Economics of Rig Industry

Economics of Rig Industry

Sakthivel Balakrishnan

Executive Summary
The demand for crude oil is increasing by the day as the developing economies are growing in spite of the present recessionary scenario. This has made the companies in oil and gas sector to gear up for more production and pass on the pressure to their service industry, particularly the rig industry by demanding more resources. This has led to the increase in demand for rigs. Although the estimated value rig industry is over $35 billion, the market structure has lot of entry barriers which prevents the increase in number of companies in this industry. The supply of rigs around the world is generally quantified based on the count of rigs around the world which drives the production. Hence the rig count can be one of the factors in determining the production and thereby the price of crude oil. Because of this the day rates for rigs are high which may be good for rig companies but, bad for refining and distribution companies unless the energy prices are rising at the same rate. Because of the high day rate, the companies need to maintain almost hundred percent rig utilization rate in order to avoid losses. Overall around the globe the rig utilization capacity has been 100 percent across all rig types. The role of government of India in the rig industry is triggered by its interest in the high utilization of the blocks it has awarded under NELP for energy security purpose and also to get more profit petroleum under the Production Sharing Contract. So the Government of India in order to motivate the rig deployment in India has made duty free import of goods apart. In this way the government also promotes the rig industry by reducing the cost incurred by the rig contractors in bringing a rig and also moving it across different locations within the country.

Table of Contents
PREFACE 2
Executive Summary 3
Introduction: 5
Industry structure: 5
Market Structure: 6
Entry barriers: 6
Exit Barriers: 6
Rig Supply: 7
Rig day rate: 10
Rig Utilization Rate: 12
Bibliography: 13

Introduction:

The rig market is dynamic, highly competitive, and regionally-specific. Market activity depends on the level of oil and gas exploration, development and production worldwide. In most parts of the world, especially areas with significant proved reserves, oil production is more closely controlled by state oil companies or the government through licenses. Broadly speaking, the offshore industry is comprised of the deepwater and shallow water drilling markets. Each market is divided into smaller submarkets based on the type of drilling rig, region, water depth capability, and other technical specifications. The market segments are affected by common characteristics and conditions specific to each segment.
Offshore drilling activity has historically been cyclical, with oil and gas prices playing a key role in driving the market through supply and demand fundamentals. Demand for rigs is directly related to the regional and worldwide levels of exploration and development expenditures. The level of spending may be influenced by oil and natural gas prices, expected changes in prices, regional and global economic conditions, political, social and legislative environments, technological advancements, and factors such as credit availability. Military, political and economic events throughout the world contribute to price volatility and will continue to do so in the future.
Rig Industry structure:
Essentially, the drilling rig business involves a contact between an oil company, commonly referred to as the operator, and an independent contractor. The contract engages drilling services for a term ranging from 30 days to 5 years. It specifies the obligations, liabilities, and rights of each party. The contractor is responsible for providing the rig, equipment and personnel. The contractor bears the operating, business and financial risks. The business is equipment intensive with a rig having numerous and diversified pieces of equipment along with the associated operating problems. Ideally, the contractor is able to allay most of these difficulties by hiring a contingent of highly skilled and experienced personnel. The rates charged in the contract are referred to as “day rates” and represent the contractors total compensation for all operating costs, capital invested and profits.
?  An overview is shown below of the process from drilling rig to consumer.

Market Structure of Rig Industry:

An estimate of the total value of the new build rig market is at over $35 billion.
Number and size distribution of sellers | Small number of sellers |
Number and size distribution of buyers | Specified number of buyers |
Product differentiation | Product is homogeneous |
Conditions of entry and exit | Entry difficult |

Entry barriers:
* Lead time to manufacture a single rig is long (almost 1 ??“ 2 years)
* Rig business requires highly specialized workers to operate the equipment and to? make key drilling decisions.
* Having ample cash is another barrier -? a company had to have deep pockets to take on the existing rig companies
* The large amounts of capital investment tend to weed out a lot of the suppliers of rigs.
* Power of Buyers. The balance of power is shifting toward buyers. Rig is standard equipment and one companys rig or drilling services is not that much different from other. This? leads buyers to? seek lower prices and better contract terms.
Exit Barriers:
* At the same time, exit barriers in the rig business are quite high. Besides the scrap value of the equipment, a rig that does not operate has no? value added capability.
* Long term contracts with customers
Factors affecting rigs demand and supply:
The supply of rigs around the world is generally quantified based on the count of rigs around the world. Rig count trends are governed by oil company exploration and development spending, which in turn is influenced by the current and expected price of oil and natural gas. Rig counts therefore reflect the strength and stability of energy prices.
However, there are many other factors at work, including:
Technology:
* Minimizes the number of wells required to develop a reservoir
* Maximizes production from new and existing fields
* Increases the operational efficiency of the active drilling fleet
* Opens new fields for exploration ( such as deepwater areas)
Seasonal spending patterns:
* Rig counts rise and fall with company budgeting and spending cycles
* Drilling activity often declines in the first quarter as prior year drilling programs expire. Activity then rises for the rest of the year, peaking in end of financial year to fulfil drilling commitments before budgets and leaseholds expire.

