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Offshore Driller Receives 6 Termination Notices – Is Rig Contract Sanctity Crumbling?

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In Diamond Offshore’s 10k SEC filing yesterday, the company offered a look behind the scenes at conversations occurring with its customers.

The disclosure suggests a frightening development in the offshore markets, where operators seem to be ignoring the sanctity of offshore drilling rig contracts on a more widespread basis than previously thought as they scale back their rig portfolios.

Admittedly, operators playing hardball is a part of the negotiation game that rig contractors must deal with. However, we submit that an apparently growing lack of regard for rig contractual commitments could have wide ranging consequences for the offshore drilling model.

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The Ocean Nomad is one of 6 Diamond rigs served with an early contract exit notice

6 Diamond Offshore Rig Contracts Being Questioned

In the past few weeks, three different customers have told Diamond that they do not plan to honor contracts signed for six different rigs. Together, the contracts now in question are worth over $735mm of revenue for Diamond.

The disputed rig contracts range from an ultra-deepwater semi to midwater semis to standard jackups, with geographies spanning Mexico, Brazil, and the UK. The rig contracts affected have any where from 3 months to 3 years remaining.

6 Diamond Offshore Rigs Impacted By Contract Termination Discussions

Rig Name Rig Type Operator Contract Coverage Dayrate
Ocean Baroness 5th gen semisubmersible Petrobras September 2018 mid-$270,000-$310,000
Ocean Nomad 2nd gen semisubmersible Dana Petroleum August 2015 $330,000
Ocean Ambassador 2nd gen semisubmersible PEMEX March 2016 low-$210,000s
Ocean Nugget 300 ft. IC jackup PEMEX August 2016 mid-$90,000s
Ocean Summit 300 ft. IC jackup PEMEX May 2015 mid-$80,000s
Ocean Lexington 2nd gen semisubmersible PEMEX March 2018 $160,000

data credit: company filings, Oilpro equipment

Conversations have ranged from the operators verbally telling Diamond that they have the right to terminate the contracts and intend to do so, to written notices of termination months ahead of the contractual schedule.

In each case, Diamond Offshore is either in discussions with its customers or in the process of defending its contractual rights.

The Terminations/Cancellations Are In Various Phases Of Negotiation

Rig Name Contract Termination Status
Ocean Baroness Petrobras recently notified Diamond that it has a right to terminate the drilling contract and has verbally informed Diamond that it does not intend to continue to use the rig. Diamond is currently in discussions with Petrobras regarding the rig.
Ocean Nomad On Feb 12, 2015, Diamond received notice of termination of its drilling contract from Dana Petroleum. Diamond does not believe that Dana had a valid basis for terminating the contract and intends to defend its rights under the contract.
Ocean Ambassador On Feb 20, 2015, a representative of PEMEX verbally informed Diamond of PEMEX’s intention to exercise its contractual right to terminate the rig’s drilling contract. Diamond has not received written notice yet and is in discussion with PEMEX about the rig.
Ocean Nugget On Feb 20, 2015, a representative of PEMEX verbally informed Diamond of PEMEX’s intention to exercise its contractual right to terminate the rig’s drilling contract. Diamond has not received written notice yet and is in discussion with PEMEX about the rig.
Ocean Summit On Feb 20, 2015, a representative of PEMEX verbally informed Diamond of PEMEX’s intention to exercise its contractual right to terminate the rig’s drilling contract. Diamond has not received written notice yet and is in discussion with PEMEX about the rig.
Ocean Lexington On Feb 20, 2015, a representative of PEMEX verbally informed Diamond of PEMEX’s intention to cancel the rig’s drilling contract. Diamond has not received written notice yet and is in discussion with PEMEX about the rig.

data credit: company filings

Offshore Drilling Rig Contract Sanctity In Question

It should come as no surprise to our readers that conditions in the offshore drilling markets are depressed and continue to weaken. So why is Diamond’s stock (and those of its peers) reacting so harshly to this news?

Diamond Down 9% Today On This News, & Other Offshore Drillers Trading Off Hard Too In Sympathy

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intraday chart of Diamond Offshore’s stock, bloomberg

Even though there have been occasional offshore drilling rig contract cancellations andterminations here and there over the past few months, Diamond’s news is catching many off guard for several reasons. Chief among these are:
i) the sheer number of rig contracts in question,
ii) the fact that different operators, regions and rig types are involved,
iii) the timing, as most of these discussions seem to have started after the Diamond’s earnings call on Feb 9, suggesting another leg down in the offshore rig market in the past few weeks, and most importantly
iv) questions over offshore drilling rig contract sanctity, especially in the cases of the Petrobras and Dana Petroleum contracts where our understanding is the operators do not have a termination provision like PEMEX tends to negotiate.

In past cycles, offshore drilling rig contracts have held up relatively well with the exception being operators defaulting due to lack of access to capital – they are ironclad agreements that protect the contractors from operators backing out in downcycles. Terms and dayrates are occasionally renegotiated but outright cancellations are rare. Admittedly, the termination discussions Diamond disclosed (especially the verbal ones) are a part of the age old negotiating game that occurs between operators and contractors. We also know that many operators are asking contractors for price concessions on existing contracts. But this downcycle, it seems that operators are being more proactive in challenging the sanctity of offshore drilling rig contracts – contract cancellations are different than contract renegotiations.

Offshore drilling rig contracts are practically a sacred bond between operators and the contractors. Rig contractors depend on the backlog associated with contracts to gain access to funding and build new rigs, which cost as much as $700mm a copy. Both operators and rig contractors also make assumptions about the validity of rig contracts when they execute rig procurement strategies (i.e. longer-term contracts are more commonly signed when the market is tight).

Offshore drilling is an incredibly capital intensive business, and contractual backlog has become a critical part of the financial engineering exercise required to build offshore rig fleets. Operators benefit from contract sanctity as it allows capital intensive rigs to sit outside their operations. Further, the rig sharing among operators that the contract model empowers is a far more efficient set-up than each operator owning its own rig fleet.

If this backlog increasingly melts away as operators challenge contracts, the foundation of the operator/contractor model will be shaken. This could have far ranging consequences for the business and is something to keep a close eye on as the downcycle matures.

Without firm contracts, there can be no such thing as an offshore drilling contractor – a notion we submit operators should keep in mind as they look to force costs out of their systems. The shortsightedness of failing to honor contractual agreements could result in bigger, more expensive problems in the long run…

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