Here's Why You Should Sell Seadrill and Transocean

I own shares of offshore driller Seadrill  (NYSE: SDRL  ) and I'm pretty positive on the long-term outlook for Transocean  (NYSE: RIG  ) . Both companies recently reported quarterly earnings that were in line and above most analyst expectations, and Seadrill even increased its already-huge dividend by a couple pennies. However, even with the positive news, and my positive view on the outlook for both of these companies, I think it's worth exploring the very real risks that lie with investing in these two big players in offshore oil and gas drilling. 


Would a Seadrill dividend cut in the next couple of years be a disaster for your retirement? If so, you may want to diversify your exposure. Source: U.S. Coast Guard.

Am I selling? No, I'm not; but maybe you should. Let's take a closer look at why. 

Bifurcated demand could cause problems for both sides 
The expected demand for offshore drillers is likely to be soft over the next couple of years, but the reality is -- as I and others have pointed out -- the offshore market is really made up of two components: traditional legacy ships, and high specification ships. While there's little doubt that demand for these legacy ships will be down, there is expectation that demand for ships that can operate in deeper and more hostile water, and can drill deeper, will be relatively strong. 

Transocean has seven drillships under construction, but only one goes online by 2015. Source: Transocean.

On the surface, this indicates that Transocean, with its massive fleet that has a lot of older ships, is most at risk, while Seadrill, with its shiny new fleet that it's adding as many as 19 ships to over the next several years, is well-positioned. While this is largely true -- though Transocean's downside is probably less than it may seem -- my concern is that many investors are going into the next couple of years as if this is simply a binary outcome situation; i.e., Seadrill will do well, while Transocean won't, and that's just not the case. 

What investors need to consider is that a lot of new ships are under construction. According to Rigzone, there are 68 new drillships under construction right now, 35 of which are scheduled to be completed by 2015. This is an incredibly important category, because drillships -- specifically ones that can operate in deepwater or ultradeep water, command dayrates of more than $500,000. However, these rates could fall, as Seadrill described in its quarterly earnings release (emphasis mine):

There are reasons, however, to believe that some of our major competitors will accept rates levels for a sixth generation vessels in the $425-$475k level. Currently, the market suffers from limited exploration drilling and delays in field developments from the major oil companies ... Oil companies are trying to determine when dayrates will trough, thus are not compelled to sign contracts if they feel dayrates are still declining. Once a leading edge is defined, others tend to be compelled to award contracts. To this point, in the recent weeks, we have seen increased inquiries by both majors and independent operators following the establishment of a leading edge dayrate.

Seadrill's newbuilds will have a lot of competition over the next two years. Source: Seadrill.

In short, oil companies are both delaying investment in offshore drilling and waiting to see if dayrates will fall further. The risk for Seadrill is a larger number of newbuilds coming online at a period where there isn't quite enough demand, even in the high specification segment of the market. Of the 68 drillships under construction, 11 are Seadrill's, and eight of those are scheduled to come online in 2014 and 2015. Lastly, the global fleet of drillships is 106, with 98 of those deepwater or ultradeep. By the end of next year, there will be another 35 in operation -- in the middle of a soft demand cycle.

See the risk now?

Debt service double-whammy 
Both Seadrill and Transocean have a lot of debt:

SDRL Total Long Term Debt (Annual) Chart

SDRL Total Long Term Debt (Annual) data by YCharts.

As you can see, Seadrill has added a lot more debt, while Transocean has actually paid its down. Most importantly, look at just how leveraged Seadrill is, with a scary-high debt-to-equity ratio. What this tells me is that, while Transocean's older portion of its fleet may suffer from lack of demand, the company is much, much less leveraged than Seadrill.

And this high leverage could create a double-whammy. Simply put, demand for drillships alone needs to grow by more than 30% over the next 20 months just to support newbuilds. If it doesn't, Seadrill could see dayrates get pushed down, and its utilization rates fall at the same time that its debt costs increase when newbuilds are delivered.  

Here's one last chart:

SDRL Payout Ratio (TTM) Chart

SDRL Payout Ratio (TTM) data by YCharts.

