The Big Four’s fourth-quarter results and related conference calls also revealed that the boom in deepwater drilling has accelerated much more rapidly than most industry observers had expected three to six months ago. Well complexity and service intensity go hand in hand; an upsurge in deepwater drilling could be a boon for oil service providers.

Management teams from Halliburton (NYSE: HAL) and Growth Portfolio holding Schlumberger (NYSE: SLB) cited a series of pre-salt discoveries offshore Angola as a catalyst for the upsurge in deepwater activity.

On Dec. 20, 2011, Cobalt International Energy (NYSE: CIE) announced an oil discovery at its Cameia-1 well in Block 21 offshore Angola. The company is preparing the well for a production test that will provide further insight into the well’s potential. With an active drilling program in each of its three Angolan pre-salt blocks, expect Cobalt International Energy to issue more press releases about potential finds. All of these discoveries will require deepwater drilling rigs to be delineated and produced.

In early January 2012, A.P. Moller Maersk’s (Copenhagen: MAERSK B) oil unit announced that its 17,500-foot Azul-1 exploration well encountered crude oil in Block 23 of the Kwanza basin. Initial assessments indicate that the well has the potential to flow more than 3,000 barrels of oil per day. A.P. Moller Maersk will need to do additional appraisal work to learn more about the field and the potential resources therein.

These announcements come on the heels of sizable deepwater discoveries by Anadarko Petroleum Corp (NYSE: APC), Kosmos Energy (NYSE: KOS) Tullow Oil (LSE: TLW) off the coasts of Ghana and Sierra Leone. (See the July 20, 2011, issue of The Energy Strategist, Africa: Oil’s Final Frontier.)

Statoil (Oslo: STL, NYSE: STO) announced a pair of major oil discoveries–Skrugard and Havis–over the past year that may hold the equivalent of 600 million barrels of crude oil. With an ambitious plan to expand its oil production 32 percent by 2020, Norway’s state-run oil company will be active in the deepwater.  

Investors also shouldn’t overlook the deepwater Gulf of Mexico. Drilling activity in the Gulf cratered because of the Macondo oil spill and subsequent moratorium on new deepwater drilling. Well permitting also slowed to a crawl after the ban was lifted.

But drilling activity in the Gulf of Mexico continues to recover. During Schlumberger’s conference call to discuss fourth-quarter earnings, CEO Paal Kibsgaard told analysts that the rig count in the region could return to pre-Macondo levels by the end of 2012:

Analyst: So you’d mentioned that your outlook for North American rig count’s flat this year, and you also said in your release that, basically, revenue was in line with the rig count, so it would seem to me that the upside here for you guys is really going to be in the Gulf of Mexico. And I was just wondering, if we strip out the strength of the seismic side, I’m curious as to where you are in your deepwater operations in the Gulf.

Are you back to the pre-Macondo levels? Are costs now fully absorbed in that market? And I guess I’m just wondering, are your margins now in the Gulf higher than in your U.S. land business?

Paal Kibsgaard: Yes, the simple answer to that is yes. This quarter, I think, was the first quarter where our Gulf of Mexico margins were accretive to North America. So, obviously, there’s been a lot of focus in on the multi-client sales for Q4, which was quite strong, but I think it’s also important to point out the strength we have on the deepwater side for well operations, both wireline and on the drilling segment. So we are quite optimistic in terms of the outlook for the Gulf of Mexico; firstly, in terms of our market share position, and in addition to how well we can leverage our high-end technology and operational performance in this type of market. So we see steady growth in deepwater drilling rig counts during 2012, roughly about a rig a month. So we would be at pre-Macondo levels for drilling rigs in the deepwater by the latter part of 2012.

Schlumberger traditionally has been one of the leading services company in the Gulf of Mexico. If the rig count in the region recovers to pre-Macondo levels by the end of 2012, that would be a huge boon for Schlumberger.

These major discoveries, coupled with a recovery in the Gulf of Mexico and Brazil’s ongoing investments in offshore production, have tightened the supply-demand balance for deepwater drilling rigs, especially the ultra-deepwater units. In the past few weeks, several contract drillers announced impressive fixtures.

