Seadrill Ltd Is Heading Into the Perfect Storm

Offshore drilling industry leader, Seadrill (NYSE: SDRL  ) recently came out and confirmed the fact that the industry was entering a soft patch. Specifically, Seadrill's management highlighted the fact that a slowdown in exploration and production spending by oil majors, due to the rising cost of oil production, has pushed the offshore drilling industry into a cyclical down-turn. 

Analysts saw it coming
Analysts have been forecasting a slowdown for the offshore drilling industry for some time now, although Seadrill has until recently remained upbeat on the market outlook.

At the end of last year analysts at Citigroup put out a note to investors warning of a possible slowdown in the offshore drilling market, this view was then backed up by comments from analysts at Barclays, UBS, and Raymond James. In the worst case scenario, analysts believe that the day rates for ultra-deepwater, or UDW, drilling units will drop by around 16%, to an average of $475,000 per day over the next few years. Following these dismal forecasts, Wall Street analysts have cut Seadrill's 2014 and 2015 earnings estimates by 9% and 11% respectively.

Still, thanks to its young, high-tech fleet, Seadrill has gotten off relatively lightly. Indeed, analysts have slashed peer Ensco's (NYSE: ESV  ) earnings estimates by 20% and 17% for 2014 and 2015 respectively, although the company's earnings are still expected to grow, growth is expected to be a lot slower than previously thought.

That said, while Seadrill's management remains convinced that it will be able to find business for its drilling units over the next few years, it is reasonable to assume that the company will not be able to command higher rates for its units in a depressed market; this could be a problem.

A growing problem
Seadrill's biggest issue right now is the company's debt pile. Now, the pros and cons of the company's debt pile have been brought up many times, so I won't go into it here. However, what is a problem is the structure of Seadrill's debt.

All companies have to pay interest on their debt; for some, this rate of interest is fixed, for others this rate of interest changes based on wider market rates. The rate of interest on Seadrill's debt changes. In particular, Seadrill's interest rate is tied to the London Interbank Offered Rate, or LIBOR, which changes daily. LIBOR is linked to global interest rates and based on the rate that banks around the world will lend to each other, so if central banks start raising interest rates, LIBOR will rise.

At present, the majority of Seadrill's debt facilities require the company to pay an annual interest rate of 3% plus LIBOR, which is currently around 0.55%. So all in all, Seadrill is currently having to pay around 3.55% per annum to borrow. However, if interest rates, and subsequently LIBOR, were to start rising then Seadrill would have to pay more interest, and in the current drilling environment, this could be a problem.

Crunching numbers
According to Seadrill's full-year 2013 earnings report, the company paid out $445 million in interest during 2013. In total, the company had around $13.5 billion in interest-bearing debt at the end of December, implying that the company paid an annual interest rate of 3.3% to sustain this debt

If interest rates rise by 1% over the next few years, it would reasonable to assume, as Seadrill's debt interest is based on the LIBOR rate, that the company's annual interest payments would rise to 4.3%, or just under $600 million a year. In the worst case scenario, if interest rates were to rise up to 2%, Seadrill's annual interest costs would jump to $720 million per annum.

Seadrill reported net income of $1.6 billion for 2013, excluding the one-off effect from the sale of its rig tend business -- a net margin of 30%. Unfortunately, a rise in interest income by $150 million, or even $250 million, would compress this margin to 27% or even 25%.

Overall, this margin compression would not be of concern, but as the offshore drilling industry is about to enter a slowdown, and day rates for drilling units are falling, Seadrill's revenue could slide during the next few years, which would put significant pressure on the company's ability to make interest payments, pay off debt, and continue to return cash to investors.

Elsewhere
Meanwhile, two of Seadrill's competitors, Rowan Companies (NYSE: RDC  ) and Ensco, appear to be in strong positions financially. In particular, based on full-year 2013 numbers, Ensco had a debt-to-equity ratio of 37%, a debt-to-asset ratio of 24%, and only paid out $159 million in interest during the year. The key thing is that most of Ensco's debt pays a fixed rate of interest, currently between 3.3% and 8.5%, which is more expensive than that of Seadrill; but fixed interest rates give clarity over future cash flows. In addition the company has access to a $2.5 billion credit facility with an interest rate of LIBOR + 1.125% per annum.

Rowan has a debt pile of $2 billion, but a net debt position of only $1 billion. Most of Rowan's debt has been issued on a fixed basis, with rates in the region of 5%, giving the company clarity on cash flows and interest costs. With the offshore drilling market stumbling toward a cyclical slowdown, it is likely the offshore drillers' revenues will decline and in this case it is best to have fixed interest costs as they give a degree of clarity over future income.

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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 April 01, 2014, at 3:14 PM, Tgar13 wrote:

    I wonder if you checked when Debt is due and

    How new deliveries will affect revenue?

    management is confident that new rigs revenue

    Will more than cover debt payments given

    The significant ramp up over the next 3 years

    And so am I

    Post Gulf Spill companies are willing to pay top

    Dollar for the best rigs and Sea Drill will continue

    To get the best prices since it has the youngest

    Fleet

    I agree that RDC is a safer bet

  • Report this Comment On April 01, 2014, at 5:09 PM, Tgar13 wrote:

    Also failed to mention drop downs to SDLP

    Will be used to pay down debt

  • Report this Comment On April 01, 2014, at 5:12 PM, Tgar13 wrote:

    Also earnings predicted to rise by $2 billion over

    Best few years ... Somehow failed to mention that?

    Why is it such focus made on increasing interest

    And interest payments but none on increasing

    Earnings?

  • Report this Comment On April 01, 2014, at 5:38 PM, dkdad wrote:

    1. So, interest rates are likely to rise materially before all current 5-year financing term loans of SDRL are paid off?

    2. The FED is likely to let the US GOVT go broke over a significant rise in its debt interest cost in the next 5 years?

    3. The existing and likely long term revenue contracts, combined with such a generous dividend with room to reduce if actually needed (& other resources John Fredriksen has at his disposal), don't offer security for addressing the debt interest liability?

    4. During the next 5-7 years when all existing debt and obligated construction loans are scheduled to be paid off, the whole world and all the new emerging country drivers will be driving Teslas to such effect that there is no increase in oil demand, versus continually diminishing supply?

    5. Are you selling the Brooklyn Bridge today?

  • Report this Comment On April 02, 2014, at 7:25 AM, M3stocks wrote:

    Oh I get it. This was an April fools article. When these articles come out is when everyone writing them starts their buying. Charts are very bullish.

  • Report this Comment On April 03, 2014, at 10:55 AM, HoerthCM wrote:

    Seadrill's debt is part bonds, part facilities on ships. Yes, the facilities portion of the debt varies with the LIBOR or NIBOR. However, Seadrill also pays about $200 million each year to buy rate swaps to 'fix' those interest rates. This is the case on a vast majority of Seadrill's facilities.

    In effect, the only thing the investor really has to worry about is the USD - NOK exchange rate, as much of Seadrill's debt is in NOK but the swaps are valued in USD (or vice versa).

  • Report this Comment On April 11, 2014, at 12:06 PM, 67Bulldog67 wrote:

    HoerthCM nailed it about the interest rate hedging that SDRL uses. A little more research on the author's part should have discovered that critical point. But then, that is a major flaw in the "Perfect Storm" story!

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