Other factors:
* Local taxation policies,
* Government sanctions
* Political unrest
* Development of new infrastructure (such as roads and pipelines)
* Availability of capital investment
ECONOMICS OF RIG COUNT
The Rig Count is the average number of drilling rigs actively exploring for oil and gas. Rig count is one of the primary measures of the health of the exploration segment of the oil and gas industry.?  In a very real sense it is a measure of the oil and gas industrys confidence in its own future. Drilling an oil or gas well is a capital investment in the expectation of returns from the production and sale of crude oil or natural gas.

Exhibit 1: World Rig count

The prices of crude oil play a major role in deciding the production of crude oil. As the price of crude oil increases, there is a simultaneous increase in the interest of companies in drilling more wells, For this they require suitable rigs and thereby the demand for rigs also shoots up.

Exhibit 2: Crude Oil Price
Exhibit 3: World Crude Oil Production

Exhibit [ 4 ]: World Crude Oil Reserves

Interpretation and analysis:
From the above graphs, it is clear that, the world oil production almost follows the pattern of rig count in the respective years. Comparing Exhibit 2 and Exhibit 3, it is clear that, the oil price follows the same pattern as production. Hence, even if the production of oil increases, the price also increases proportionally to the extent of the gap between the demand and supply. This is because the demand for oil has also increased over the years in the emerging economy which has resulted in increase in world oil demand. Exhibit 4 shows the world proved crude oil reserves which when compared with the world oil production; the gap between the two promotes the gap between demand and supply. Hence, this gap can be attributed to the rig count which drives the production.

Indian Scenario

The rig demand in India over current years has been more towards offshore rigs. As can be seen from the graph below that apart from growth in the demand for offshore rigs there has been an increase in the oil rigs and a comparative decrease in the number of gas rigs. Also it can be observed from the graph below that from 1998 until 2003 the general trend was the decrease in the no. of oil rigs & an increase in the no. of gas rigs .From 2003 to 2005 the oil rigs again started increasing while the gas rigs saw a considerable decline

Exhibit [ 5 ]: No. of Rigs in India

Rig day rate:
Day rates: Oil and gas drillers usually charge oil producers on a daily work rate. These rates vary depending on the location, the type of rig and the market conditions. Higher day rates are great for drilling companies, but for refiners and distribution companies this means lower margins unless energy prices are rising at the same rate.
When a well is drilled, the fact that oil or gas is found does not mean that the well will be completed as a producing well.?  The determining factor is economics. If the well can produce enough oil or gas to cover the additional cost of completion and the ongoing production costs it will be put into production.?  Otherwise, it??™s a dry hole even if crude oil or natural gas is found.?  The conclusion is that if real prices are increasing we can expect a higher percentage of successful wells. Conversely if prices are declining the opposite is true.

Exhibit [ 6 ]: Average day rate for rigs offshore in India

The dayrates for rigs working offshore India has increased from an average of approximately $28,000 in 2000 to an average of nearly $175,724 this year, with the competitive jackups that compose the majority of the fleet earning $129,000 per day on average.
Rig Utilization Rate:
Rig utilization rate refers to the ratio of current usage of the rig to its actual production capacity.
Overall around the globe the rig utilization capacity has been 100 percent across all rig types, which means it is being used to its maximum capacity. The main reasons for the high utilization rate are
* High day rates:
The high day rates of the rig act as an incentive for the rig contractees to use it at its maximum production capacity.
* Minimum work commitments:
Due to the constant pressure of sticking to the minimum work commitments the rig holders have to use the rig at its full utilization rate.

Implications of low rig utilization rate:

* If rigs are not utilized at their maximum then the company incurs losses on account of the decrease in the production.

* Also in the Indian context as the companies are required to stick to minimum work commitments(MWC) under NELP therefore it is essential that companies utilize the rig properly as otherwise the company might have to shell out liquidated damages to the Government of India for not sticking to its MWC under the Production Sharing Contract(PSC).

* Also as there is a regular scheduling in terms of the work completion during the first 7 years of exploratory phase, the utilization rate has to maintain constantly at maximum possible levels.

* During production phase also the company might lose out on sales if it falls short on production capacity as there is no shortage of demand and therefore as much the company makes will be utilized.

