We first recommended SeaDrill (NYSE: SDRL) in 2007 and pounded the table for the contract driller’s stock after the Macondo oil spill in 2010.
But we dropped SeaDrill from our Focus List in September 2013 because the stock had hit a record high of more than $45 per share and further upside in day-rates appeared unlikely.
And we reiterated our sell call in April 2014, when conditions in the markets for jack-up and deepwater rigs began to deteriorate. (See Why SeaDrill Rates a Sell.) On Sept. 12, 2014, we sounded the alarm once again, warning investors that the stock faced more downside.
Our most recent analysis of SeaDrill and the offshore contract drillers called for the company’s stock to drop to about $25 per share, a controversial piece that stirred up a lot of negative comments from investors who decided to hold and hope.
At Energy & Income Advisor, Roger Conrad and I apply our almost 40 years of experience analyzing energy-related markets to identify the best opportunities for our subscribers. Taking profits and avoiding names that find themselves on the wrong side of downtrends are big parts of our value proposition.
We don’t make these calls to garner attention; our goal is to provide our readers with reliable information and analysis that they can use to make informed investment decisions.
In truth, we didn’t expect our bearish thesis to play out so quickly; SeaDrill’s stock has given up about 36 percent of its value since the start of September.
We’d like to address five common myths about SeaDrill that ignore the gravity of the situation—and the gravity pulling on its share price.
The bifurcation in the market for deepwater rigs has led to differentiated performance since the 2010 Macondo oil spill in the Gulf of Mexico.
At the time, Transocean’s (NYSE: RIG) Deepwater Horizon, the rig involved in the accident, was 10 years old. The rig’s blowout preventer (BOP), a hulking piece of equipment that seals a well during emergencies, failed to function as advertised.
Some have suggested that the decade-old BOP lacked the power to counteract the ultra-deepwater field’s immense geological pressure.
In the wake of this disaster, most producers began to favor new rigs that could accommodate more powerful BOPs. Some industry participants reported increased demand for high-specification rigs that had sufficient deck space to house two BOPs, a luxury that limits downtime for maintenance and repairs.
Even in areas where regulations didn’t mandate the safety features that come standard on newer rigs, major integrated oil companies such as Chevron Corp (NYSE: CVX), Exxon Mobil Corp (NYSE: XOM) and Royal Dutch Shell (LSE: RDSA, RDSB; NYSE: RDS A, RDS B) have paid up for these high-specification units to limit the risk of an expensive, reputation-damaging spill.
SeaDrill and other contract drillers with newer fleets thrived in this environment. Day-rates that newly delivered rigs earned climbed progressively higher, eclipsing $600,000 in some instances.
Over the four years ended June 1, 2014, shares of SeaDrill had rewarded investors with a 184.2 percent total return, while Diamond Offshore Drilling (NYSE: DO), a name burdened with an extensive portfolio of older drilling rigs, eked out an 8 percent gain—including dividends.
This bifurcation remains an important industry dynamic. When the supply-demand balance starts to improve in the market for deepwater drilling rigs, this reversal of fortunes should favor operators with the youngest fleets.
However, investors who cite SeaDrill’s portfolio of modern drillships and semisubmersible rigs as a reason to buy the stock overlook the significant headwinds that all offshore drillers with out-of-contract rigs will face over the next 18 to 24 months.
Not only have major oil and gas producers reined in spending on exploratory drilling, but the timelines for developing many complex offshore projects have also moved to the right.
At the same time, the industry faces an influx of excess capacity from newly built rigs and existing units whose fixtures expire in coming quarters.
Higher-specification rigs likely will compete with older units for less lucrative work in shallower waters, driving down day-rates.
Obtaining an accurate picture of leading-edge day-rates is difficult in the current environment because operators have engaged so many rigs under long-term contracts that were negotiated 18 to 24 months ago. Each quarter brings only a handful of new fixtures for units capable of drilling ultra-deepwater fields.
That being said, signs of softness have emerged in the market for even the most capable drilling rigs. On Sept. 11, Noble Corp (NYSE: NE) announced that its Danny Adkins rig had secured a two-year contract in the US Gulf of Mexico at a daily rate of $317,000.
Although the Danny Adkins was built in 1999, Noble in 2009 completely rebuilt and re-equipped the dynamically positioned semisubmersible rig to make it capable of operating in water depths of up to 12,000 feet.
Admittedly, the Danny Adkins isn’t the most capable ultra-deepwater rig on the market; however, the rig should command a bid that’s in line with sixth-generation floating units.
