Contractors, operators clash as market contraction continues

The number of stacked rigs continues to grow in the Sabine Pass area off the Texas coast of the Gulf of Mexico.

The party's over. The only question now is who's going to pay the bill. As the oil price floats around $13-14/bbl, operators are understandably concerned about the long-term contracts signed with drillers to use newbuild and conversion drilling units. These deals made sense at $21/bbl or even $17/bbl, but at $14/bbl, there is simply no way to win.

Of course, this is not the first time oil prices have crashed, just when everyone thought they were poised to go up. There are several differences between the current environment and that of the late 1980s, when the previous crash occurred.

First, most companies are leaner to start with. All the fat (and some of the muscle) that was cut out after the last downturn has never been replaced. This means even the sweeping personnel cuts currently taking place among the majors and independents could affect performance more than the bottom line. There simply are not the excessive layers of middle management in place.

Second, the drop in prices this time around was followed fairly soon with cuts in drilling programs and projects postponement or cancellation. In the 1980's, it took most of a year for the price drop to affect the future plans of oil companies. In the 1980s, no one seemed willing to admit that the bubble had burst and everyone went on as if prices would soon resume. This time, it was as if the companies were anticipating a drop in prices.

Long-term contracts

Part of the anticipation today can be seen in the fact that very little speculative building was done. The building that did go on without supporting contracts was for the most part in niche markets, where the delay in contracting was seen as an aggressive move to take advantage of ever increasing prices. The bulk of the construction going on now is fully or substantially funded by longer-term contracts, covering 60-80% of the cost of the rigs.

Some newbuilds have received the much-coveted full-payout contract, which covers the total cost of the rig in the initial contract. The reasoning here is sound. Why should a driller expend hundreds of millions of dollars without a guaranteed return? In every sense, these contracts were designed to protect the drilling companies from what is going on now, meaning a drop in prices and drop in demand.

If that was all there was to contract re-negotiation, then there would be little to say. The operators would take it on the chin; the drillers would have their new rigs paid for; and the oil industry might conceivably crash under the burden of all this debt. Instead, the operators are fighting to either get out of these deals or renegotiate a day rate that relates to the current market. Drilling contractors see irony in the fact that operators are complaining about the high day rates they created by bidding up the price of rigs during the recent boom.

Global Marine CEO Bob Rose said the operators are responsible for high day rates. If the contractors were in charge there would be a day rate set that reflects rig demand, but also the possibility of a downturn and the cost of operating the rig. This is generally where the day rates start, but then an operator bids them up trying to secure a rig for a long-term contract. This is fine during the boom, but once the drillers begin to rely on these higher rates, using the cash flow to expand the fleet, for example, then problems develop if the operator needs to re-negotiate to a lower rate or get out of the contract.

Different approach

Rose said the attitude of the operators is very different this time around. During the last downturn, there were deals made. There had to be. Things took time, but the over-capacity of the market was massive. Rose said the operators were willing to negotiate in the 1980s and a lot of this went on very quietly. During the downturn, private meetings would result in quietly reduced day rates. While negotiations were tough, they were also convivial and discreet. One representative with Diamond Offshore said he doesn't blame the operators for trying to get out of these contracts. It is the only way they can avoid facing massive losses. If there is a loophole in a contract that allows the operator to get free, then it is his fiscal duty to do so.

Rose and others blame a variety of sources for the current public hostility between contractors and operators. For one thing, the oil price dropped much faster this time around. Operators did not have time to be subtle, and in some case, a re-negotiation of the day rate wouldn't solve the problem. What was needed was a cancellation. Also, the operators are performing in a much more public environment. With a variety of investors looking on, it takes dramatic moves to impress Wall Street. Rather than focusing on the numbers of an individual deal, some operators might be playing to the financial markets.

Length of contract

Rose said whatever the reason, operators should think twice before pulling out all the stops. When the cycle of prices goes back up, the shoe will be on the other foot and operators will have to negotiate with the same drillers that took them to court. Rose said it would be better for everyone involved to negotiate a fair price during the slump, so that the same style arrangement can be made during the next upturn. When the prices do rise again, the operators will rely on the drillers to provide rigs and the tables will again be turned.

One area that several drillers have turned to in this tight market is the length of contract. Diamond Offshore, for example, is willing in some cases to accept a lower day rate with the understanding that there will be an extension of the contract term. This strategy keeps the rigs working, even at a lower day rate and helps to develop a backlog. Working rigs are of primary concern, to avoid the costs involved in putting the rigs on standby, or hot stacking or cold stacking them.

Also a backlog of work, especially in a market as tight as this one, looks good on a driller's balance sheet. This is an example of how operators and contractors can negotiate win-win deals during the slump in business. An operator may not have the money to pay high day rates, but the firm may be able to offer something else of value to offset the lost revenue.

Need win-win

Drillers are closely allied in how contracts are viewed, but each has a slightly different perspective:

• Jean Cahuzac, President of Sedco Forex, said, "In order to make these contracts work, operators and contractors must come to a win-win situation that benefits both parties. His company has not seen any cancellations as of yet, but will negotiate these on a "case by case" basis. This means the company will keep an open mind concerning alternatives to high day rates, such as contract extensions. He said the contracts on Sedco's three new semisubmersible rigs will pay out the cost of the rigs.

Because the new drilling vessels are coming onto the market in a staggered time line Sedco is hoping the oil prices, and eventually day rates, will turn before the last of the rigs goes to work in the end of 2000. The contracts that Sedco does have to negotiate during the price downturn will be short term, Cahuzac said. The goal is to keep the rigs working, but not commit them long term to low day rates.

