Oil prices have continued to move upward in recent weeks, and that has spurred the talk of rig counts possibly increasing and production coming back online. As oil prices flirt with the $50 mark, this may become a reality to onshore producers in the U.S.

However one important area of production is still struggling to find solid footing: offshore oil and gas.

Offshore drilling and exploration has been hit hard in 2016, and the hits just keep on coming. On May 23, Seadrill Ltd. (ticker: SDRL) announced that the company had received notice that the contract for the semi-submersible drilling vessel West Hercules had been cancelled by Statoil (ticker: STO). The contract was initially scheduled to go through January 2017 and be a source of $94.8 million in revenue for Seadrill. That is no longer the case as Statoil has decided that it is better to pay Seadrill a $61 million termination fee rather than continuing to drill. This equates to a loss in revenue of $33.8 million for Seadrill.

On May 24, 2016, Freeport-McMoran (ticker: FCX) announced the company had terminated an agreement with Rowan Cos. PLC for the Rowan Relentless drillship. The contract was initially scheduled to run through June 2017. Freeport-McMoran will pay Rowan $215 million in cash outstanding receivables and early termination of the contract. Rowan may also receive additional contingent payments from FMOG of $10 million and $20 million, respectively, depending on the average price of oil over a 12-month period. Freeport-McMoran also canceled contracts earlier this month with Noble Corp. (ticker: NE), paying $540 million in fees to do so.

These contracts present only a snippet of the total picture, however they do call on a greater question about the health of offshore drilling. It says a lot about the state of offshore when an oil producer is more willing to give a company $61 million to stop drilling than it is to pay $95 million to drill for oil.

Freeport-McMoran is in the process of redirecting its business back to mining and away from oil and gas, so there is likely some causation associated with that, however, the need to pay out termination fees rather than drill points more towards the economics of offshore drilling.

High Cost Drilling

Offshore drillers have faced a double whammy of collapsing demand amid crashing oil prices and a wave of new rigs, widening oversupply. Contract awards are at their lowest level since the 1980s, Seadrill said last month, and drillers are now accepting “survival rates” well below $200,000 per day for floating rigs. That compares with fees that went as high as $650,000 per day at the peak of a boom in 2013.

The dayrates associated with offshore drilling are substantially larger than onshore drilling, making offshore drilling a more significant capital expenditure than onshore. With companies cutting capital expenditure budgets, new exploration and drilling has been shelved by a lot of companies in favor of increasing production from legacy wells.

Increasing the stress on the offshore drilling companies is the supply glut of rigs. As more companies lay down rigs and cease expenditures in offshore drilling, dayrates have suffered and the rig glut will keep them low for the foreseeable future. The utilization rates for drilling companies have taken a significant hit, with some companies choosing to retire rigs and cold stack them. Transocean Ltd. (ticker: RIG) Chief Executive Officer Jeremy Thigpen expects it will have to wait at least another three years before his company can begin charging higher rates for offshore rigs.

In an industry report, Moody’s said, “With so many newbuilds on the horizon, rig companies will have to cold-stack or scrap substantially more rigs over the next several years.”

“Oil and gas producers are still cutting rig exposure to preserve liquidity and will defer most exploration and appraisal drilling as well as high-cost early-stage development projects at current oil prices as they reassess project economics, development timing, and long-term strategies,” Moody’s says. “Without a significant, sustained recovery in oil prices, it could be difficult for oil companies to maintain even today’s reduced drilling levels through 2017.”

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