So both the internal willing of the company in terms of achieving high sales as well as external pressures act as a stimulus in maintaining 100% rig utilization rate.

Obviously factors outside the firms control such as bad weather which might disrupt its operation are not taken into account while calculating the rig utilization rate. It is only calculated on the no. of days the rig was in condition to work and provided that it was put to its maximum production capacity.

Govt. Role in rig industry in India
The role of government in the rig industry is triggered by its interest in the high utilization of the blocks it has awarded under NELP for energy security purpose and also to get more profit petroleum under the P.S.C.
The structural pattern of the cost and revenue of a petroleum company can be seen below:
REVENUE
GOVERNMENT TAKE
CONTRACTOR TAKE

Royalty
Cost Petroleum
Profit Petroleum
Tax
Profit Petroleum

Exhibit [ 7 ]: Cost and Revenue Structure of petroleum sector

The government under the current NELP VIII offers 7years to contractors for carrying exploration activities in the awarded blocks under which they are required to have a minimum work commitment towards the G.O.I failing which they are required to give liquidated damages to the G.O.I
The following Liquidated Damages shall be levied in case of unfinished committed work programme including wells committed during the 5th, 6th and 7th years of exploration.
(In US $) Onland Shallow water Deep water |
Per well 1,000,000 3,000,000 6,000,000 |
Per sq.km of 3D 5,000 1,500 1,500 |
Per line km of 2D 2,500 1,000 1,000 |
Exhibit [ 8 ]: Liquidated damages payable to Government of India
Many of the blocks which were offered in the earlier NELP biddings are unable to stick to the MWC (minimum work commitment) which is partly due to the shortage of rigs that the contractors are facing.
When the work is unable to complete in the stipulated time it is also a loss to the government in terms of revenue it loses on account of profit petroleum which has therefore pressurized govt. in taking decisions which promote the rig employment.
Profit petroleum is the total value of product saved from a particular contract area under P.S.C payable to the G.O.I and calculated in specified manner. The following graph shows the money generated by the government from profit petroleum and it`s trend over the years.
The government earned $995 million from profit petroleum in the year 2007-08. Now if the rigs are not available and no production takes place govt. stands to lose out on these revenues apart from the increase in its energy dependence due to lack of production caused by rig shortage.
As is evident from the graph below that profit petroleum is an important source of revenue for the Government of India.

Exhibit [ 9 ]: Revenue to Government of India through Profit Petroleum
On the other hand it is also very hard for the companies to stick to the deadlines mentioned under P.S.C as they do not have the rigs to carry out drilling works. To compensate for these problems the government offers suspension of operation until the first rig is available provided a drilling contract has been executed prior to lease expiration.

In this way it minimizes the effect of such uncontrollable factors on the work commitment parameters.
Announced in the spring, NELP VIII is offering 70 Indian blocks for exploration and production, of those 62 are located offshore. After the planned 11 bidding rounds, India hopes that 80% of its sedimentary basins will be under exploration.
As the current trend shows that close to 90% of the blocks offered by NELP VIII are stationed offshore, this is due to the fact that most of the onshore resources have been explored and are under production.
To explore deep waters offshore technologically superior rigs capable of handling harsh deepwater conditions are required. As even for onshore rigs owning or hiring strategy has to be planned well in advance due to their unavailability on account of earlier contracts, for offshore rigs it is even more complex.
Production of an offshore rig would take anywhere between 3-4 years.
So the Government of India in order to motivate the rig deployment in India has issued a notification No. 21/2002 customs dated 01.03.2002 which entitles operators for duty free import of goods apart from issuing NOC??™s for transfer of goods within the country.
In this way the government tries to reduce the cost incurred by the rig contractors in bringing a rig and also moving it across different locations within the country.

Conclusion:
The factors affecting the rig industry are mostly related to the changes occurring in either the price or production of crude oil. The rig industry is now facing more demands for offshore rigs as more and more companies are willing to take the risk of going in deep waters. The correct rig procurement at a reasonable rate is a tough job and needs intensive market search.
In the Indian scenario the non availability of rigs is reducing the production capacity of the oil companies and also their ability to stick to the M.W.C. As the duration for which the rig is used by a company and its utilization rate gives a measure of the crude oil production, so the rig counts are often taken as a indication of the health of the oil industry.
In the coming times wherein the demand for crude oil is bound to increase, the rig industries will play a significant role in the ability of the oil production companies in meeting these demands.
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Bibliography:
www.rigzone.com
www.riglogiix.com
www.dghindia.org
www.bakerhughes.com
www.petroleum.nic.in
http://www.gomr.mms.gov/homepg/regulate/environ/ongoing_studies/gm/GM-92-
http://www.investopedia.com/features/industryhandbook/oil_services.asp