• Royal Dutch Shell (NYSE: RDS A) hired Noble Corp’s (NYSE: NE) Jim Day, a semisubmersible drilling rig capable of operating in water up to 12,000 feet deep, to work in the Gulf of Mexico from January 2012 to January 2016. The international oil company will pay $530,000 per day. The contract also includes a 15 percent bonus if the rig meets certain performance goals, which brings the potential day rate to $610,000. The rig’s current contract features a day rate of $485,000.
• On Jan. 19, 2012, Aggressive Portfolio holding SeaDrill (NYSE: SDRL) announced that Royal Dutch Shell had extended its contract for the deepwater drillship West Navigator by 18 months. The new deal is worth about $320 million, which amounts to slightly less than $600,000 per day.
• On Jan. 31, 2012, Ensco (NYSE: ESV) announced that a customer had booked one of its newly built deepwater rigs under a two-and-a-half-year contract in the deepwater Gulf of Mexico. The day rate on this contract is $530,000.
• Rumors are swirling that SeaDrill rejected an offer from Total (Paris: FP, NYSE: TOT) to book the West Polaris at a day rate of $625,000 for two years or $575,000 for four years.

This recent spate of rig commitments suggest that E&P firms are eager to lock up the few remaining rigs that are available in 2012 and 2013. The day-rates in some fixtures could easily exceed $600,000–one of the reasons that SeaDrill may have held out on Total.

Rising day rates on deepwater drilling rigs bodes well for margin expansion in international markets. CEO Pall Kibsgaard explained why rising day rates are bullish for Schlumberger during a conference call on Jan. 20, 2012:

Analyst: [T]he deepwater rigs are becoming, again, very, very scarce. You highlighted what’s going on in Angola pre-salt and the potential demand there. With rates maybe pushing back to $600,000 again, historically, those have been levels where oil companies really start paying attention to technology that can improve reliability or technology that can shorten cycle time, and yet you don’t really talk about pricing. So could you help us a little bit with how you view the tightness in the rig market and the higher rates impacting either the service quality for pricing or whether it’s the standard technology or whether it’s new technology?

Paal Kibsgaard: Yes, and like I said in the previous question, I think there is typically a lag between the moves in the rig rates and the moves in our service pricing, so I think that’s the first point. But to your point in terms of what our customers are looking for, I think, like I said, there’s a growing focus on operational performance. Obviously, that is even more where the rig rates are high, like in deepwater, but we also see that in more conventional offshore operations as well.

Playing the Deepwater Boom

Among the Big Four oil services companies, Schlumberger has the most upside leverage to increased spending and pricing for deepwater contracts. The company’s WesternGeco division performs seismic surveys of offshore reservoirs, using sound and pressure waves to map subsea rock formations.

Seismic operators generally have two basic product lines: multi-client surveys and contract surveys.

Multi-client surveys typically provide data on a large area that’s prospective for oil and gas. Exploration and production firms often purchase multi-client surveys to evaluate offshore licenses coming up for auction.

Contract surveys, on the other hand, are typically completed on demand and focus on a specific portion of a field. Producers might use this information to identify specific high-probability drilling targets or to help formulate a plan to extract oil and gas from a play.

Demand for seismic data tends to pick up when deepwater exploration and development accelerates. WesternGeco reported that its backlog of unfinished seismic work increased to $1 billion in the fourth quarter of 2011, up from $850 million at the end of the third quarter.

Management also expects the segment to post strong utilization rates through the first nine months of 2012, thanks to robust demand in Angola, the Gulf of Mexico, the Arctic and the North Sea. The US Bureau of Ocean Energy Management will auction leases in the Central Gulf of Mexico around midyear–the agency has yet to announce the official date. This highly anticipated auction should bolster sales of multi-client surveys among potential bidders.

As a result of this growing backlog and planned new projects, Schlumberger has suggested that pricing for seismic services could increase by mid-2012.

