Seadrill's Profits Are Strong but Investors Fret Over Outlook

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2014 has been a disappointing year for offshore drilling companies, and Seadrill's (SDRL) earnings report this morning may have only muddied the waters for investors. In short, the ultra-deepwater drilling market isn't improving as fast as investors hoped, and that's sending shares of Seadrill lower after it reported second quarter results. But long-term the picture might not be as bad as the market thinks.

Where different rigs are drilling for oil and natural gas. Source: Seadrill. 

The numbers
Seadrill's income statement and balance sheet has been complicated over the past year because of the launch of Seadrill Partners (SDLP), which now holds six floaters and three tender rigs that were once on Seadrill's balance sheet. So, financial comparisons to a year ago aren't exactly apple-to-apples.

With that said, total revenue in the second quarter fell 3.6% to $1.22 billion and net income fell 62.7% to $653 million, or $1.24 per share. On the income side, the quarter's earnings were helped by a $131 million gain on the sale of part of Seadrill's stake in SapuraKeneana, and the year ago quarter included a $1.26 billion gain on the sale of Seadrill's tender rig business.  

Seadrill's West Jupiter drillship. Source: Seadrill.

A better look into Seadrill's operations comes from a few operating metrics. The floater segment achieved a 96% economic utilization rate in the second quarter, up from 94% in Q1, and the economic utilization for jack-ups was 93%, down from 97% in Q1.

Both utilization rates are extremely high for the drilling industry and show the value of Seadrill's young, high specification fleet.

Outlook disappoints investors
What had the market spooked today was the announcement that "Seadrill will refrain for the time being from ordering additional rigs until a clearer direction can be seen in the market." To the market, that was a warning sign that rough offshore conditions in 2014 may get worse before they get better.

But before we go and call the offshore drilling boom over, consider that Seadrill already has 18 rigs under construction, including seven drillships, three semi-submersibles, and eight jack-ups. So, taking a breather from a massive expansion plan probably isn't a bad thing.

There are also 73 new ultra-deepwater rigs due to be completed by 2018, which could flood the market if demand for these rigs doesn't improve. But management also noted that 128 of 300 floater currently in operation are over 25 years old, so while new rigs are coming online others will likely be retired. Still, a cautious approach is probably prudent, especially for a company with a $12.2 billion debt load.

Offshore drilling isn't dead yet
The other thing investors in Seadrill and any other offshore drilling company need to consider is the capability of the rigs their company owns. New rigs have capabilities and safety features that explorers covet and are willing to pay for. 

Consider the weak market rig owners have experienced overall in 2014 and then look at the contracts signed by Seadrill for its recent or soon to be delivered rigs. These are strong dayrates despite what is supposed to be a very weak market at the moment.

Source: Seadrill fleet status report.

What has been noticeable this year is that contract terms are getting shorter and explorers are waiting until the last minute to agree to terms, rather than lock up rigs years in advance.

This dynamic is the result of exploration and production companies big and small cutting back on capital spending because they're seeing return on equity and cash flow fall for their existing projects. As new oil reserves have moved from easily developed locations to shale and ultra-deepwater the risk and cost of projects has increased, something they don't have a lot of appetite for right now.

Seadrill's jack-up rig West Defender. Source: Seadrill.

Long-term, this dynamic will lift but it may require oil prices to rise, increasing the potential return for these projects. In the meantime, Seadrill will probably grow slowly and may see dayrates fall slightly. But given the young age of its fleet I think it'll be somewhat insulated from a price war taking place on the low end of the offshore drilling rig market.

Seadrill is on the edge of boom or bust
At the end of the day, Seadrill is still highly profitable with one of the best positioned fleets in the industry. Backlog of $12.6 billion for the floater fleet and $5.5 billion for jack-ups should also give some stability and flexibility to the company going forward.

The long-term question is whether or not oil explorers will increase their drilling rate enough to absorb new rigs over the next 3-5 years. If they do, Seadrill should see an explosion in revenue and profits as new rigs come online. If not, dayrates can fall quickly and Seadrill may be forced to reduce its dividend, sell assets, or even increase debt further.

I think the drilling market will pick up and the recently signed contracts for newbuilds show evidence of that. But this isn't an investment for low-risk investors, and if you don't have a very long-term investment horizon this isn't a stock I would recommend because the drilling market can be too volatile quarter to quarter.