Will Natural Gas and the Debt Ceiling Sink Seadrill?

Here are three certainties:

  • U.S. energy consumption is actually declining. 
  • Advanced drilling techniques are making onshore "unconventional" oil and natural gas plays cost-effective, potentially reducing the need for offshore drilling. 
  • The Federal government is inept.

Okay, so the last one may look like a quick jab, or just a way to justify a splashy headline. But the reality is, there are implications of the budget and debt ceiling negotiations for Seadrill (NYSE: SDRL  ) . Seadrill's debt is growing as the company heavily invests in new ultra-deepwater rigs, and rising interest rates could cripple the company, especially as it builds these new ships without contracts in place once they hit the water. And with the demand for oil in the U.S. -- the world's largest consumer of oil -- declining, and domestic onshore production increasing, this could be a very real threat to Seadrill. 

Is the risk of higher interest rates and reduced domestic demand overblown, or a serious threat? Let's take a closer look.

Domestic energy boom, reduced consumption
US Natural Gas Marketed Production Chart

US Natural Gas Marketed Production data by YCharts

As the chart above shows, domestic production of both gas and oil has grown by 25% from 2002 to 2012, as technologies like horizontal drilling and hydraulic fracturing, or fracking, have made production cost-effective. Combine this with reduced domestic demand and oil imports are down significantly. This has been a boon for domestic onshore oil and gas companies like Chesapeake Energy  (NYSE: CHK  ) and Ultra Petroleum  (NYSE: UPL  ) , which have both seen revenues grow more than 2,300% and 1,400% respectively over this period, and their stock prices have outperformed the market over the same time frame. 

UPL Revenue TTM Chart

UPL Revenue TTM data by YCharts

But more recent investors haven't done so well, with shares in the two down more than 60% and 78% respectively since June of 2008, when natural gas prices were over $12. Factor in serious mismanagement at Chesapeake (though it looks like the company has turned the page) and gas prices falling consistently below $3 for most of 2012 (unprofitable for most producers), and it's been tough on investors for the past few years. 

But demand and production continue to increase as more export terminals, like Cheniere Energy's Sabine Pass liquefaction project, are approved to capitalize on the demand for natural gas in foreign markets, where it routinely sells for much higher prices than it does in North America. Lastly, the expansion of natural gas as a transportation fuel -- specifically targeted at the 25 billion gallon domestic diesel market -- is just ramping up. As you can see, there is a lot of room for natural gas to grow, and everywhere you look it's taking a slice out of the pie that Seadrill is eating from. 

Rising interest rates and growing debt 
This is the major threat, as Seadrill spends heavily on a new fleet of safer, more effective ultra-deepwater rigs. Two-thirds of the rigs still under construction are not under contract yet; there's a risk that some of the ships hit the water more like an anchor than a boat, dragging on the bottom line, if they don't get commitments from customers. 

Through the first half of the fiscal year (ended June 30) the company carried over $8.5 billion in "interest bearing" long term debt. While this was down slightly from almost $8.7 billion from the year before, the company has since added an additional $500 million in the form of senior notes paying 6.125% interest. Next, consider that interest expense grew 38% through the first half of the year, before this additional $30 million in annual debt expense, and debt (and the expense of servicing it) is growing faster than net income is. If Seadrill needs to return to the markets for more cash, the cost of servicing the debt could start hurting shareholders where it counts -- right in the dividend, which is one of the most attractive attributes of the stock. 

Reality-check closing thoughts
Seadrill having already added $500 million in cash should mean the debt ceiling negotiations -- and any impact they have on lending rates in the short term -- should have limited impact on the company. One only has to look at Chesapeake as a moral lesson in the danger of huge debt for unused assets in a commodity business, but the difference here is the management team. While former Chesapeake CEO Aubrey McClendon made a lot of poor moves that seriously harmed his company, Seadrill has a solid track record of getting ships under contract and keeping them working. 

And while the domestic boom in onshore natural gas and oil production has reduced the demand for oil in North America, it's a great big, growing world. China recently passed the U.S. as the largest importer of oil, and it's still growing, as are other developing parts of the world like India and South America. So even as domestic demand decreases and supply increases, there will continue to be a growing worldwide need for oil, including oil found in deep water where only drillers like Seadrill can reach. 

 

More ways to profit from the energy boom
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Read/Post Comments (13) | Recommend This Article (6)

Comments from our Foolish Readers

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  • Report this Comment On October 18, 2013, at 12:36 PM, DukeMontrose wrote:

    As this is written, SDRL stock is UP $1.00 = 2.17%

    per Yahoo Finance.

  • Report this Comment On October 20, 2013, at 2:30 AM, TMFVelvetHammer wrote:

    >>As this is written, SDRL stock is UP $1.00 = 2.17%<<

    Not sure what that implies...

