3 Reasons Seadrill Ltd's Stock Could Fall

Offshore drilling rig owner Seadrill (NYSE: SDRL  ) is one of the industry leaders in a growing ultra-deepwater drilling market, but the stock has lagged the market by a wide margin over the past year.

SDRL Total Return Price Chart

SDRL Total Return Price data by YCharts.

One reason for the weak performance is evidence that rig contracting is slowing in 2014. Another is the company's high leverage and dividend yield of 11.1%, which sound warning bells for investors. There's no guarantee that any stock will rise or fall in the future, but here are the three things Seadrill investors should be worried about in the long term.

Big oil cutting back spending

A big factor that has me concerned right now is falling capital spending by big oil companies, who typically drive demand for ultra-deepwater rigs.

ExxonMobil is cutting its capital budget from $40 billion in 2013 to a long-term target of $37 billion from 2015 to 2017. Chevron spent $42 billion a year ago and has budgeted just $39.8 billion for this year. Even Shell's capital spending is expected to plunge from $46 billion in 2013 to $37 billion this year.

Big oil companies are spooked by falling returns on equity and increasing risks for multibillion-dollar projects around the world. If this cautious approach lasts long, it could mean reduced drilling in ultra-deepwater, which would be terrible considering the 73 new ultra-deepwater newbuilds that will be completed in the next three years.

Global energy demand could fall

It seems like energy demand will grow forever, but the truth is that demand for oil has fallen in Europe and the U.S. over the past decade. The higher cost of energy, increasing fuel efficiency, and alternatives to gasoline have created a dynamic that has led to a slow decline of oil.  

European Union Oil Consumption Chart

European Union Oil Consumption data by YCharts.

So far, emerging markets have more than picked up the slack, particularly in China, India, and the Middle East, where growing middle classes are driving more and using far more energy. But if these economies stumble, or efficiency and alternative fuels catch on in emerging markets like they are in the U.S., we could see a rare decline in overall oil demand.

This is the biggest macro risk for Seadrill, because if you think big oil companies are cautious about capital spending now, just imagine how they'll cut back if demand for their end product is in decline.

Seadrill's West Jupiter drillship. Source: Seadrill.

Leverage kills

Hanging over all of these operational risks is the financial leverage management has employed to build out its fleet. At the end of 2013, long-term debt stood at $13.5 billion, which could literally sink the company if the offshore drilling market goes through a major slump. Let's run through an example to show how fast conditions could go south.

In 2013, Seadrill had $5.28 billion in revenue, $3.25 billion in operating expenses, and $445 million in interest expenses on debt. So, operating income minus interest expense was $1.65 billion.

If revenue falls just 10%, and operating expenses and debt costs stay flat, the operating income minus interest expense would fall 33.2% to $1.06 billion. It's this operational and financial leverage that provides a major risk to investors, particularly with large cash outlays for Seadrill's dividend.

Seadrill well positioned but risky

The greatest advantage Seadrill has is its position in offshore drilling with a young fleet heavily focused on the ultra-deepwater market. The downside is that the company is at the whim of customers for demand of its rigs and has a tremendous amount of debt hanging over the company. If operations keep going well, the stock could be a good value, but there are major risks to go along with that potential.

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