With oil prices still below last year's levels due to the OPEC-Russia price war and exacerbated by COVID-19-related demand loss, exploration and production (E&P) companies have further reined in capital spending and reassessed their production and spending goals for the next few years. E&P companies' focus has shifted from production growth to generating positive free cash flow and increasing shareholder returns, resulting in less capital available for drilling activity. This is hurting all oilfield service companies significantly, particularly offshore drillers, given higher all-in costs, greater exploration and operating risk, and longer payback periods for offshore projects relative to onshore plays. However, there is a divergence between deepwater and shallow water market conditions. S&P Global Ratings believes deepwater market conditions will remain extremely arduous until at least late 2022, when we expect demand to begin slowly recovering and the number of marketed offshore rigs to decrease as companies scrap older and less capable rigs, although activity in shallow water has already begun to improve.

Meanwhile, leverage for most of the offshore drillers is unsustainable, and our ratings reflect each company's specific liquidity runway. Of the U.S.-rated drillers, only Vantage Drilling Co. hasn't defaulted, but with an issuer credit rating of 'CCC' and a negative rating outlook, we believe a default is highly likely over the next 12 months. Of the three rated European offshore drillers, ADES International Holdings PLC and, to a lesser degree, Shelf Drilling Holdings Ltd., are in a relatively stronger position, given their exposure to Middle Eastern oil producers with low breakeven points. ADES International remains the only drilling company we rate above the 'CCC' category, given its above-average profitability margins, supported by its onshore drilling exposure and a favorable exchange rate between Egyptian-pound-denominated costs and hard-currency-denominated contracts.

The offshore drilling industry has seen several defaults and bankruptcies this year, with Valaris plc being the latest company to file Chapter 11. Falling revenues, negative free cash flows, and unsustainable leverage for offshore drillers--combined with limited demand visibility--have raised the specter of bankruptcy or restructuring. However, longer term, we believe offshore production will remain an integral part of global energy supply, and therefore there will be survivors in the offshore drilling sector. Companies that are able to reduce debt (most likely through the bankruptcy process) and right size their rig fleets are more likely to remain operational.

The Offshore Rig Count Has Fallen Since 2014 As E&P Companies Exercised Capital Discipline And Shifted Activity Onshore

Chart 1

The number of active offshore drilling rigs has dropped nearly 50% since 2014 because of lower oil prices, higher all-in exploration and development costs offshore relative to onshore plays, longer payback periods, and oil and gas producers' desire to live within cash flows. These factors combined to lower overall upstream capital spending and shift producers' focus to onshore unconventional plays. We estimate the average breakeven West Texas Intermediate (WTI) oil price for onshore projects is currently below $50 per barrel (bbl), while many deepwater greenfield projects require an oil price sustained above $60/bbl, although certain brownfield or step-out developments may have lower per-unit costs depending on how much new infrastructure is needed. For example, Royal Dutch Shell PLC estimates per-unit costs at its Gulf of Mexico Kaikias development (sanctioned in 2018) at below $30/bbl, but this excludes prior exploration and appraisal costs, lease bonuses, feasibility studies, research and development costs, idle rig expenses, and decommissioning charges, while it includes estimated proved, probable, and contingent reserves. In addition, the project is a subsea tieback to an existing production platform so little infrastructure spending was required.

We estimate average breakeven oil prices for shallow-water fields in the $45/bbl to $50/bbl range. However, cost isn't the only factor E&P companies consider when allocating capital between offshore and onshore projects. Both deepwater and shallow-water production generally carry a higher risk of weather-related disruptions than onshore fields, as well as higher initial exploration and appraisal costs (which may include unsuccessful wells) and eventual plugging and abandonment costs. Also, with E&P companies' focus on free cash flow generation, there isn't much appetite to spend money today with first production and cash flows not materializing for two or more years.

With the drastic crash in oil prices earlier this year started by the OPEC-Russia price war and exacerbated by demand loss due to the COVID-19 pandemic, and the one-year strip currently in the $40/bbl area, E&P companies have materially reduced their overall capital spending plans--particularly offshore--leading to a further drop in demand for offshore rigs and services. This has translated to decreasing utilization and dayrates for the offshore drillers, because customers have cancelled contracts, renegotiated rates, and deferred signing many new contracts. S&P Global Ratings assumes WTI oil will average $45/bbl in 2021 and $50/bbl in 2022 and thereafter, with Brent prices averaging $50/bbl in 2021 and $55/bbl thereafter. We accordingly believe that offshore floater utilization will remain weak at least until late 2022, with dayrates recovering thereafter. Interestingly though, jackup utilization and dayrates have already begun to pick up compared with 2017 lows, as breakeven costs for shallow-water wells are generally lower than for deepwater projects.

Chart 2

Chart 3

Although rig contracts generally have favorable terms for the drilling contractor, there have been a number of contract renegotiations and cancellations as oil companies do whatever they can to reduce spending (see table). In some cases, customers had to pay cancellation fees, partially offsetting the lost margins for the drillers.

