Despite stronger demand for offshore drilling services, especially in the jack-up segment, S&P Global Ratings believes industry-wide market conditions will remain challenging until the latter half of 2020, with a more meaningful recovery in 2021. As a result, we have reduced our revenue and cash flow estimates for offshore drilling contractors, and have recently lowered our ratings on Valaris plc, Transocean Ltd., Noble Corp., and Diamond Offshore Drilling Inc. We have downgraded all four companies to 'CCC+', reflecting our view that leverage has become unsustainable, and that they are all dependent upon favorable business conditions to meet their long-term financial obligations. Ratings on international offshore drilling companies Vantage Drilling International, Pacific Drilling S.A., and Seadrill Partners LLC remained unchanged at 'CCC+'. Valaris, Transocean, and Pacific Drilling have a negative outlook attached to the ratings, and Vantage, Noble, Seadrill, and Diamond Offshore have a stable outlook, due to their relatively stronger liquidity positions.

In our view, market conditions for offshore contract drilling services, especially in the deep-water segment, will remain challenging through 2020. We expect a more meaningful recovery in 2021 driven by both the continued uptick in demand as exploration and production (E&P) companies look to replace reserves and additional scrapping of older or less competitive rigs. By then, we expect higher utilization will allow day rates to meaningfully strengthen from today's near break-even levels on many new contracts.

Offshore Competing With Shale

Most new deep-water projects face stiff competition from onshore shale. Shale's quick payback, particularly under our long-term price assumptions for West Texas Intermediate (WTI) and Brent crude oil of $55 per barrel, and lower operational risk and costs, have shifted oil and gas producers' capital allocation away from long-term offshore projects. This is particularly true given the volatility that crude oil prices have exhibited throughout 2019, which makes returns on decades-long projects difficult to forecast. In addition, the long lead-time and high capital spending prior to first production for offshore projects does not conform to E&P companies' newfound capital discipline to live within cash flows and return excess cash to investors. We believe demand for offshore contract drilling rigs and services has bottomed out, but will remain somewhat weak in the next 18 to 24 months, especially for deep-water rigs, as we expect E&P companies to continue to allocate the majority of their capital to develop oil and gas onshore. A sustained improvement in market conditions and contract drillers' financial performance will depend on supportive crude oil prices, rig attrition, and the industry's ability to continue lowering costs and improving efficiency such that offshore returns become competitive with onshore.

Deepwater rigs are still in the storm, but skies are clearing for jack-ups

In our view, market conditions for offshore contract drilling services, especially in the deep-water segment, will remain challenging through 2020, with a more meaningful recovery in 2021.

In the drillship and floating rig segments, we believe market day rates have not meaningfully increased beyond the break-even cash flow level, despite improving utilization since 2017. Many recent contracts have also been relatively short term and would easily allow operators to drop a rig if crude oil prices weaken. We do not expect any meaningful improvement in day rates until utilization improves closer to 75% to 80%, which we expect to occur in 2021. We estimate most contracts signed for work in the remainder of 2019 and 2020 provided only minimal cash flow. We have pushed back our assumptions for the recovery in day rates on ultra-deep-water rigs and now assume contracting rates will be in the $200,000 to $225,000 per day range in 2020, increasing to around $250,000 per day in 2021, with some variation depending on the rig quality and location.

We estimate warm stacking costs for ultra-deep-water rigs can run at least $15 million per year, versus less than $5 million to cold stack. That can hurt margins, near-term, for those companies that choose to warm stack rather than cold stack or scrap their rigs. Mobilization and reactivation costs will also likely offset much of the near-term benefits when these rigs are reactivated. On the other hand, these warm stacked rigs are easier and less expensive to bring back to work than cold stacked rigs, putting them at a competitive advantage when the market recovers. In fact, we do not expect many cold stacked rigs to return to service given the high potential reactivation costs of $40 million to $100 million per vessel.

In the jack-up market, and especially the high specification/harsh environment segment, rigs have already seen higher utilization levels and strengthening day rates. Some fixtures even enjoy multiyear duration, while this market has typically seen short-term or spot contracts. We believe this reflects the typically shorter horizon and lower risk projects these rigs typically support, making returns more competitive with onshore projects. However, jack-ups continue to generate lower margins than deep-water rigs and we believe day rates have not yet recovered to their full potential.

Chart 1

Industry consolidation brings long-term upside potential, short-term drawbacks

Several transactions in the sector led to further consolidation in the U.S. offshore drilling industry over the past three years, including:

• The 2019 merger of Ensco PLC (now Valaris) with Rowan PLC;
• The 2018 acquisition of Ocean Rig by Transocean;
• The 2017 acquisition of Atwood Oceanics Inc. by Ensco; and
• The 2017 acquisition of Songa Offshore SE by Transocean.

These transactions aimed at reinforcing market positions of industry leaders Ensco and Transocean in the ultra-deep-water segment (the Ocean Rig and Atwood Oceanics acquisitions), the harsh environment segment (Songa) or in the high-spec jack-ups segment (Ensco/Rowan merger). While the main benefit of this consolidation movement lays in a reduction in operational support, and general and administrative costs, we believe an accelerated rig attrition rate might occur as well. However, any positive impact on cash flows will be limited in the short-tem, as acquisition and severance costs generally offset cost savings in the first 12 to 18 months after the transaction. In addition, weak market conditions translate into weak cash flow generation from newly acquired rigs. In the medium to long-term, the enhancement in fleet size and quality should give the consolidating companies a boost in revenues and profitability once the industry fully recovers.

Table 1

Despite unsustainable debt leverage, solid liquidity should keep companies afloat over the next 12 months

Under our utilization and day rates assumptions, we expect all offshore drillers to have leverage in excess of 10x over the next 12 to 24 months, a level we deem unsustainable. We forecast leverage metrics for most entities to return to more normalized levels (under 10x) at the end of 2021. In the meantime, we note that most industry players have large cash balances, limited debt maturities coming due in the next 24 months, and access to large, undrawn (or little drawn) revolving credit facilities. However, we expect mounting pressure on these issuers' capital structure given the protracted nature of the downturn. We believe any debt refinancing will likely be under less favorable terms, including the addition of secured features, higher interest rates, or reduced commitments for bank debt.

Table 2

Overall, we believe an improvement in offshore market conditions, and consequently, the financial performance of the offshore drillers, will depend on stable crude oil prices, rig attrition, as well as the E&P industry's ability to lower costs and gain operating efficiencies that make offshore returns competitive with onshore.

Further, we believe oil and gas output from offshore fields will remain an important piece of the global energy supply, as other sources of energy will not suffice to meet the growth in energy demand. In addition, the need for independent E&P and major integrated companies to replace offshore reserves after years of significant underinvestment will support improving demand for offshore rigs. Currently, offshore production accounts for about one-quarter of global oil volumes, with much of that production from projects sanctioned prior to 2014. Offshore production also provides a portfolio benefit to E&P companies and majors, by providing large-scale wells with lower initial declines as an offset to the much smaller scale and steep initial declines typical of shale wells.