Anyway you slice it, Seadrill's high debt load has supported the dividend in the past. Sure, it's not taking out loans to pay the dividend, but if it weren't paying a dividend that's more than double what its peers pay, it wouldn't need to take on so much debt. It's good to see the payout ratio falling below 100%, but as debt grows, dayrates and utilization rates must remain high as well. 

Final thoughts: Find balance in your portfolio 
As I wrote above, I'm not selling my Seadrill shares. As a matter of fact, I could see myself buying more, or buying shares of Transocean. That's because I'm still 25 years from retirement, Seadrill is only 1.5% of my portfolio, and I don't own shares of any other offshore driller. It's about my level of risk, timeline, and total exposure to the industry. 

If you're heavily exposed to offshore drillers, close to retirement, and will depend on income from these companies in the next few years, you should at least consider rebalancing your exposure. I can live with a bad couple of years for offshore drillers. Can you?

If not, maybe it's time to sell off part of your Seadrill or Transocean shares. 

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Read/Post Comments (12) | Recommend This Article (12)

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 June 03, 2014, at 10:29 AM, Nohjnogias wrote:

    Yeah, but here's why you should not sell your shares of SDRL: $1.00 per share dividend. OK, I correct myself, don't sell your shares until the ex dividend date on June 10.

  • Report this Comment On June 03, 2014, at 10:32 AM, postnasaldrip wrote:

    "If you're heavily exposed to offshore drillers, close to retirement, and will depend on income from these companies in the next few years, you should at least consider rebalancing your exposure. I can live with a bad couple of years for offshore drillers. Can you?" SDRL is the ONE driller I wouldn't even consider selling. Just signed new contract for $602k per day, with another at about the same rate on the way. Says their rigs are in demand and will still garner significant day rates. Huge deal with SDRL/NADL with Russia which should provide employment for any new or off lease rigs for many years to come. This is just the beginning for SDRL, not the "end" as you're suggesting to sell.

  • Report this Comment On June 03, 2014, at 11:06 AM, awallejr wrote:

    Amazes me how many blogs are surfacing concerning SDRL. Where were you when it was at 48? Now that the stock had bottomed and is slowly rising we start to get a ton of negative blogs.

    And pulling from your own article SDRL management talked about a leading edge day rate. They just signed a $600,000 day rate contract. Could that leading edge day rate have now been put in?

    Well this and Russia and Mexico heating up, I personally think it has.

  • Report this Comment On June 03, 2014, at 11:08 AM, tobaccocard wrote:

    I'm a SDRL holder. I'm as impressed as can be with the management of the company. They have a belief in their strategy, are willing to take risk, and have the expertise to address significant issues when they arise. You can't make money without taking risk.

    In this low interest rate environment only a fool would spend capital when they can use debt to grow. I can take a loan when I need to meet personal needs for a fraction of the capital gains tax if I sold investments.

    SDRL has shown its ability to use the tools of the system to manage it's balance sheet, including the transfer of assets and debt to an MLP which is no longer on its balance sheet.

    Would be analyst articles like this one, and many well-paid analysts as well, frequently fail to adequately credit the skills of the management team of a company.

    Given a desire to limit my investment in midstream companies to avoid undue concentration in a sector, it was a no-brainer to choose SDRL over RIG.

  • Report this Comment On June 03, 2014, at 11:49 AM, Anysimplefool wrote:

    Never hurts to be reminded of the risks in a stock. Retirees that are yield hogs need the reminder. For them, the question is, why did you buy SDRL? If they blindly bought a fat yield, it is time to wake up.

    Simple

  • Report this Comment On June 03, 2014, at 12:12 PM, tobaccocard wrote:

    Any investment carries risk. And investing for yield has been more risky since bankruptcy law was turned on its head by the GM and Chrysler bankruptcy.

    Retirees have been particularly hard hit by the FED and Administration actions the past 5 years, and have to balance daily vs long-term risk.

    They are playing in a rigged game and that is what they really need to be reminded of.