Prior to securing its latest fixture with privately held Deep Gulf Energy (DGE), the Danny Adkins earned $498,000 per day under a roughly three-year contract with Royal Dutch Shell.
Most analysts had expected the upgraded rig to earn a day-rate of at least $350,000 to $400,000—a significant discount to its prior contract.
SeaDrill backers often point to announcements of newly delivered rigs starting fixtures that pay impressive day-rates. For example, next June, SeaDrill undoubtedly will issue a press release when the West Mira starts its contract with Husky Energy (TSX: HSE, OCT: HUSKF) at a daily rate of US$590,000.
Investors shouldn’t make the mistake of assuming that this day-rate reflects current trends; SeaDrill and Husky Energy finalized this fixture on Nov. 12, 2012.
And although SeaDrill in August 2014 announced that its newly built West Saturn rig will earn a day-rate of $633,750 working for Exxon Mobil in Nigeria, the tendering process for this fixture took place in late 2012 and early 2013—a far more sanguine market than today.
In short, this fixture announcement doesn’t provide valid insight into the current day-rate environment for ultra-deepwater rigs.
During SeaDrill’s second-quarter earnings call, CEO Per Winther Wulff shared his assessment of prevailing dynamics in the market for offshore drilling rigs:
As for our short-term outlook, the market continued to be challenging. However, SeaDrill is well positioned with few rigs exposed to the near-term pricing weakness. You can see it on the slide. Day-rates are falling faster on all our units, and it’s important to be focused on the high-end assets. As you will see, SeaDrill combines both of these elements.
Our largest five competitors have an average 38 units each delivered prior to year 2000. SeaDrill has only two. These units are simply not competitive with SeaDrill’s fleet. SeaDrill also has the lowest percentage of rigs that are free and clear from today until end 2016.
The near-term market is partly driven by a reduction in exploration drilling. However, there is evidence of positive developments in the number of tenders that have materialized for 2015, 2016 and ongoing.
In the meantime, independent E&Ps [exploration and production companies] could potentially fill some of the exploration gap that has been created by the cost and exploration spending from the major oil companies. We have seen opportunistic independent oil companies use the present market weakness to tender for projects where profitability has improved due to lower rig rates in the Gulf of Mexico.
Reduced activity levels for major oils also led to a number of sublets which again puts further pressure on the market.
The reported overall contracting activity has increased. However, we do see some industry participants, especially those with older units and significant portions of their fleet requiring renewal in short-term driving prices down.
Although Wulff puts a positive spin on tendering demand for 2016, the CEO acknowledges the market’s near-term weakness and notes that independent producers have taken advantage of the opportunity to engage rigs at reduced rates.
Bifurcation in the rig market will continue, but don’t expect SeaDrill’s modern fleet to insulate the firm from an unfavorable supply-demand balance.
SeaDrill’s oft-cited backlog represents anticipated revenue from signed contracts, a relatively reliable indication of future cash flow. For example, the recently announced two-year fixture for the West Saturn drillship added $462.64 million to these projected revenues.
Floating drillships and semisubmersible rigs account for about $12.6 billion of the company’s backlog, while jack-up units that operate in shallower waters contribute about $5.5 billion.
We don’t question the size of SeaDrill’s backlog. However, investors must realize that the total amount is less meaningful than when new contracts start and existing fixtures expire.
In 2014, about 97 percent of the company’s available rig days are covered by contracts.
Next year, however, the fifth-generation semisubmersible West Venture and other rigs come off contract. Meanwhile, some of its under-construction rigs have yet to secure fixtures. All told, 78 percent of SeaDrill’s floating-rig capacity is under contract in 2015, while 73 percent of the jack-up fleet’s available rig days are covered by fixtures.
SeaDrill’s backlog protects its annualized dividend of $4 per share through the end of 2015.
But if the firm fails to secure solid day-rates for its available rig days in 2016, its backlog will decline and the dividend will no longer be sustainable.
In short, SeaDrill’s current backlog represents its past success; mounting evidence of softness in leading-edge rates for floating and jack-up rigs suggests that the firm’s cash flow will take a hit in coming years.
Investors who continue to buy SeaDrill for its double-digit yield are betting on the company’s past glory, not its future prospects.
SeaDrill should be able to maintain its dividend through at least the first quarter of 2016, implying $5 to $6 in dividends per share before a payout cut becomes a serious risk.
But a reduction to the dividend would result in more than just a lower income stream; investors would suffer significant capital losses that dwarf any upside from a year and a half of accumulated dividends.
