

So, as with the contract awards for the lower specification floating rigs, the contract awards for the 4,000'+ semis and drillships have also exhibited a "peak" in day rates on three to four year contracts before seeing significant declines in rates on contracts longer than four years.

Why the Peak?
As we discussed in the previous rig review, we had expected to find drilling contractors offering more favorable day rates to entice operators into longer contracts and thereby securing more future revenue. However, with the historically strong demand for offshore rigs and the massive increases in day rates that have occurred in the last three years, it has made less sense for rig managers to lock into longer term contracts at lower rates when rates continue to climb.

Among the jackup fleet, the trend was generally towards higher day rates for longer contracts, with a few bumps along the way. For the floating rig fleet, the trend has been higher day rates on longer contracts up to a point, with day rates dropping back off for the longest contracts.

The implication of the "peak" in day rates for floating rig contracts is that the demand for floating rigs is expected to be strong for the next two to four years, but in order to get operators to sign the four-plus year contracts, a more attractive day rate must be provided. While certainly not scientific or statistically sound, this could be an indication that sentiment among floating rig owners is that day rates may ebb after the next two to three years.

This could be due in large part to the fact that by the end of 2010 the deepwater floating rig fleet is set to grow by nearly 60%, with 48 newbuilds joining the current fleet of 81 semis and drillship rated for 4,000'+ water depths. This huge influx of rigs will undoubtedly relieve some of the demand pressures for this segment of the fleet and help bring day rates lower across the board. Even back in 2005, when this trend began, a total of 12 new floating rigs were ordered, which would clearly have affected the future supply and offset rising day rates three to four years out. The same is true for 2006, when 27 new deepwater rigs were ordered, and the expectation would also likely have been that day rates would decline in three to four years when these newbuilds joined the fleet.

On a broader scale, the comparative reluctance of operators to sign longer contracts and the willingness of drilling contractors to offer lower rates on longer contracts also points to the general uncertainty as to what will happen to oil and gas prices in the coming years. In an industry notorious for its boom and bust cycles, there is certainly some level of expectation that oil prices (and subsequently day rates) will not continue at their current levels for more than a few more years. At some point, the investments in increased drilling activity will lead to increased production, supply will catch up with demand, and oil prices will fall. While the actual likelihood of this happening is somewhat debatable, the fact that it has happened repeatedly in the past is not. More succinctly, future commodity prices three to four years out are difficult to predict, and operators do not want bear the risk of being locked into higher-than-market rates should oil prices fall.

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