  • Report this Comment On June 03, 2014, at 12:48 PM, SoFoolishIsRick wrote:

    The amount of negative articles about any stock with huge short interest must often be taken as self serving advice.

    Look to China, Russia and the Gulf of Guinea for the big Petro appetites for domestic consumption and export revenue. So significant it is that I expect idle new builds will not be a significant problem.

    Also ask yourself if $125 oil in 2015 is likely.

    Then ponder how price motivates international E&P.

    My foolish advice is to be patient, wait and see.

    If you think me foolish on $125 oil, just look at the majors countries offline due to internal strife. It will only take one more event. Say Nigeria's problems works it's way to their west coast and hinders the Gulf. Many other scenarios. Too many.

  • Report this Comment On June 03, 2014, at 1:16 PM, sklarb wrote:

    I don't know how many times I have to respond to negative articles about the deep water driller with the most modern fleet with the following links about on land shale plays in the US and elsewhere being a big lie and that most of the fossil fuels from here on out will come from deep water:

    Charlie Munger: Energy Independence Is A Dumb Idea

    http://www.businessinsider.com/charlie-munger-on-energy-inde...

    Arthur Berman:

    http://www.businessinsider.com/arthur-berman-shale-is-magica...

    http://en.mercopress.com/2014/03/11/shale-the-last-oil-and-g...

    Jim Rogers:

    http://www.jimrogers.info/2013...

    Bill Powers:

    http://bill-powers.com/

    http://www.ohio.com/blogs/ril...

    Aubrey McClendon:

    http://www.sfgate.com/business...

    Geologist David Hughes:

    https://www.chinadialogue.net/...

    NY Times on water battle in the West:

    http://www.nytimes.com/2012/09...

    Fort Worth Weekly, ranchers versus drillers:

    http://www.fwweekly.com/2012/0...

    Wall Street Journal, Ranchers versus the gas industry:

    http://online.wsj.com/news/art...

    Financial Times on Shell's shale write down:

    http://www.ft.com/cms/s/0/cf41...

    http://publicsource.org/shared-sources/where-did-all-shale-g...

    Shale: Miracle, revolution or bandwagon?

    http://www.ft.com/cms/s/0/382ec9ba-8d8e-11e3-bbe7-00144feab7...

    http://peakoil.com/production/us-energy-independence-another...

    U.S. officials cut estimate of recoverable Monterey Shale oil by 96%

    http://www.latimes.com/business/la-fi-oil-20140521-story.htm...

    Is there really 100 years’ worth of natural gas beneath the United States?

    http://www.slate.com/articles/health_and_science/future_tens...

  • Report this Comment On June 03, 2014, at 1:36 PM, ppettigrew wrote:

    Rig had a good quarter and still has a huge backlog and everyone has been saying the market is going to be soft for the next 12-18 months(starting back in OCT 2013) with a recovery coming in 2018 for all drillers. So, isn't this the time to be investing for the long run? Rig has many advantages coming: less debt, MLP, dividend, refurbishment, still the innovator, much of the litigation is behind them, and new platforms coming on line. So, how bad do earnings have to get? Less than 3 dollars a share? Yes, I am a holder of Rig shares. This article is a poorly made argument for either company and feels more like cronyism. MHO

  • Report this Comment On June 03, 2014, at 5:40 PM, TMFVelvetHammer wrote:

    Just a comment to point out that this article isn't calling Seadrill a "sell."

    If you read the entire article, you see that I own shares, and intend to own for the long haul.

    But investors with heavy exposure and a short-term outlook should consider the short-term probabilities. I love Seadrill and the management team. But it's a reach that it is a guaranteed winner.

    Just keep risk management in mind, Fools.

    Jason Hall

  • Report this Comment On June 04, 2014, at 12:33 PM, funbuddy wrote:

    And check out gas price for $4 plus in California

  • Report this Comment On June 09, 2014, at 10:37 AM, Heidikitty wrote:

    Nothing ventured Nothing gained and I am holding and keeping check on any info I can find. Thanks for the info again.

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