Plunging oil prices have crushed offshore driller Seadrill's (NYSE:SDRL) stock and, as a result, its dividend yield has been pushed up to 19%. Seadrill has always been a high dividend payer, but that's a nosebleed level that most companies can't sustain for long.
Seadrill's management hasn't talked much about the dividend since reporting earnings in August. Third-quarter earnings are due out on Nov. 26 and it's possible management will make changes to its dividend. A lot of income investors may not want to see a change to the dividend, but long-term investors who have an eye on the health of Seadrill's business may feel differently next week.
Seadrill's business is under fire
What's tanked Seadrill's shares, as well as others in the industry, is a sharp drop in oil prices since mid-summer. If oil prices are low, explorers will have less incentive to drill for oil offshore and demand for offshore rigs will fall, leading to fewer of the lucrative contracts we've seen in the past few years.
This is true in theory and if oil prices stay below $80 per barrel long-term, that will absolutely play out. But Seadrill has $23.3 billion in existing backlog and is focused on the ultra-deepwater drilling market, where decisions aren't made on a three-month move in oil prices, but rather the long-term needs of the industry. This context is needed when discussing the health of Seadrill's business and its dividend.
When Ensco reported better than expected third-quarter results, it was this long-term view that the market seemed to miss in analyzing the company. The company's long-term contracts are what keeps cash flowing in even when oil prices fall.
Seadrill's management has already said that its existing backlog will allow it to pay the existing $4 per share dividend through 2015. There are also a few financing tools management has at their disposal should conditions in the energy market get worse.
Operationally, I don't think Seadrill has a lot to be worried about, at least for the next year or two. But the company has committed to spending $6 billion on newbuilds through 2017 and had just $543 million of cash on the balance to pay for newbuilds, expiring debt, as well as the dividend. So a cash crunch is more of a threat than not finding work for the drilling fleet.
The cookie jar
Seadrill has begun to use its subsidiary Seadrill Partners (NYSE:SDLP) as something of a cookie jar when it needs cash, which gives management a lot of flexibility. It sold West Auriga to the subsidiary earlier this year, receiving $355 million in proceeds, and made a similar transaction earlier this month by selling West Vela to the subsidiary, generating $238 million.
These sales generate cash and the subsidiary structure allows Seadrill to maintain about 75% of the economic interest in the rigs in the future. This and ownership interests in Sevan Drilling, North Atlantic Drilling, SeaMex, and Asia Offshore Drilling give the company assets to sell if it needs to fund newbuilds, debt, or a dividend. But that doesn't mean it should stretch itself just to maintain the dividend at current levels.
Seadrill should cut its dividend (and probably will)
At today's price, Seadrill's stock is being priced as if the dividend isn't going to last, at least at current levels. Given the need to pay for $6 billion in newbuilds, and over $1 billion in debt coming due next year, I think it would be prudent to save some cash rather than paying $1.85 billion in dividends each year. Cash flows from the fleet could even give a nice cash cushion if management wanted to keep cash on the balance sheet.
Based on recent meetings with investors, it sounds like management is starting to open up to a lower dividend as well. Companies often get tied to maintaining or raising its dividend in an effort to look more stable to investors. But in today's offshore drilling market, it would be prudent to take a conservative approach to cash until we know Seadrill can fund its other commitments and demand for rigs improves.
I expect Seadrill to cut its dividend next week and while that may seem like a bad thing, I think it would actually be good for the stock long term. Stay tuned to see if management and the market agrees.