Falling oil prices and a general malaise in the offshore drilling market have crushed drilling rig owner Seadrill's (SDRL) shares during the past few months. Investors have to be worrying that a series of risks for the stock may all be coming true at once.
Big oil began cutting back on capital spending before the beginning of this year, leading to a decline in drilling activity. Recently, a boom in U.S. shale drilling and an expansion in exports from Saudi Arabia have flooded the market with oil. What began as temporary weakness in offshore drilling is now becoming a structural problem.
To make matters worse, there are dozens of brand new ultra-deepwater drilling rigs due to hit the water in the next few years. If demand doesn't pick up soon, we could see rig owners fighting for contracts by lowering prices, leading to lower profits across the industry.
A weak drilling market is hurting contract momentum for rig owners. Image source: Seadrill.
The problem is particularly challenging for Seadrill because it not only has billions in debt and new drilling rigs to pay for, it has committed to a massive dividend to shareholders. Founder and chairman John Fredriksen says the dividend is safe through 2016; but could there be better uses for that cash? Here's why I think Seadrill should slash its dividend and focus financial resources on shoring up its balance sheet.
Billions in commitments coming
The first challenge for Seadrill is the commitments it's already made to acquire new drilling rigs and pay for debt that's coming due. Below, I've put together a chart of cash that's needed to fund newbuilds, debt maturities, and the dividend as it's currently set, all based on the most recent quarterly report. You can see that nearly $8 billion will be needed in the next year alone, with nearly $6 billion needed in the following 12 months.
Source: Seadrill financial reports.
Note: I've assumed annual newbuild commitments are spread evenly throughout the year.
If the drilling market had high demand, we would expect that Seadrill could fund newbuilds with new debt, and roll old debt into longer maturities; but if debt markets have lost faith in the company's cash flows, that may not be so easy. The simple fact is that Seadrill has billions in commitments in the next two years, and its current stream of cash flows won't cover those obligations and the dividend.
Can cash flow cover committed cash?
New debt could cover Seadrill's commitments, but cash flows from operations will help, as well. During the past 12 months, cash flow from operations was $1.91 billion, and they've been rising because of newbuilds entering the fleet. But you can already see that cash flow is dwarfed by the cost of new rigs and debt maturities.
The question is, how will management prioritize the cash flow it has coming in? Management could use it to pay a dividend, as is planned, but the $1.85 billion dividend eats up almost all of the cash flows of the business, leaving nothing to pay down debt, or pay for new rigs.
If Seadrill reduced the dividend, or suspended it altogether, the company could pay for new rigs, and reduce the need to continually finance both existing rigs and expansion through debt. Debt would still go up if the dividend went to $0, but it wouldn't rise nearly as fast through 2016.
Commitments to acquire new ultra-deepwater rigs like this one put Seadrill's finances in question. Image source: Seadrill.
Seadrill should take the conservative approach for once
John Fredriksen has made sure Seadrill is committed to a high dividend rate throughout its history; but current needs for cash in an uncertain drilling environment should trump those payouts to investors -- at least for now. I think it would be wise for Seadrill to slash its dividend to $0 -- gasp! -- for at least the next year until the market smooths out, and we have an idea whether offshore drilling will pick up.
Seadrill has predicted that the slow activity in offshore drilling is temporary in nature and, before long, big oil companies will be spending billions on ultra-deepwater drilling contracts, once again. I tend to agree with that thesis; but that doesn't mean that Seadrill has to bet the farm to prove that it's right. It could save some cash during the next year or two as existing contracts generate revenue and use that cash to reduce the amount of debt needed to pay for newbuilds coming in the next two years. If the market picks up again, it would be easy to reinstate the dividend, and even pay a special dividend if there's excess cash.
One problem is that management often gets caught up paying regular and steadily increasing dividends to make a business seem stable. But offshore drilling isn't stable and, right now, I think Seadrill is doing more harm than good keeping a $4 per share annual dividend in place.
It would be far better to take the conservative approach until oil prices rise and drilling picks up; but right now, that doesn't look like something Seadrill is going to do until it's absolutely necessary. Hopefully, by then, it's not too late.
