Oil driller Seadrill (SDRL +0.00%), like others in its industry, has a clouded future. In the near term, difficulties persist because its customers are cutting back on capital expenditures. This is confusing, considering the fact that commodity prices are high. Nevertheless, cutbacks in new rig orders are creating bumps in the road that Seadrill and peers like Transocean (RIG 4.04%) have to contend with.
Still, the long-term economics of oil drilling are sound. The world has a seemingly unquenchable thirst for energy, particularly in the emerging markets. That's why management isn't afraid to keep increasing dividends, even with an imminent slowdown.
Let's examine Seadrill's past, present, and future to see what it can offer you as an investment.
Seadrill West Callisto. Source: seadrill.com.
Seadrill is cautiously optimistic
Seadrill management acknowledges the bind it's in. Like other oil drillers, it's encountering prolonged periods of downtime as oil companies hold off on placing rig orders. For example, Seadrill's consolidated utilization rate of 88% for its floaters disappointed management. This is due to longer-than-anticipated downtime for its West Aquarius, West Capricorn, West Alpha, West Phoenix, and West Pegasus rigs, which have collectively experienced 149 days of downtime.
Transocean's fleet utilization stood at 78% last quarter due to prolonged idle times. To its credit, Transocean managed to increase revenue by about 3%, thanks to fleet revenue efficiency climbing four percentage-points from the prior quarter.
Seadrill is banking on execution to get it through the rough patch. The company's dayrates will be protected by the fact that it has solid contract coverage over the next two years. For instance, Seadrill has estimated floater coverage of 96% and 66% this year and in 2015, respectively.
Strong contract coverage goes a long way to insulate an oil driller from swings in commodity prices. Seadrill was able to make it through the last severe downturn in oil prices because it had already secured profitable contracts. For example, the company sailed through the 2008 decline in oil prices. Even though oil sank to $40 per barrel in just a few months, Seadrill experienced only a slight drop in profits.
To be sure, Seadrill is seeing some hiccups in its orders. Customers are delaying placing orders, which is adding to the uncertainty. Seadrill management also notes that even when contracting activity picks up once again, dayrates are likely to be below where they were last year. This tends to prolong the downturn in order placement, since customers aren't compelled to place orders if they feel dayrates will continue trending lower.
But there's a critical difference between customers cancelling orders altogether and just postponing them. And in the meantime, both Seadrill and Transocean plan to reward their shareholders with huge dividends until the environment for global oil drilling improves. They can do this because of their healthy cash flow.
Seadrill just raised its dividend to $4 per share annualized, and provides a huge double-digit yield. For its part, Transocean's shareholders recently approved the company paying $3 per share, which represents a 7.2% yield.
A mixed bag for oil drillers
On the surface, oil drillers look like compelling investment opportunities. Seadrill and Transocean look cheap, since they trade for single-digit P/E multiples and offer huge dividend yields. At the same time, though, there's a reason for their discounted valuations. The near-term outlook for oil drillers is very cloudy.
Oil and gas companies are delaying placing new orders, because they're cutting capital expenditures and are hoping dayrates keep going down. That is putting pressure on the oil drillers. At the same time, though, the downturn is likely temporary. Oil prices continue to be supportive, and increased energy demand in the emerging markets remains a viable opportunity.
The end result is that if you're interested in owning an oil driller, the time is now. As Warren Buffett once said, "if you wait for the robins, spring will be over." The uncertain near-term outlook is offering you a good buying opportunity, but it won't last forever.