In deepwater programs, there is a necessity of a long-term contract to assist the operator in determining the cost of a drilling program. In this situation, it is not the day rate, but the overall cost of the well that concerns the operator, Cahuzac said. By putting an advanced rig to work on these wells, the operator may pay more in a day rate, but makes up for this in greater efficiencies.

• David Herasimchuk, Vice President for Marketing with Global Marine, said when push comes to shove the drilling companies have to fall back on the contract they drafted with the operator. In a tight market, it may not seem that the drilling companies have much leverage with the operators, but if the contract is well written, then it does give the driller some negotiating power. Herasimchuk said the goal in enforcing the contract is not to break the bank of the operator, but to preserve the deal. What the drillers don't want to see are rig cancellations, if an "iron-clad" contract can be used as a bargaining chip to bring the operator to the table, then it has served its purpose.
• Michael Talbert, CEO of Transocean, agreed. He said, "Ninety percent of contract problem result from the way the contract was written. Goodwill disappears when times are bad, and the ability to negotiate depends on how well the contract was written."

As far as terminations are concerned, Diamond Offshore said that there are five main ways in which a contract may be terminated.

• The contract is incomplete.
• There has been a total constructive loss of the rig.
• The operator feels the driller has produced unsatisfactory performance in accordance with the language of the contract and there is a clause allowing for cancellation.
• A force majeure has occurred and both sides of the contract must absorb their own losses.
• The driller or operator has been declared insolvent.

Unsatisfactory performance

Of these five, the contractors agreed that the "unsatisfactory performance" clause is the most subjective. In fact, a few of the cancellations that have been experienced in recent months were based on alleged "performance breaches."

While one could argue that the operators are trying to take advantage of the subjectivity of the performance language in a contract, a representative of Diamond Offshore said the stakes for the operators are much higher in this low-price environment. The margins of profit are so narrow that the rigs have to arrive on site, on time, and function at or near perfection, to make any money.

Talbert said that most contracts do allow for termination based on downtime. This is usually due to equipment failure. When there is equipment failure, the contract typically goes to a lesser repair rate for a time specified in the contract, usually 24 to 36 hours, and then if the repairs have not been completed, to zero rate. If the rig cannot return to work by the time specified in the contract, usually 30 days, the operator may elect to cancel the contract.

When a breach of contract is cited, the rig can be operating, but not to the standards of the operator. Herasimchuk said he has seen several cases in the last few months where operators have cited breach of performance and delivery clauses in the contracts as a reason to cancel. In some of these situations, the vessel had not yet been delivered, but the operator was complaining about unsatisfactory performance. Rose agreed this is the most subjective portion of the contract.

However, when any of these operating problems occur, there is some notice and cure period. The operator must remit in writing the problem and give the contractor ample time to reply and fix the problem. If the problem is not fixed, the contract is cancelled in good faith.

The same goes for late delivery problems, which again usually stem from equipment problems. Rose said the areas where there are most likely to be cancellations are rigs with long-term contracts. The short-term contracts, around one year, are not a real target for cancellation because the time and expense involved in renegotiating the contract outweigh the value of the contract.

Prototype problems

These equipment problems are not entirely the fault of the contractor. Many of the equipment problems stem from prototype, never-been-tested, "Serial Number 1" equipment that was requested by the operator. Diamond said that it is hard to go into the field with unproven equipment. Testing and refinement for optimum operation add to delays. Diamond said the contractors do want to have this prototype "Serial Number 1" equipment, but it seriously adds to the risk of delay.

As the industry rushed to deepwater during the last boom much of the equipment required for these new rigs was innovative in its design. Transocean said that contractors take on too much risk with new technology.

The Discoverer Enterprise has a lot of "Serial Number 1" equipment, such as the dual-activity technology, and there have been delays. But, Transocean did admit that the company marketed the rig without the detailed engineering being completed. Talbert said the more innovative a design, the less likely the engineering can all be done before construction.

When Amoco ordered the Enterprise, Transocean entered into the contract based on estimated costs and began construction before the engineering was completed. Talbert said this type of operation is extremely inefficient and has been a growing industry problem for the past few years. The operators add to this inefficiency, he said, in that they would spend an extended period of time deciding whether a new rig with more capability needed to be built, and gave the contractor only a few weeks to calculate and present a firm price. This haste also has added to the cost increases and delays.

Incomplete engineering

Many have blamed the fabrication yards for the delays, saying they under-estimated how quickly they could get a job done, with problems such as equipment backlogs and manpower shortages. But, Talbert said, the blame lies also with the drilling contractors. He said they entered into the contracts with incomplete engineering making it difficult to get fixed cost contracts. Also the large increase in equipment orders resulted in price increases and delivery delays from many of the equipment providers.

While the price of oil has taken a tumble, causing friction between operators and contractors, forcing projects to be delayed or cancelled, there may be some long-term benefits for both in the current down cycle.

• The rapid increase in day rates that was driving up the cost of drilling and putting a squeeze on the rig market has been curbed.
• Manufacturers and shipyards now have a chance to catch their breath.
• While it may never show up on a balance sheet, this short-term drop in activity will give many in the industry much needed time to perfect their new technology and work all of the bugs out of new rig designs.

True, there are still incredible performance pressures on new rigs to meet goals and avoid delays, but the equipment they will be using will have had additional time to be refined and perfected before being sent into the field, where all lessons come at a high price.

Copyright 1999 Oil & Gas Journal. All Rights Reserved.