Given the negative trends taking place in the offshore-drilling market, it may seem tempting to try to capitalize on the industry's struggles by shorting offshore-drilling stocks. Seadrill (SDRL), in particular, may be an attractive short target because of its highly leveraged balance sheet and recent contract troubles with Petrobras and Russia's Rosneft. The risks, however, are high in betting against this drilling giant.
Image source: Seadrill.
Oil can shock the market at a moment's notice
One way to kill a good short trade is with a shocking market movement. There may be no entity able to shock the market more than OPEC, and even whispers that it will cut production in 2015 could send the price of oil sharply higher.
Any sort of bullish signs for oil prices could send Seadrill's stock sharply higher, reversing the course we've seen in the past six months. The problem for short-sellers is that we have no idea when OPEC may make an announcement that could help or hurt the price of oil. That would give me heartburn if I was short Seadrill stock.
Seadrill remains a profitable offshore driller
The offshore-drilling market may be slowing, but that doesn't mean Seadrill isn't making money. In the fourth quarter of 2014, the company had an operating profit of $452 million, and net income of $150 million, including $285 million in losses on derivatives.
For each of the next two years, Seadrill has $5.0 billion in revenue backlog, which should at least keep the company afloat if the industry's doldrums continue. The big downside will come two or three years down the road when there's less backlog; but if no one is drilling for oil in the meantime, we can presume that oversupply in the market will fall, and prices will rise again.
Betting against a profitable company that's trading at just 4.7 times forward estimates is a high-risk proposition, and one I wouldn't want to make.
Image source: Seadrill.
Don't bet against the industry's best fleet
The final reason why I wouldn't short Seadrill stock is simply that there are better stocks to short in the offshore-drilling industry. Seadrill has one of the youngest fleets in the industry, and with drillers wanting more capabilities and better safety measures installed on rigs, Seadrill's rigs are more desirable than older ones. The company may have to take lower rates for its rigs than in the past, but it will be able to find work.
Think of it like buying a used car: If the price were the same, would you want a 1997 Honda Civic or a 2007 Honda Civic?
The chart on the right is a good illustration of the age of fleets. Based on this chart alone, I think Transocean (RIG 3.72%) and Diamond Offshore (DO) run riskier businesses than Seadrill. In an extended downturn of the market, they have a greater risk of cold stacking or retiring rigs, and would be better options for short-sellers.
If Seadrill still had a market cap of around $20 billion as it did a year ago, I would be inclined to think this would be a good short candidate. But with a market cap of $5.2 billion, a young fleet, and a profitable business, the stock has too much upside risk to consider shorting at the moment.
