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Debt Could Sink This Offshore Oil and Gas Driller

Seadrill  (NYSE: SDRL  ) could have a problem on its hands as demand for the company's drilling units could be starting to slow. Unfortunately, if this is the case, Seadrill could be in trouble.

Seadrill has been aggressively building up the size of its drilling fleet during the past year or so, buying new, high-spec ultra-deepwater, or UDW, drilling units faster than any of its peers. All of these orders have been funded with debt as a major financing component, with the belief that strong demand for drilling units will ensure utilization remains near 100% and the company can service its rapidly growing debt pile.

A cold wind
However, there could be trouble brewing as Seadrill's peer, Transocean (NYSE: RIG  ) , revealed at the end of November that it had 14 deepwater drilling units coming off contract during 2014, and 39 units were coming off contract industrywide. According to industry analysts, this is an unusually high number of units to come off contract in a single year. Contracts usually run for five years or more within the industry, so it's odd for a whole bunch of units to come off contract at once. Seadrill has five rigs coming off contract during 2014, and Ensco (NYSE: ESV  ) has eight rigs coming available.

Furthermore, according to Terry Bonno, Transocean's senior vice president for rig marketing, the rig business is cyclical and customers often strategically wait for over-supplied markets before pressing ahead with drilling, helping to secure long-term contracts at low rates. Bonno also cited a customer who said recently that there was a cold wind blowing in the rig market, presumably this means that demand for drilling units is slowing.

This cold wind could leave Seadrill credit freeze. Specifically, Seadrill's aggressive, debt-funded growth has left it exposed to high interest repayments, as well as the prospect of higher interest rates when rates finally start to move up.

Addicted to debt
Nonetheless, Seadrill seems to be addicted to acquisitions, the most recent of which is speculated to be Saipem's offshore drilling business. Saipem is a Norwegian oil services company, which counts Italy's Eni as its top shareholder. Analysts estimate that Sapiem's drilling division is worth around $5.3 billion, half of Saipem's market capitalization.

However, one thing Seadrill can't be faulted for is its growth rate over the past few years, which has been impressive to say the least. Seadrill has actually managed to grind out sector-leading earnings-per-share growth over the past five years.

Still, investors need to start asking the question of whether or not Seadrill can sustain this level of growth without additional borrowing. Seadrill could eventually run out of headroom on its credit facilities, and creditors might soon start asking if the company can sustain its current level of borrowing.

Detective work
To find out if Seadrill's growth during the past few years is sustainable, without additional borrowing, I want to take a look at Seadrill's return on capital invested. This enables us to compare what kind of return Seadrill is able to achieve based on the company's assets value inclusive of debt, essentially all the money invested in the business.

Now it does get a bit complicated here, luckily has already put the figures together for us. According to Marketwatch Seadrill's return on invested capital is a tad over 7.4%. In comparison, Transocean's return on invested capital is reported to be 3% and Ensco's is booked at 7.5%.

Interestingly, these numbers reveal to us that Ensco is better than Seadrill at generating revenue from its assets; although only just.  On that basis, it is reasonable to assume that without its aggressive borrowing and acquisitions, Seadrill would not be able to grow that much faster than its peers.

Foolish summary
So overall, it would appear that Seadrill could have a problem on its hands if the market for oil and gas drilling units slows significantly. What's more, it would appear that Seadrill has been able to achieve its rapid rate of growth during the past five years only because it was borrowing heavily. When the company reaches its credit limit, it is likely that Seadrill's growth will slow and the company will have to work very hard to repay debt.

A defensive pick
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Read/Post Comments (3) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 11, 2013, at 11:58 AM, pwready wrote:

    Didn't these people recommend SDRL. Now they bad mouth it? SDRL has been dropping like a rock so the Fool is jumping on the band wagon?

  • Report this Comment On December 11, 2013, at 6:31 PM, KGaider wrote:

    new budget deal has removed the moratorium for deep ocean drilling in gulf of mexico and chevron always uses SDRL rigs so SDRL should have NO PROBLEMS getting rig rental renewals....go read this...

  • Report this Comment On December 14, 2013, at 4:04 PM, awallejr wrote:

    The author might want to stick to tobacco plays since he knows very little about SDRL. RIG's problems are not SDRL's problems. While we are able to squeeze out oil through fracking the real deposits are in the continental shelves which requires deepsea rigs. And SDRL has THE best. There is no forseeable glut of these rigs either.

    As for the debt, right now interest rates are low historically so take advantage. In any case SDRL can always drop rigs into its mlp SDLP and free up debt.

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