    -jh

  • Report this Comment On October 20, 2013, at 3:56 PM, awallejr wrote:

    Apparently you don't realize that the bulk of Seadrill's rigs have nothing to do with the US. As you said here: "it's a great big, growing world," and Seadrill is covering it.

  • Report this Comment On October 21, 2013, at 1:55 AM, TMFVelvetHammer wrote:

    awallejr,

    Actually, that was a big point of this exercise -- to remind investors that it's not all about the U.S.' energy consumption.

    With that said, I think you are ignoring the other half of the message about rising interest rates, and the fact is the US economy and federal monetary policy has a very large impact on interest rates globally.

  • Report this Comment On October 21, 2013, at 8:47 PM, awallejr wrote:

    Actually I don't agree rising interest rates are in the cards anytime soon. Aunt Janet will be just as accomodating as Uncle Ben was. Also the builds are already under contract so unless they entered into variable rate loans (highly unlikely) a raise in rates would only impact future builds.

  • Report this Comment On October 21, 2013, at 9:24 PM, awallejr wrote:

    Here is a nice quote from another TMF article:

    "A recent presentation from SeaDrill, citing Rystad Energy's work, predicted that the current global fleet of 256 floating drill rigs will increase to as much as 358 by 2020, but the market may demand 455 rigs. There's an opportunity to double the number of rigs being built by then."

  • Report this Comment On October 22, 2013, at 1:34 AM, TMFVelvetHammer wrote:

    >>Also the builds are already under contract so unless they entered into variable rate loans (highly unlikely) a raise in rates would only impact future builds.<<

    Not true.

    As of last quarter's earnings, only about 1/3 of rigs under construction had contracts in place when the rigs are complete.

    SeaDrill isn't using fixed-term financing, here where it makes a monthly payment and after a few years, the debt is paid off. It is primarily paying interest only on a lot of its debt today, meaning the bill will come due and it will either have to pay off the note, or refinance. Today, it's refinancing almost all of its debt, not paying it off. Eventually it needs to start reducing that debt load, because a) the point of debt is to grow the business and the new ships had better start paying off that debt, and b) today's cheap money won't be around forever, meaning the cost to service debt will rise at some point in the future.

    I'm still long SDRL (both as an investor, and in my general outlook for the company) but I don't recommend any investor ignore the reality of Seadrill's leverage.

  • Report this Comment On October 22, 2013, at 12:04 PM, awallejr wrote:

    The contracts I was refering to were the financing ones, not any leases in place. But I see how people could have thought otherwise.

    Yes there is leverage here but this is the best time to use it, in a world of historically low interest rates that will probably remain so for many years to come. There really isn't any forseable catalyst to raise rates dramatically anytime soon. Certainly not in the US anyway.

    Believe me I am no stranger to high interest rates having had a 15% mortgage many years ago. But that was in a completely different world then with double digit inflation.

  • Report this Comment On October 22, 2013, at 6:01 PM, TMFVelvetHammer wrote:

    >>Yes there is leverage here but this is the best time to use it, in a world of historically low interest rates that will probably remain so for many years to come. There really isn't any forseable catalyst to raise rates dramatically anytime soon. Certainly not in the US anyway.<<

    But it's always the unforeseen ones that get us, isn't it?

    I agree that the current rate environment makes the idea of what Seadrill is doing with this leverage very good, but I am very close to uncomfortable with the amount. It's very, very close to too much leverage. There's two sayings about too much of a good thing...

    ... I'm hoping this case is Mae West/Warren Buffett's version of too much of a good thing: Wonderful.

    -jh

  • Report this Comment On October 22, 2013, at 8:23 PM, awallejr wrote:

    Well it would really have to come from ramped up inflation. Gold action is certainly telling us there isn't much on the horizon. Further you would need considerable increased wage growth for the average worker. While you might see that in emerging markets I don't see it in the US or Europe.

    I guess it comes down to trusting John Fredriksen here. He isn't perfect (FRO) but he does take longer term views.

    If they are still seeing deep sea drill rig shortages in 2020 then I think we have a ways to go. I am confident this stock will see $60-80 over the years with increasing distributions supporting the price.

  • Report this Comment On October 22, 2013, at 8:30 PM, awallejr wrote:

    BTW good discussion, you don't take disagreements personally. If you were Alex you would be calling me names by now heheh.

  • Report this Comment On October 22, 2013, at 10:47 PM, TMFVelvetHammer wrote:

    >> BTW good discussion, you don't take disagreements personally<<

    Heck no! You're not calling my kid ugly or anything. :)

    I learned a long time ago that it's engaging with those who disagree with you that leads to better understanding, and in investing its not about giving MY best answer. It's about finding the RIGHT answer.

    With that said, I think we mostly agree. I'm probably just being more conservative about the debt than you.

  • Report this Comment On October 23, 2013, at 12:28 AM, Heidikitty wrote:

    I am holding for now and believe SDRL will come out on top.That CEO does not give up easy.

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