And remember that income-oriented stocks tend to fall in anticipation of a dividend cut and rally after reducing the payout.
For example, Exelon Corp (NYSE: EXC) disbursed a quarterly dividend of $0.525 per share for almost five years—until depressed natural-gas prices and expiring wholesale electricity contracts forced the utility to slash its payout by 41 percent.
The market began to price in this dividend cut at least 12 months before Exelon officially announced the move; the stock slumped 17.5 percent over this period, lagging the 7.5 percent total return posted by the Philadelphia Stock Exchange Utility Index.
However, in the three months after announcing this dividend cut, Exelon’s shares soared by about 20 percent, almost doubling the return posted by the Philadelphia Stock Exchange Utility Index.
The same thing happened to Boardwalk Pipeline Partners LP (NYSE: BWP), a master limited partnership (MLP) that slashed its quarterly distribution to $0.10 per unit from $0.5325 per unit in early February.
In the 12 months leading up to this announcement, the stock tumbled by 50 percent, reflecting the market’s growing concern about the sustainability of Boardwalk Pipeline Partners’ payout.
However, since cutting its distribution, Boardwalk Pipeline Partners’ stock has rallied by 37 percent, outpacing the 16 percent gain posted by the Alerian MLP Index.
Bottom Line: SeaDrill’s dividend may be safe until early 2016, but that doesn’t make the stock a good investment.
In our last commentary on SeaDrill, we warned that the stock could sink to at least $25 per share before the selling abates. We were wrong.
This short-term price target in part reflected prominent lows for the stock in 2011; stocks tend to exhibit some short-term strength near these support levels.
Although the stock could catch a bid if the broader market rallies and the price of Brent crude oil climbs into early 2015, continued weakness in leading-edge day rates could push the stock to as low as $17 per share at some point next year.
Forget stock price and yield. We would need to see fundamental improvements in the market for deepwater drilling rigs before we become more positive on SeaDrill and its peer group..
First, contract drillers would need to scrap older rigs or place them in permanent storage (cold stacking). We’ll pay particular attention to press releases and conference calls for Diamond Offshore Drilling for signs that operating costs on older rigs have exceeded day-rates.
A retrenchment in the day-rates earned by sixth-generation drilling rigs will also be necessary to boost demand.
With few new fixtures announced for high-end equipment, quantifying prevailing day-rates for these rigs remains somewhat of a guessing game. The recent contract that Noble Energy secured for its Danny Adkins rig is an imperfect gauge, at best.
Once day-rates drift below $500,000, interest in pursuing deepwater developments should improve, helping to alleviate the supply overhang.
Although analysts tend to focus on floating rigs, the day-rates earned by jack-ups should weaken significantly in 2015. We look for this pain to catalyze further downside for SeaDrill and other names with exposure to this market; however, falling day-rates in this rig class are necessary to spur cold stacking and scrapping of older units.
Shares of offshore contract drillers will also need the price of Brent crude oil to rebound to more than $100 per barrel; prolonged weakness in international oil prices (not West Texas Intermediate) would prompt further reductions in spending on offshore development, especially among independent producers.
At least six to nine months will need to pass for these scenarios to play out.
The bearish outlook for SeaDrill has little to do with John Fredriksen, Seadrill’s current management team or insiders’ decisions to buy or sell shares in the stock.
Fredriksen deserves credit for having the foresight to lever up SeaDrill and build a fleet of highly capable drilling rigs at a time when exploration and production companies started to ramp up their capital expenditures. This aggressive moved delivered impressive total returns to investors who sold near the top.
However, this strategy involves significant risk when the supply-demand balance deteriorates in this highly cyclical market.
Investors looking for a place to hide should consider SeaDrill Partners LLC (NYSE: SDLP), a master limited partnership (MLP) that owns an interest in some of SeaDrill’s rigs that operate under longer-term contracts.
More than 90 percent of SeaDrill Partners’ capacity is covered by contracts through the end of 2016, insulating the firm from near-term weakness in day-rates.
To raise cash, SeaDrill will accelerate plans to monetize its backlog by dropping down interests in rigs that operate under longer-term agreements to SeaDrill Partners, fueling the MLP’s cash flow and distribution growth.
In August, SeaDrill Partners hiked its quarterly distribution to $0.5425 per unit, an increase of 30 percent from year-ago levels.
Whereas SeaDrill should be able to maintain its dividend through the end of 2015, SeaDrill Partners could grow its distribution by more than 20 percent next year.
Elliott and Roger on Aug. 27, 2018
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