What's Ahead in 2006

Is it a brave new world, or back to the future?

Robert E. Warren, Vice President, Pride International, Inc., Houston

As 2005 draws to an end, imagine predicting two or three years ago that we would see a sustained oil price at or above $60/bbl, and natural gas above $12 or even $14/MMBtu. Is that moment around the corner? Is a paradigm shift at hand in the drilling sector?

But wait! Haven’t we been here before? Shouldn’t drilling contractors fall all over themselves, order new rigs (both onshore and offshore), buy idle units or buy each other? Isn’t this the part when we start to expand, get obligated for a few billion dollars, and then watch it all go back in the tank?

The community is abuzz with talk about whether this is a brave new world or simply another cycle. My tea leaves and chicken bones are no better than the experts’ in seeing the future, but under all scenarios, we should do a number of things to take advantage of this once-in-a-lifetime opportunity. We should reshape a vital industry for long-term stability and cost containment.

Today’s urgency is not whether oil and gas prices will stay at $60/$12, $50/$10, or $40/something. It is about long-term market viability, plus vision, collaboration and leadership among companies. It is about inspiring a younger generation to seek energy as a career, so that we don’t continue to hire each other’s people in a dwindling labor pool. We need healthy, profitable business relationships to build the infrastructure required to cost-effectively meet ever-growing demand for energy.

Most of us don’t get it. Our problem is that we don’t get it. Our clients say they like us and are pleased with our work, but they have a subjective AFE cost for drilling services. When rig costs increase, it doesn’t make the project unprofitable. It just makes it higher risk, so an adversarial relationship continues around every rate increase.

Our shareholders would argue that rates must continue to rise, as they do not yet justify major capital investments, and have not in over two decades. Consumers believe that operator profit has been astronomical in recent years and off the chart, so far, in 2005. So much so, that Congress summoned our clients to hearings and hammered on them about a windfall profits tax.

We are at an unprecedented crossroads for changing the way our industry does business. Energy costs are not likely to fall, and drillers are poised to move into a new era for revenue generation, fleet replacement, growth and career development. Today’s market is about establishing best contracting practices. Does indexing rates to a rational base formula make sense at a time of spiking expenses to operators? Is it heresy to consider a direction for stabilizing the historic roller coaster that has followed an upturn like this one? Or will the downturn not occur until somewhere out on the horizon?

The answers are hidden in the last two cycles, when day rates lurched upward, and contractors avoided rekindling mammoth construction programs of the early 1980s. Sure, some incremental building and rig retirements took place. But earlier capacity excesses had never quite been absorbed. The average return on drilling investment ran in single digits – until now.

Different times determine different needs. Significant consolidation might have never developed enough momentum to overcome a perpetually soft market, if not for a few reasons:

• Excess capacity – too many rigs onshore and offshore of every size and flavor.
• Unbalanced drilling contracts – it had been an operator’s market for setting (thin) rates, and onerous terms. Operators transferred additional risk to drillers.
• Fractured pricing among drillers – excess capacity precluded serious rate increases from the 1990s through much of 2004.
• Not unlike airlines, one contractor here and one there made bold (and the right) decisions for future positions. However, there were few Southwest Airlines clones in the drilling sector.
• Limited opportunities provided by clients – when oil prices climbed toward $40 (yikes), $50 (wow) and $60 (gasp), expectant drillers, along with observers and owners of our stocks, wondered why rig profitability didn’t move with pricing.

Something was different. Most clients told us that they A) had few feasible prospects; B) needed to tidy up their balance sheets; and C) had to deal with Sarbanes-Oxley and corporate governance issues. Drilling budgets stayed flat-to-down, and we waited.

An exception evolved, when some national oil companies (NOCs) began to ramp up E&P efforts and tender for long-term work. Heading this group was Pemex, as the contracting winds were changing. Pride snapped up the opportunity by winning bids for over a dozen jackups. Pemex’s strategic development provided a home for much of the excess Gulf of Mexico capacity. Other NOCs began tendering for offshore work, and global utilization started to energize. 

Catching the wave. Simultaneously, gas prices headed to new levels, and drilling onshore picked up rapidly. Now, the notion of going to manufacturers and shipyards to add capacity is being discussed and debated. However, we’re still not buying, because clients balk at our hurdle rate and term for newbuild investment. Meanwhile, day rates are moving ahead everywhere.

Fast forward well into 2005, and check the utilization rate again. Now, it’s close to 100% for just about everything that qualifies as a rig. Day rates are at historic highs and growing stronger. Drillers are looking at replacement strategies and growth opportunities. Some things will remain the same. Prices will rise and fall, driven by unforeseeable events. Capacity additions will be unpredictable, driven by speculators. Asset life and investment cycles will be much longer than our ability to forecast. But some things are different – significantly different.

Fundamental changes have been made to the offshore rig supply. The build-up of excess capacity and its extended life cycle has, to a large degree, been worked off. As more rigs are required, contractors find limited construction capacity, and newbuild pricing is set to the expected value, not to building cost. More sophisticated management realizes that throwing money at capacity is not sustainable.

Encouragingly, contractors’ value proposition has shifted – it is no longer just steel. Operators still want suppliers to manage and mitigate investment risk, but they also demand the ability to operate rigs safely and reliably. Fundamental changes have also impacted rig demand. We have a history of price-insensitive oil demand growth for nearly 30 years. Production and reserve replacements still fall short of this demand. So, what is the bottom line?

Narrowing supplies and continued pressure for greater output will contrast with higher E&P costs. However, consumers seem willing to pay to make it profitable. This has caused a shift in price/ boe planning assumptions. These factors create a mandate for much more drilling, but also at higher prices that support healthy, reliable suppliers.

The path less traveled. This industry needs rational application of revenue generation that secures acceptable returns for investors in return for best practice services. Within that framework, companies must have sufficient, long-term predictable results to enable development of new people, application of new technology and replacement of fleets, all of which best serve customers and shareholders.

THE AUTHOR

Robert E. (Bob) Warren is vice president of Investor Relations at Pride International, Inc., responsible for all company interfacing with the investment community. During his 15 years with Pride, he has served as vice president of Russian Operations and vice president of Marketing & Communications, together with his present role. He has managed drilling operations in Iran, Libya, the UAE and Pakistan. Mr. Warren holds a BS degree in petroleum engineering from Texas Tech University and an MBA degree from the University of Texas.