Looming Debt Maturities Will Likely Lead To Additional Defaults

Offshore drillers haven't completely recovered from the oil market crash of 2014, and their balance sheets have progressively weakened over the past five years, with aggregate debt to EBITDA increasing from 2x-3x in 2014 to over 10x last year. The industry was able to access the capital markets during 2014-2016--for newbuilds and acquisitions--and now faces significant upcoming maturities in addition to an influx in rig supply (see chart 4). Nevertheless, the drying up of business and several contract cancellations, combined with the costs of stacking rigs, have made it difficult for companies to service their debt, leading to the default or near-default of two-thirds of the offshore drillers we rate.

Chart 4

With the capital markets all but closed to deeply speculative energy companies, and cash flow generation expected to be neutral or negative, drillers will be hard-pressed to refinance their upcoming maturities along traditional lines. Not surprisingly, three companies: Diamond Offshore Drilling Inc., Noble Corp., and Valaris plc have already filed for Chapter 11 protection, while Transocean Ltd. and Seadrill Partners LLC have executed distressed exchanges, Pacific Drilling S.A. is considering a bankruptcy filing, and we expect Vantage Drilling Co. to restructure its debt within the next 12 months.

Where Do We Go From Here?

Given the number of contracts rolling off and limited demand growth anticipated over the next two years, we don't expect deepwater rig utilization to improve significantly until late 2022 at the earliest, when we expect oil prices to stabilize and the number of marketed rigs to decrease. Over the next two years, we expect to see more scrapping of older and less capable rigs, particularly those that need to be refurbished, thereby bringing down supply. We will also need to see more offshore projects reduce their all-in costs, bringing risk-adjusted returns in line with onshore plays.

At that time, we believe nearly all of the drillers will have gone through a formal restructuring process (via Chapter 11 or not) to lower absolute debt levels and cash interest costs. The companies with the most capable rigs will then be best positioned to benefit from the expected increase in offshore drilling demand. Interestingly, all three of the bankrupt companies: Diamond Offshore, Noble Corp., and Valaris, are continuing to operate and have recently been awarded new contracts.

With regard to mergers and acquisitions, we don't expect many more large deals because much of the potential overhead savings has already been captured in the last round of business combinations (e.g., Ensco-Rowan [now Valaris] and Transocean-Ocean Rig). Furthermore, to keep costs low for their customers, drillers are moving toward standardization of rigs and equipment, meaning any acquired rigs would have to be refurbished to the new owner's specifications.

Current Ratings On Offshore Drillers

ADES International Holding PLC (B+/Negative/--)

The negative outlook on our 'B+' rating on ADES reflects the increasing risks and uncertainties from the effects of low oil prices and the pandemic-related fallout on the drilling market, which could present contract cancellations and operational disruptions for ADES. Although the company benefits from high profitability, with margins of about 40% and good cash flow visibility over the next 12-18 months, supported by an expanding backlog and strong relationships with the Saudi Arabian Oil Co. (Saudi Aramco) and the Kuwait Oil Co., which constitute 81% of backlog, we believe rising sector uncertainties could prove challenging for deleveraging. Also, the company's exposure to onshore drilling is favorable relative to purely offshore focused peers.

Noble Corp. PLC (D/--/--)

We revised our rating on Noble to 'D' from 'CCC-' after it skipped the interest payment on its 7.75% senior notes due 2024. The company subsequently filed Chapter 11.

Seadrill Partners LLC (SD/--/--)

Conditions in the drilling market have been tested over the past few years, causing Seadrill's capital structure to become unsustainable, with S&P Global Ratings-adjusted debt to EBITDA close to 8x in 2019. We think it's unlikely the company will be willing to pay the interest by the end of the grace period unless lenders agree to capitalize the interest.

Shelf Drilling Holdings Ltd. (CCC+/Stable/--)

We believe that leverage during the next couple of years will likely stay well above 5x (10.4x as of Dec. 31, 2019). Also, we believe the company will be generating negative free operating cash flow in 2020. Finally, we see the risk of distressed debt restructuring leading to the 'CCC+' rating.

Transocean Ltd. (SD/--/--)

Transocean has significant capital spending requirements and a heavy debt amortization and maturity schedule over the next two years, and, after completing one debt exchange, recently announced a broader debt exchange that we view as distressed.

Valaris PLC (D/--/--)

We lowered our rating on Valaris after it skipped its June 1 interest payments on its senior notes due 2022 and 2042. The company subsequently filed Chapter 11.

Vantage Drilling International (CCC/Negative/--)

Our rating reflects our view that leverage will remain unsustainably high as backlog continues to decline, and the company will likely engage in a debt exchange transaction we would view as distressed.

Other offshore drilling companies

We've discontinued the ratings on Diamond Offshore Drilling and Pacific Drilling.