Why Seadrill Ltd's Shares Tanked Today

Although we don't believe in timing the market or panicking over market movements, we do like to keep an eye on big changes -- just in case they're material to our investing thesis.

Offshore drilling rig owner Seadrill Ltd (SDRL) has gotten rocked again Tuesday, falling 8% in early trading. The stock has fallen 39% year to date, and right now there seems to be no end in sight to the drop.

Today's move isn't just a crazy market reaction though; it's driven by an asset sale the company made to one of its subsidiaries. It was a move that was expected, but there was a warning sign hidden in the announcement.

Seadrills' West Jupiter rig is one of the company's ultra-deepwater drillships. Image source: Seadrill.

How Seadrill dipped into the cookie jar today
Tuesday's news was the sale of West Vela to Seadrill Capricorn Holdings LLC, a company that's 49% owned by Seadrill Ltd itself and 51% owned by Seadrill Partners LLC (SDLP). In essence, Seadrill Ltd sold a quarter of the interest in West Vela to Seadrill Partners outside holders but kept three quarters of the economic interest.

The move itself isn't a surprise. In fact, I predicted in late September that West Vela would be pushed down to a subsidiary similar to what Seadrill did with West Auriga earlier this year. 

What's shocking is the difference in the value of the two rigs only eight months apart. You can see below that West Auriga commanded an implied price of $1.24 billion and West Vela, which is a similar rig and has a similar drilling contract through 2020, was sold for $340 million less. Cash proceeds to Seadrill Ltd were also much lower.

Source: Seadrill press releases.

The driver of the lower price is the recent weakness we've seen in both oil prices and the broader offshore drilling market. Seadrill can't push West Vela down to a subsidiary for an inflated price and has to come up with a market price, hence the drop in value.

What does this mean for Seadrill?
While the price Seadrill is realizing for West Vela isn't impressive, it's still ridding itself of debt and gaining some much needed cash in the meantime. Plus, it still owns about three quarters of the economic interest in West Vela, so if the market strengthens it'll realize the benefits of that long term.

The real impact Seadrill was looking for will come in 2015 and 2016. The company has about $10 billion in debt and newbuild commitments and needs to generate cash and shore up its balance sheet to fund its operations. If its cash level gets too low it would risk not being able to raise debt or refinance old debt, so the move makes sense from that perspective.

If oil prices stay below $80 for long we could see even the shallow water drilling market collapse. Image source: Seadrill.

This is essentially just dipping into the cookie jar founder John Fredriksen created when he launched Seadrill Partners. The company can take on rigs that have long-term contracts and essentially generate a profit for Seadrill over the cost to acquire the new rigs when cash and debt are considered in the transaction.

Should you be jumping on Seadrill stock today?
The question is whether the market's reaction to Seadrill's asset sale is a buying opportunity. Long-term, that depends on oil prices, and today oil has fallen well below $80, so that isn't happening, at least short-term.

The bullish thesis is that deepwater offshore reserves now account for more than half of the new oil found each year, and eventually these reserves will have to be tapped. There's only a limited number of rigs that can do that and Seadrill has one of the newest and most capable fleets when the market returns.

We just don't know if or when offshore drilling will become a growth market again and there's a lot of trepidation with current oil prices. I'm staying long the stock because I think the upside potential outweighs the downside risk, but it's a big risk. The good news is that Seadrill can stay afloat by tapping the Seadrill Partners cookie jar as it did today, but right now that's not enough to save the stock.