This has been a terrible year for offshore drillers such as Transocean (NYSE:RIG), Seadrill (NYSE:SDRL), Ensco (NYSE:ESV), Noble (NYSE:NE), and Diamond Offshore (NYSE:DO). In addition to the cyclical downturn in the offshore drilling market that began with an short-term glut of new rigs, now the price of oil has plunged nearly 25% because of concerns over a slowing global economy and oversupply courtesy of America's shale oil boom.
The combination of these factors has caused offshore drilling shares to plunge by as much as 43%, as yields soar to levels not seen since the financial crisis. For example, my favorite offshore driller, Seadrill, is now yielding 17%.
Anytime a stock is yielding that much, the market is pricing in an imminent dividend cut. Let's look at the security of Seadrill's dividend in the context of the cyclical downturn in the offshore drilling space, as well as a more recent threat: Russian sanctions.
How Russian sanctions might hurt Seadrill
Recently I wrote about how harsher sanctions against Russia might affect energy dividend stocks such as ExxonMobil (NYSE:XOM), Schlumberger (NYSE:SLB), and Halliburton (NYSE:HAL). I pointed out how the sanctions might mean hundreds of billions in lost opportunity for these companies but that their immediate earnings and dividends probably wouldn't be affected in the short term.
That's not the case for Seadrill and its MLP subsidiary North Atlantic Drilling (NYSE: NADL), both of which have several important deals that sanctions are threatening to destroy.
The biggest risk to these two companies is North Atlantic's recent $4.25 billion deal with Russian oil giant Rosneft, for long-term contracts for six of its deepwater rigs. The rigs would be employed through 2022 and as part of the deal Rosneft would own 30% of North Atlantic in exchange for cash and 150 onshore rigs in Russia. The land based rigs would also receive five year contracts.
Seadrill's share of the deal (which is expected to close in the forth quarter) would total $746 million and leave it with 50% ownership of a larger and more diversified North Atlantic Drilling.
At the time the deal was struck, management believed it was in compliance with sanctions. However, on Sept. 11, Seadrill CFO Rune Magnus Lundetrae warned investors that there is a chance harsher sanctions could scuttle the deal. "It's not game over yet. It's terribly difficult to give a very good answer," Lundetrae said of the matter during an interview in Oslo.
Seadrill's concerns over sanctions also extend to the five rigs it has contracted with Rosneft. The earliest contract is set to begin in 2015, with another in 2016 and two in 2017.
If the sanctions result in Rosneft's having to cancel those contracts, then Seadrill will be forced to secure new clients in an environment where day rates are plunging, and at the same time it has several new rigs being delivered. In fact, between now and 2017 Seadrill has 19 rigs scheduled for delivery, 14 of which don't yet have contracts.
Should oil prices and day rates remain low for several years, Seadrill's high debt load of $12.3 billionand high number of yet uncontracted newbuilds might force management to cut the dividend. Though I don't think that will happen, some Wall Street analysts do, a topic I'll explore in another article.
Russian sanctions could hurt Seadrill in two ways. First, by potentially scuttling the Rosneft deal with North Altantic Drilling, Seadrill would be denied hundreds of millions of dollars in cash, higher distributions, and IDR fees from its MLP. Second, sanctions could result in the loss of five rig contracts Seadrill currently has with Rosneft, forcing it to find replacement customers during difficult market conditions. Both of these scenarios could potentially threaten the security of the dividend, which many analysts are expecting to be cut in the coming years. Though the risks to the company are very real, and potential investors should be aware of them and allocate their positions in Seadrill accordingly, I continue to believe that this company represents a strong long-term investment.
Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Halliburton, and Seadrill. The Motley Fool owns shares of Seadrill, and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.