Scaling the Peaks
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Scaling the Peaks


A look at the underlying market dynamics of the past year’s unprecedented surge in offshore drilling.


By Downs Matthews
Photography Chris Shinn



The message is relatively simple, yet stark: The entire energy framework is stretched to
the limit. Capacity constraints range from oil production, to global drilling rigs, to refining, and human capital. And none of these constraints are subject to a quick fix. Against this background is the escalating world demand for hydrocarbons. That growing demand, coupled with dwindling supplies, is often cited as the main cause of the sharp rise in oil and gas prices over the past 12 months. With this increase in commodity prices came an unprecedented increase in the utilization of offshore drilling rigs and a corresponding increase in dayrates worldwide for all classes of offshore drilling units—but with particular emphasis on the floater markets.



Currently, the effective utilization rate for all classes of offshore drilling units is virtually
100 percent, compared to just over 80 percent last July. And the ODS-Petrodata short-term forecast into next summer is for an increasing shortage of available rigs. As a result of the current and growing supply constraint, dayrates in many cases are exceeding previous peaks, having doubled, tripled, and in some cases, quadrupled rates of only a year ago. For example, second and 3rd generation semisubmersibles that were cold-stacked in the Gulf of Mexico last summer, today are fully committed at new peak dayrates of up to $175,000. Fourth generation units earning $70,000 per day last year are committed at new peak dayrates of up to $240,000, and 5th generation rigs are setting new peaks in the $300,000 range, compared with rates one half that amount a year earlier. How long this upturn in offshore drilling activity will continue
is difficult to predict. After all, offshore drilling is a highly cyclical business. But with system-wide capacity constraints and the global demand for hydrocarbons steadily rising, the current increase in upstream capital spending by the oil companies is showing signs of sustainability.



For Diamond Offshore, the dramatic turn-around in drilling activity that began in July 2004 created a noteworthy year, as demand for the Company’s mid-water and deepwater semisubmersible rigs improved with unprecedented velocity. The increase in demand for offshore drilling rigs, which is continuing at this writing in June 2005, lifted dayrates around the world. But the demand surge has had the greatest impact in the U.S. Gulf of Mexico and the North Sea, two markets where the Company has a significant presence. Diamond Offshore’s jack-up fleet has also experienced steady growth in utilization and dayrates, but with less velocity than the floater units.



The dramatic upturn in rig utilization began last summer after market forces prompted oil companies worldwide, seemingly in concert, to initiate new exploration and development programs. With marketed semisubmersible rigs in short supply, dayrates escalated as operators rushed to secure floater units into the first half of 2005 and beyond.



At this writing, virtually 100 percent of Diamond Offshore’s mid-water and deepwater floater rigs are committed in 2005 and approximately 75 percent of the Company’s floater units are committed in 2006, though good market exposure remains for 2007.



If all of this is not enough, there is increasing speculation that the world may rapidly be approaching a seminal moment when global oil production will reach its peak. A peak in world oil production would subject the world to its first-ever sustained shortage in energy—a commodity essential to the functioning of the world’s economy. A number of knowledgeable experts forecast that the peaking of conventional oil production could occur sometime within the next 10 years, after which the world would enter a new era where oil production is gradually declining and unable to meet worldwide demand. Given today’s oil demand levels and usage patterns, such a forced disruption, along with attendant rising oil and gas prices, could have negative impacts on the economies of all oil-importing nations, and perhaps the exporting ones as well.



(The phrase “Peak Oil” was first coined by Shell Oil Company geologist King Hubbert, who predicted in the 1940s that the United States would reach peak production in 1971, and as a result, would become a major importer. His timing turned out to be almost perfectly on the money; clearly he saw the big picture.)



Or perhaps these Malthusian-type predictions may simply be wrong, as they have been in the past. What appears certain, until viable alternative energy sources and conservation measures are developed and implemented, is that world oil demand, already at 84 million barrels a day, is increasing. To meet increased demand, ever-larger volumes of oil will have to be produced. Not only must new reservoirs be continually discovered and brought into production to compensate for depletion of older reservoirs, additional discoveries will have to be made to increase the supply.
But the Peak Oil issue is not about running out of oil in the absolute sense, which will not happen for many years. Rather, it is about the rapidly appearing differential between the daily supply of oil and the world’s growing demand for it.



According to energy major ExxonMobil, global oil depletion is running at four to six percent annually. This translates into the need for the world to annually discover approximately four million barrels a day of production just to stay even. As late as 1990, only the U.S. and Romania were depleting reserves faster than they were bringing them on stream. Now there are 18 major oil producing countries in this position, and the total number rises to over 50 if all the small producers are added.



On the demand side, energy consumption in the United States has increased about four percent each year over the past three years. Elsewhere, countries such as China and India report energy consumption levels rising at two to three times that rate. Will Davie, writing for Simmons Oil Monthly, states simply, “Global demand growth is outstripping the oil and gas industry’s ability to supply oil and refined products.” Davie’s counterpart at Lehman Brothers, Senior Vice President Angie Sedita, agrees, and adds, “Tight global oil capacity resulting from strong oil demand and limited supplies has pushed up commodity prices, which should remain high for some time to come.” The answer, at least until alternatives can be developed, is to find more oil. And that is possible, but the question is, at what price?



The world is definitely not running out of oil. Of the earth’s estimated reserves of six trillion barrels of oil, at least three trillion remain undiscovered in the ground, geophysicists say. But the “easy” discoveries have been made, both onshore and offshore. And the oil industry is having to push to new frontiers in deeper pay horizons over five miles beneath the earth’s surface and increasingly in waters between one and two miles deep in the world’s oceans in the search for new reserves.



