It only took 90 days for the offshore drilling sector to go from bad to worse. I say that because it was a little more than 90 days ago that Seadrill Ltd (NYSE:SDRL) told its investors its dividend was safe through 2015, and it was increasingly comfortable that the payout would be safe well into 2016. Everything changed last week, when the company announced it was halting its dividend amid an unforeseen collapse in oil prices. The dividend cut was quite a shock given Seadrill's strength heading into the downturn. It also begs the question of whether or not any offshore drilling dividends are safe.
So much for visibility entering the storm
Heading into the storm in the offshore drilling sector, Seadrill was in an enviable position. It entered with the youngest fleet as well as the strongest contract backlog, as we see on the following slide.
As that slide notes, just 3% of Seadrill's fleet is more than 15 years old, while only 38% of its rig capacity was uncontracted through the end of 2016. That was a much more enviable position than Diamond Offshore Drilling (NYSE:DO) or Transocean Ltd (NYSE:RIG) were in when the downturn began. And yet, Seadrill was the first to cut its dividend.
The reason Seadrill made the tough decision was because it started to see its funding sources tighten up as oil prices plunged. That could have proven to be a problem, as the company had $3.9 billion in yard installments that needed to be financed over the next two years at a time when it also had about a billion dollars a year in debt maturities that would need to be rolled over. Because of this, the company needed additional financial flexibility, and axing its $2 billion annual dividend would certainly help.
More dividend cuts likely
Because of older fleets and weak contract coverage, there is now growing concern that both Transocean and Diamond Offshore will be forced to make dividend cuts, too. This concern was evident earlier this week when an analyst from Guggenheim downgraded both stocks and said that both are likely to cut their dividends early next year. The analyst noted that the older fleets posed a growing risk that these companies will have no choice but to begin to retire older rigs sooner rather than later, as the likelihood of a quick recovery in the offshore drilling market has deteriorated with the price of oil. Those rig retirements would reduce future cash flows and weaken the asset side of their balance sheets, which will put both companies in a weaker financial position.
Because of the worsening outlook, it remains to be seen how deep these companies might end up slashing their payouts, if either does decide to take that action. While its certainly possible both companies could keep the payouts at current levels, given the rapid fall in oil, either company might now opt to join Seadrill and completely eliminate their dividend, or simply reduce it.
Diamond Offshore Drilling might opt to halt its special dividends while maintaining its regular quarterly dividends. That said, investors have come to expect the company's very generous special dividends each quarter, as Diamond Offshore Drilling has paid $0.75 per share in special dividends each quarter since 2010, while only paying $0.125 per share in regular dividends each quarter. However, the cash used for those special dividends could go a long way toward helping the company meet the company's own funding requirements for its newbuilds so that it can continue to maintain a pristine balance sheet. Meanwhile, Transocean's dividend of $0.75 per quarter adds up to $1.1 billion in cash outlays each year. That's a lot of money that could be used to fund its own newbuild program, which the company expects will continue to average $1.5-$2 billion per year. While both companies could continue to try and maintain their dividends, the fact that Seadrill already cut its payout makes it easier for these two companies to follow suit.
A cut above the rest
All that being said, not all offshore drilling dividends appear to be at risk. Atwood Oceanics (NYSE:ATW) just started paying a quarterly dividend this fall, and it's important to note that the company is starting small with an easy-to-manage plan of increasing the payout by 10% per year. That plan is backed by a very strong contract backlog that is expected to produce $1.5 billion in after tax cash flow over the next two years, which is more than enough to cover the company's $1.1 billion remaining capex requirements for its newbuild drillships. As we see on the following slide, the company's dividend is well covered.
Even post-2016, when most of the company's current contracts run out, the company's dividend rate will be just $78 million, which should be relatively easy to fund given that it has no more newbuild obligations at this time.
The plunge in oil prices is going to make it even more difficult for offshore drilling companies to maintain their dividends as the market was already in the doldrums. That said, not all dividends will be eliminated, as Diamond Offshore could opt to spare its regular dividend and just cut out its special dividend. Meanwhile, Atwood Oceanics' recently initiated dividend has little risk and should actually grow, even if the rig market doesn't recover by 2016.
Matt DiLallo owns shares of Seadrill. The Motley Fool recommends Atwood Oceanics and Seadrill. The Motley Fool owns shares of Atwood Oceanics, 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.