Why Income Investors Should Choose Seadrill Over Transocean

Over the next 20 years the world’s demand for oil is likely to increase considerably and a great deal of this extra demand will have to be filled by offshore drilling. This article explores why, over the long-term, Seadrill is likely to outperform Transocean in both yield and capital gains.

Apr 29, 2014 at 10:20AM

According to a study by Morgan Stanley and Rystad Energy, by 2035 the world's demand for oil is likely to rise from about 87 millions barrels per day to 100 million-110 million barrels per day (a 15%-26% increase). This is likely to result in oil prices of $125/barrel-$150/barrel. Total oil production is expected to grow just 1.3% CAGR through 2020 but ultra-deepwater production is projected to soar by 19% CAGR. The expected demand will require 455 ultra-deepwater rigs, which is 165 more than exist or are currently being constructed. 

All this means is that the demand for new, state-of-the-art ultra-deepwater oil rigs will outstrip supply over the long-run and keep day rates high. This is excellent news for offshore drillers such as Seadrill (NYSE:SDRL) and Transocean (NYSE:RIG). Of these two companies, I believe Seadrill to be the superior long-term investment -- both on a yield and potential capital gain basis. 

The case for Seadrill
The investment case for Seadrill consists of three parts: 

First, the fundamental growth prospects are very strong. The company has a fleet of 49 rigs, with 20 more ordered (11 of which are ultra-deepwater rigs currently in highest demand). The average age of its ultra-deepwater (UDW) rigs is five years old, the youngest in the industry and much younger than Transocean's UDW fleet.

The ultra-modern fleet has the advantage of being able to command continued strong day rates despite the current industry weakness. For example, Seadrill's highest day rate contract ($653,000/day) was signed during the fourth quarter of 2013 and ends in the third quarter of 2018.

The combination of continued strong day rates for the most modern fleet in the industry along with a 60% growth in fleet size is causing management to guide for 20% EBITDA growth through 2016. This massive growth in cash flow will service the company's high debt and ensure the safety of the dividend (and its growth). Which brings me to the second reason to invest in Seadrill -- the fantastic yield. 

At 12%, the current yield is the highest in the offshore drilling industry and represents one of the highest and safest yields available anywhere. Management is taking steps to further secure the dividend with its recent creation of a dividend fund (20% of future drop downs to its MLPs will be used to grow the dividend), with increasing cash flows focused on improving the balance sheet. Management is expecting dividend growth to be slow until industry conditions improve (past 2015). 

The final reason for investing in Seadrill is its rock-bottom valuation. Currently trading at a P/E of 5.99 (due to analyst pessimism about the industry's short-term strength and concerns about falling day rates), Seadrill is likely to deliver excellent capital gains when the offshore drilling industry recovers strongly post-2016.

The combination of sky-high yield, a growing dividend (backed by superb long-term growth prospects), and likely strong capital gains means that Seadrill should deliver market-beating returns over the coming decade.

Why Transocean falls flat
The primary issues for this company can be summarized in three points: 

First, its UDW fleet is among the oldest in the industry (23 years). These older rigs are lower spec (meaning less advanced) and will have a difficult time commanding high day rates during this industry downturn. After the deepwater horizon oil spill many companies are only considering the safest and most modern rigs. This leaves them coming to Seadrill and ignoring Transocean.

The second reason is that Transocean has 20 ultra-deepwater rigs coming off contract in 2014. Already four rigs are sitting idle and the flood of contract expirations leaves the company very vulnerable to falling day rates (with commensurate cash flow declines that threatens the security of the dividend). 

Finally, Transocean has a very unreliable record of paying dividends. Management has announced a $3/share dividend that would yield 7.4% but cost the company $1.3 billion. Given the shrinking backlog (down $2.6 billion in 2013), upcoming contract expiration cliff, and the company's heavy exposure to short-term day rate weakness this dividend is not safe and has little potential for growth in the next few years.

Bottom line
When it comes to investing in the ultra-deepwater drilling megatrend, Seadrill represents a far superior investment to Transocean. Its fleet of ultra-modern state-of-the-art rigs will likely insulate the company from short-term pricing weakness over the next two years. With two MLPs to tap as a cheap source of financing and a stable $20 billion backlog, the 12% yield is safe and likely to grow (slowly through 2015 and faster past 2016). Transocean's much older fleet, in contrast, is much more exposed to short-term price weakness in day rates. The backlog is shrinking and the company is currently unable to cover its dividend with cash flows. The company will be forced to replace its fleet, which will increase capex, place even more pressure on the dividend, and decrease future dividend growth prospects. 

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.



Adam Galas owns shares of Seadrill. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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