RIG RATE FORMATIONS IN THE NORTH SEA Axel Roshauw Tidemann 93406 Henrik Borgen Nordby 93629 Characters: 236,949 | Pages: 119 | Supervisor: Tim Mondorf | May 15, 2019 MSc - Applied Economics and Finance | Master Thesis Master Thesis Copenhagen Business School May 15th 2019 ABSTRACT This paper seeks to understand the offshore drilling market and specifically the formation of the contracted day rates on drilling operations. An industry analysis and a strategic analysis form the basis for an econometric model explaining day rates. The model is used to build forecasts on the day rates, which are used in a valuation of Odfjell Drilling, in order to illustrate a potential use case of the research. Drilling Rig Supply and Demand The supply of rigs is found to be fixed in the short-term but is adjusted in the medium- to long-term with drilling companies stack, scrap, and build rigs in order to meet the expected demand of the exploration and production (E&P) companies. We also see that rigs are principally purpose-built, where geo-specific regions demand different needs, mainly for water depths and the need for harsh weatherproofing. These geo-specific needs also create sub-markets where drilling rates vary with the technical specifications and capabilities of the rigs. The drilling demand comes from the exploration and production companies. Their need for drilling rigs fluctuates with their profitability, where the price of oil dictates their wish for exploratory spending. We also uncover a bargaining relationship between the drilling companies and the E&P companies. Here it seems that rig fleet availability dictates the pricing power of the drilling companies. Rig hires move from a spot-like market in times of high availability, where drilling companies could be viewed to be close to price takers, to a tight contract market where the E&P companies move close to becoming price takers. Modeling and Forecasting Day Rates Based on the analysis, we consider a multiple linear regression model explaining average rig rates, with smoothed Brent oil prices, a cross product of smoothed Brent oil prices and capacity utilization, average contract length, average contract lead times, average wage of petroleum workers in Norway and Real Interest rates (U.S. 10 year T-bills), as explanatory variables. We forecast a base case using Brent futures and a slight increase in utilization. Given these inputs, rig rates decrease slightly in the five-year forecast period. The paper also presents four alternative scenarios to test the rig rate forecast given its inputs. Here we test for an increase in Brent spot prices, increasing utilization, a combination of increasing Brent spot prices and utilization, as well as simulating a relatively large reservoir discovery. Rig Rate Forecast – Applied Use Case Finally, to further test and showcase the usefulness of the model, our findings are applied in a calculation of Odfjell Drilling’s future free cash flows. Here, we apply the model as a tool for valuating the fair value of Odfjell Drilling. The model allows for future analysis of the industry to be translated into rig rates and further into share price calculations. 1 Master Thesis Copenhagen Business School May 15th 2019 CONTENTS 1 MOTIVATION ........................................................................................................................................................ 4 2 PROBLEM STATEMENT AND CHAPTER GOALS/QUESTIONS ............................................................... 5 2.1 THE OFFSHORE DRILLING INDUSTRY .................................................................................................................... 6 2.2 STRATEGIC ANALYSIS ........................................................................................................................................... 6 2.3 MODELING AND FORECASTING DAY RATES .......................................................................................................... 6 2.4 ODFJELL DRILLING ............................................................................................................................................... 7 2.5 WACC .................................................................................................................................................................. 7 2.6 FORECASTING AND VALUATION ............................................................................................................................ 7 3 LITERATURE ........................................................................................................................................................ 8 3.1 LITERATURE REVIEW ........................................................................................................................................... 10 3.2 METHODOLOGY AND DATA .................................................................................................................................. 16 3.3 STRUCTURE OF THE PAPER .................................................................................................................................. 19 3.4 LIMITATIONS ....................................................................................................................................................... 20 4 THE OFFSHORE DRILLING INDUSTRY....................................................................................................... 20 4.1 DRILLING COMPANIES IN THE OIL AND GAS VALUE CHAIN ................................................................................ 20 4.2 THE RIG TYPES ................................................................................................................................................... 23 4.3 RIG STATES OF ACTIVITY .................................................................................................................................... 26 4.4 INDUSTRY DEVELOPMENT AND TRENDS ............................................................................................................. 27 4.5 UTILIZATION ....................................................................................................................................................... 28 4.6 MARKET PLAYERS .............................................................................................................................................. 29 4.7 CONCLUSION ....................................................................................................................................................... 30 5 STRATEGIC ANALYSIS .................................................................................................................................... 31 5.1 SHIPPING MARKET MODEL ................................................................................................................................. 31 5.2 THE RIG DAY RATE MECHANISM ........................................................................................................................ 54 5.3 THE BARGAINING MODEL ................................................................................................................................... 55 5.4 CONCLUSION ....................................................................................................................................................... 61 6 MODELING AND FORECASTING DAY RATES........................................................................................... 62 6.1 INTRODUCTION ................................................................................................................................................... 62 6.2 DATA .................................................................................................................................................................. 62 6.3 FRAMEWORK ....................................................................................................................................................... 69 6.4 ESTIMATION RESULT........................................................................................................................................... 69 6.5 FORECASTING ..................................................................................................................................................... 76 6.6 CONCLUSION ....................................................................................................................................................... 83 2 Master Thesis Copenhagen Business School May 15th 2019 7 ODFJELL DRILLING ......................................................................................................................................... 84 7.1 HISTORY ............................................................................................................................................................. 84 7.2 FLEET .................................................................................................................................................................. 85 7.3 ORGANIZATION AND MANAGEMENT .................................................................................................................... 86 7.4 INTERNAL ANALYSIS........................................................................................................................................... 86 7.5 FINANCIAL ANALYSIS ......................................................................................................................................... 91 8 WACC .................................................................................................................................................................