More Gloom In Store For Seadrill Before Results

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Feb 13, 2015

Seadrill (SDRL, Financial) has been among the worst hit offshore drilling companies in the recent decline in oil prices resulting in challenging market conditions for offshore drillers. The primary reason for the big decline in Seadrill has been high leverage and I believe that the leverage problem will continue to impact the stock sentiment in 2015. I have discussed the leverage perspective for Seadrill in few of my earlier articles. This article primarily focuses on the company’s contract coverage as the company released an update on Petrobras contract today.

According to the company’s press release, it was announced in November 2014 that Petrobras approval had been received for the extensions of its ultra-deepwater semi-submersibles the West Taurus and West Eminence.

However, due to recent developments within Petrobras, Seadrill believes the contracts will be no longer concluded in the timeframe or on the previously approved commercial terms. As a result, Seadrill will be removing $1.1 billion from its order backlog that was reported in 3Q14. In other words, the company’s order backlog declines from a reported $20 billion to revised level of $18.9 billion.

It is not so important that the order backlog has been revised in comparison to the point that lower oil prices can translate into more such cancellations in the coming quarters. Oil and gas companies have been revising their capital expenditure and I believe that there is more pain to come for offshore drillers. Therefore, I will not be surprised if Seadrill loses a few more contracts in 2015 from solid counterparties.

The reason for being bearish is the fact that offshore drilling has a higher break-even cost as compared to onshore drilling. Therefore, with oil at $50 per barrel, several offshore oil companies would find it unprofitable to continue with their drilling activities. This will have a direct implication on Seadrill’s fleet utilization, day rates and EBITDA margin.

It remains to be seen what the company has to comment on the market conditions when 4Q14 results are released later in the month. However, I expect the company to set a bearish tone for 2015 and this is likely to take the stock lower from current levels. Therefore, in my view, Seadrill can be avoided before 4Q14 results and I believe that the stock will remain unattractive over the next 2-3 quarters.

The important point to note here is that even if there is minimal downside for Seadrill from current levels, the upside potential is not significant and it does not make sense investing in offshore drillers at a time when oil prices are likely to stage a “u-shaped” recovery. The upside for Seadrill or any other offshore driller is therefore not coming anytime soon.

Another important point, from a order backlog and cash inflow perspective, is the uncertainty related to the contract North Atlantic Drilling (NADL, Financial) has signed with Rosneft. With relations with Russia getting bitter and with the Russian rouble staying volatile, I believe that the contract with Rosneft is unlikely to commence. This might be another big setback for Seadrill and North Atlantic Drilling in the first half of 2015.

Therefore, from a contract coverage perspective, Seadrill will witness challenging market conditions as several of its rigs go off-contract in 2015. I expect a higher number of idle rigs as well as rigs with significantly lower day rates in the coming quarters. All this will keep the stock depressed even if the stock does not correct meaningfully from these levels.

Considering these contract related factors, I am of the view that Seadrill can be avoided at least for the first half of 2015. Depending on how oil prices recover the outlook for the second half of 2015 can be revised.