A tightening market for seismic services also bodes well for Aggressive Portfolio holding Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY). At the company’s recent capital markets day, management noted that only three advanced vessels capable of collecting 3-D data will join the global fleet in 2012, compared to six in the previous year.

Petroleum Geo-Services has reduced its debt burden from about $1.2 billion in 2008 to about $400 million. Management also emphasized that the firm will begin paying a dividend equal to about 25 percent to 50 percent of its net income. These payouts will likely be modest at first, but could grow substantially if the market for seismic data tightens. Buy Petroleum Geo-Services’ American depositary receipt under USD17.50.

The most direct play on rising rates for deepwater rigs is, of course, the deepwater contract drillers. Contract drillers own fleets of rigs and lease those rigs to operators for a daily fee known as a rig rate; as I noted earlier, the day-rates for the most advanced deepwater rigs are currently close to $600,000 are rising rapidly.

Deepwater contract drillers represent the best bet on rising day rates. We prefer SeaDrill, which owns the youngest and most advanced fleet of deepwater and ultra-deepwater rigs in the business. As producers increasingly favor newer, higher-specification models after the Macondo oil spill, SeaDrill has a substantial competitive advantage. Younger rigs also tend to experience less downtime.

SeaDrill’s basic business model is to build a backlog of long-term fixtures for its deepwater rigs. With the rigs locked into multiyear contracts at fixed day-rates, the company has a stable source of cash flow to support its  ample quarterly dividend of $0.76 per share. The company has the scope to raise the dividend in coming quarters.  

SeaDrill has one deepwater rig–the West Polaris drillship–slated to come off contract in October. The rig currently earns $611,000 per day, and rumors abound that SeaDrill rejected an offer of $625,000 per day from Total. If SeaDrill books this rig under a lucrative long-term deal, expect the company to raise the dividend.

SeaDrill has three rigs available in 2013: the West Leo, West Auriga and West Navigator. Given the recent uptick in day-rates, these uncommitted rigs represent a significant opportunity for SeaDrill to grow its cash flow. SeaDrill now rates a buy up to 45.

Investors should also consider Pacific Drilling (NYSE: PACD), the latest addition to the Aggressive Portfolio. The company owns a fleet of four newly built ultra-deepwater drillships and will receive two additional rigs in 2013. These state-of-the-art vessels are capable of drilling in water depths of 10,000 feet to 12,000 feet and to a total well depth of 40,000 feet, making them suitable for a wide range of jobs.

The firm has already booked its fleet under favorable long-term contracts. The Pacific Bora was delivered in mid-2011 and secured a contract with Chevron Corp (NYSE: CVX) in Nigeria that expires in late 2014 and amounts to a day rate of $475,000. Total booked the Pacific Scirocco through the end of 2012 at a day rate of $470,000 and has an option to extend the contract for another four years.

The Pacific Mistral is now under contract to Petrobras (NYSE: PBR A) through 2013 at a day rate of $458,000, while the Pacific Santa Ana will start a five-year contract with Chevron in spring 2012 at a day rate of $467,000. Pacific Drilling secured these fixtures months ago, when prevailing day rates were a bit lower than they are today.

Pacific Drilling’s newest fleet additions, the Pacific Khamsin and the Pacific Sharav, will arrive April and September 2013, respectively. The timing couldn’t be better: Few rigs will be available at that time, so Pacific Drilling could secure day rates that are above $600,000.

With a fleet of only six rigs, booking two new rigs at much higher rates could be a major upside catalyst for the stock. As a percentage of the size of its existing fleet, no deepwater drilling contractor has more available capacity in 2013 than Pacific Drilling.

Management recently announced that the company extended an option to have Samsung Shipyard build a seventh ultra-deepwater drillship that would arrive in mid-2014.

Pacific Drilling went public in November 2011 and has yet to capture investors’ attention. As other operators sign new contracts for rigs at day rates of $600,000 or more, investors will focus on Pacific Drilling and other names that have significant uncommitted rig capacity.

Pacific Drilling likely won’t pay a dividend in 2012 but could initiate a quarterly payout in 2013 when its new deliveries should be under contract. Pacific Drilling rates a buy under 11.