The Biggest Threat Facing Offshore Drillers Keeps Getting Worse

Few industries have been so negatively affected by the oil crash as offshore drillers. In the past I've attempted to finddrillers whose contract backlogs were relatively insulated from the downturn. To this effect I recommended SeaDrill Partners , because just 20% of its rigs had contracts expiring through 2016. Now however, news of contract cancellations from BP mean that the risk of contract cancellations -- which I believe to be the biggest risk to the industry -- is rising and in a most alarming way. Find out why and what it might mean for your portfolio.

West Sirius Rig. Source: SeaDrill Partners.

What happenedOn March 30 SeaDrill Partners received a notification that BP was cancelling its contract for the West Sirius Ultra Deep-Water--or UDW--rig. Prior to the cancellation BP had swapped day rates and contract lengths with the West Capricorn UDW rig, whose contract now extends to 2019. However, while that bit of good newshelps soften the blow somewhat, SeaDrill Partners backlog will still be decreased by a total of $160 million due to this contract cancellation.

Why this affects the entire industryThere are three reasons why this news is exceptionally bad for the offshore drilling industry.

First, prior to the contract term swap the West Sirius was contracted through 2019 at a day rate of $535,000 -- the same terms that now apply to the West Capricorn.With the West Sirius's contract being cancelled SeaDrill Partners will now have to cold stack one of its most modern and advanced rigs -- at an estimated cost of $110,000 to $120,000 in maintenance costs per day -- unless it can secure a new contract.

Management says it doesn't expect this cancellation to materially affect its cash flow situation until July of 2017 because of the $160 million early cancellation fee it will receive. However, in my opinion this cancellation increases the risk that further BP contracts may get cancelled or renegotiated such as those of the West Auriga and West Vela, which are not only currently contracted for higher day rates than the West Sirius was -- $565,000 vs $535,000 -- but are both also operating in the same area, the US Gulf of Mexico..

Further bad news from BP also came in the form of it cutting short its contract with Ensco for its DS-4 UDW rig, for which it was being paid $560,000 per day. Come July 2015 Ensco will need to find new work for this rig, or face the prospect of cold stacking it as well.

Ensco DS-4 Rig. Source: Ensco PLC.

However, perhaps the worst implication of this news is the location of the rigs whose contracts were just cancelled; the Gulf of Mexico, an area that was one of the few bright spots in the industry. In fact the analyst firm Raymond James had previously called it "one of the strongest regions for offshore drilling".

The fact that BP would rather pay Ensco a $160 million cancellation fee rather than continue drilling means that the economics of drilling in the Gulf at current oil prices may no longer make sense. This is especially bad news for Ensco, who has eight other rigs in the Gulf of Mexico, two of which are already idle and three whose contracts expire by September of 2015.

At the very least so many idle rigs in this region will likely cause day rates in the Gulf to crash further, that is if other oil companies are even willing to continue drilling in the Gulf at all. If they are not all of these rigs will need to be moved to other areas of the globe to take work at substantially lower day rates if only to prevent the need for cold stacking -- which would only act as a further drain on Ensco's already deteriorating finances.

Takeaway: Most recent contract cancellations mean no one's backlog is safeTwo major rig cancellations in the Gulf of Mexico -- an area that had previously been thought a relative safe haven for drillers -- is terrible news for the industry as it means that the economics of drilling in that region at current oil prices is now in doubt. With oil prices down more than 50% and potentially having further to fall, I wouldn't be surprised to see more contract cancellations in the future. This would likely increase further short to medium-term downward pressure on global day rates and potentially result in a large number of idle and cold stacked UDW rigs. Investors in the offshore industry must be aware of this risk and should consider their individual risk profiles and adjust their holdings accordingly. Until oil prices recover its becoming increasingly obvious that no company's contract backlog is safe.

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Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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