Part of the urgency to find new reserves comes because, until recently, oil exploration has not been the top priority for the major oil producers of the world that it once was. Over the past decade, industry analysts report, investor-owned oil companies liked the idea of rebuilding balance sheets and the economics of replenishing reserves by buying crude oil already found and owned by smaller oil companies. But consolidation is really a zero-sum game, because new discoveries are not being made. Today, buyers scrambling for supplies worldwide have bid up crude oil prices to over $50 a barrel, once again encouraging oil producers to start “turning to the right” to find undiscovered reserves.



And that new focus on exploration has created a robust demand for drilling units of all types—particularly for semisubmersible drilling rigs and drillships. John Gabriel, Diamond Offshore Senior Vice President, Contracts and Marketing, says that prospects for oil exploration offshore are hot throughout the world. “I would be hard pressed to find a spot that isn’t,” he says. “Some areas may be lagging behind others in terms of their rate of growth, but they are not being left out. Our commitments on the books take us well into 2006. I have a fair level of comfort about 2007, and I’m optimistic about 2008.



The pattern is consistent throughout the industry as a whole,” Gabriel says. “Demand for our rigs has outstripped supply. And our large fleet of mid-water and deepwater equipment has put us near the forefront of the increasing demand for floater rigs—particularly in the Gulf of Mexico and the North Sea.”



“We foresaw the need for deepwater equipment a number of years ago and began transforming our fleet through an extensive modernization program to meet that future need,” says Larry Dickerson, Diamond Offshore President and Chief Operating Officer.



“Today we have achieved that goal and are focused on maintaining our fleet in the forefront of technologies that are driving our industry while making rigs more efficient." Diamond Offshore Executive Vice President David Williams, “We have gone from a meat-and-potatoes fleet to a caviar-and-lamb chops fleet that will let us deliver healthy returns for our shareholders during this period of high demand.” The Company has invested over $2 billion to fully modernize its fleet of 29 semisubmersibles, 14 jack-ups and one drillship. Most recently, it has upgraded the Victory-class Ocean Rover and Ocean Baroness to full 5th generation capability for less than half the cost and in about half the time it would take to complete a comparable new-build semisubmersible.



The Company is currently upgrading the Victory-class Ocean Endeavor to 5th generation capability for delivery in the first quarter of 2007. When complete, the Endeavor will be capable of drilling in water depths of up to 10,000 ft. to meet the growing movement to deepwater plays. Diamond Offshore expects to complete purchase of a sister rig, the Garden Banks, early in the third quarter of 2005 and initially will hold the unit in reserve for potential upgrade to 5th generation capability.



To date, there has been very little activity in terms of new-build floater capacity because new-build economics have been prohibitive. At a cost of $450-$550 million each, a new-build semisubmersible needs to earn an average dayrate of close to $300,000 over a 20 year lifecycle to achieve a return on investment in the 15 percent range. (That compares with a dayrate of approximately $170,000 for a $250 million upgrade to earn a similar return.) What that means for new-build investors is that they must believe that when the new-build is delivered three or four years after construction begins, that the market will still offer the type of peak dayrates the industry is seeing today and be able to sustain it going forward. At this writing, only three speculative new-build semisubmersibles have been announced, none by the major drilling contractors.



However, on the jack-up side, the story is different. Nina Rach, Drilling Editor of the Oil and Gas Journal, predicts that the global fleet of 386 jack-up rigs will both grow in number and gain in efficiency over the next five years. Though a new jack-up rig right from the shipyard costs around $150 million, dayrates of $80,000 and more have encouraged drilling contractors and speculators to order a total of 34 new-build jack-up rigs for delivery between 2005 and 2008 (including two Diamond Offshore super premium jack-up units, see p. 18). Four of these units will be delivered this year, eight in 2006, 13 in 2007 and the balance in 2008. Taking into account a historically normal attrition rate of approximately five units per year and anticipated strong incremental demand for new jack-up rigs, the current robust global market is expected to be able to absorb the new capacity with little impact, if any, on dayrates.



Ultimately, the answer to the world’s ravenous appetite for energy will likely be a combination of increased hydrocarbon supply, alternative energy sources and conservation. In the near-term, new technology is helping the petroleum industry in its search for new reserves.



For example, John Kennedy, Editor-in-Chief of the Oil and Gas Journal, credits 3-D seismic technologies for finding oil fields that would have been missed by older methods. Kennedy cites a new 4-D seismic technology that detects movements in fluids as they are produced. He points to new logging techniques, control systems, and down-hole sensors that lead to better control of oil well performance.



Altogether, Kennedy says, new technologies have combined to lower the costs of deepwater exploration from $12 to $15 a barrel in the late 1980s to $4 to $6 a barrel today. Such savings and efficiencies increase the success rate of offshore oil exploration by sixfold over methods in use 50 years ago. Projects are now possible that would have been inconceivable just 20 years ago, Kennedy says.



“We used to say that the technologically advanced offshore drilling rig of the future would be manned by one man and a dog,” says Williams. “The man was there to feed the dog, and the dog was there to make sure the man didn’t touch anything. We know now that this isn’t the way the world works. The more complicated and automated rigs become, the greater the importance of having a staff of knowledgeable people who know how to make things work,” Williams says. “What’s happening out there is unprecedented,” reiterates Dickerson. “And Diamond Offshore is well positioned to respond to the need.”
Originally from the Summer 2005 issue of Rigamarole