Weekly Offshore Rig Review: Day Rate Driver

In last week's offshore rig review, we examined the relationship between oil prices and offshore rig utilization, focusing on how accurately oil prices can be used to gauge upcoming rig utilization. The key observation from that study is that offshore rig utilization trends do follow the trends in oil prices (to a certain extent), trailing by about six to twelve months.

This week, we will be continuing that analysis by taking a look at the relationship between oil prices and offshore rig day rates. We'll start by revisiting some of the basic oil price information that we covered last week and then move on to an examination of day rates.

Oil Prices
In this examination, we will be using NYMEX front-month crude prices as a representative benchmark for crude prices in general. The graph below presents the history of NYMEX crude prices from the start of 1996 until October 2007. In particular, we will be looking at "inflection points" where the price of oil peaked or bottomed out. We will be looking at these points to compare between the highs and lows in oil prices and the peaks in offshore rig day rates.

The first of these points within our range of interest is the peak that occurred in January 1997, when NYMEX crude prices reached an average of $25.18 for the month. This was a 34% increase over one year earlier, and it marked the high point for oil prices at that time. Subsequently, oil prices went on a downward trend that lasted almost two years until a new low point was reached in December 1998 when the NYMEX price averaged $11.31 for the month. That represented a 55% decline from the earlier peak and a 38% decline from one year earlier. After that, crude oil prices were back on the rise for nearly two years, with NYMEX crude peaking at an average of $34.26 (up 203% from the previous low) for the month of November 2000 before beginning a year-long decline to an average of $19.40 (a 43% decline from the peak) in December 2001. Since the start of 2002, oil prices have generally continued to move up.

Offshore Rig Day Rates
As with our examination of rig utilization, we are looking to assess the closeness of the relationship between crude oil prices and day rates. With just a cursory glance between the day rate graph below and the oil price graph presented above, it is immediately apparent that there is a strong correlation between oil prices and day rates.

Profitable Peaks
Looking at the two peaks in oil prices that have been seen during the time period from 1996 to today, we want to look at how much a lag there has been between peaks in oil prices and the subsequent peaks in day rates.

When oil prices peaked at around $25 per barrel in January 1997, day rates continued to rise for nearly a year. Then between December 1997 and January 1998, average day rates fell 19% from $106,000 to $86,000. In that case, there was an 11-month lag between when oil prices peaked and when day rates peaked and fell.

When oil prices peaked again in November 2000, day rates again continued to rise for more then a year after the high oil price was past. The rise in day rates continued until March 2002 before turning noticeably downward, although this time quite a bit more slowly than in the previous downturn. Whereas day rates dipped nearly 20% between December 1997 and January 1998, at this peak day rates only moved down 6% over the course of 6 months, dropping from $75,000 to $71,000.

Thus, between the data gathered from these two peaks, it is clear that rig day rates react somewhat slowly to peaks in oil prices, waiting between 12 and 16 months before seeing a similar peak and decline in day rates.

Vexing Valleys
While the peaks in oil prices and day rates mean bigger profits for drilling contractors, declining day rates mean dwindling revenues. From February 1997 until December 1998, oil prices moved steadily downward before bottoming out at the end of 1998 and beginning a recovery in 1999. During this time, day rates shrank very rapidly, declining 68% from their high of $106,000 in December 1997 to a low of $34,000 in July 1999. Day rates reached a low point just seven months after the oil price hit a low, which was about half the time it took the market to react to a peak in oil prices and bring day rates down.

Oil prices witnessed another low point in December 2001, dropping down to an average of $19.40 per barrel at that time. That marked a 43% decline from the previous high. Day rates did not react so quickly or dramatically, however. In fact, day rates were still moving slowly upwards when that new low in oil prices was hit. Over the course of the next three years, day rates meandered slowly downward to a low of $67,000 in December 2004. That marked only a 12% decline from the high seen during that cycle, which was far less significant than the drop in oil prices.

Thus, the two cases in which we witnessed valleys in oil prices and day rates had markedly different trends. In the earlier dip, day rates followed oil prices quite closely, beginning to climb back up just seven months after oil prices began moving upwards. However, in the more recent case, the average day rates still followed the same trend as the oil price, but in a much slower and drawn out pattern, taking three years to begin moving upwards after oil prices had started their climb.

Continual Climb
Since January 2002, oil prices have generally been moving steadily higher. While day rates have not been rising for nearly as long, they have witnessed a very similar growth pattern over the last three years. Given the strength in oil prices and the fact that a significant portion of rigs already have higher paying contracts for next year, average day rates are set to continue climbing higher well into 2008 and possibly beyond.

How high oil prices will continue to climb is still very much up for debate, but if history is any indication, day rates will continue to follow their lead, albeit at a distance.

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