Investors in offshore drilling stocks have seen the risks the industry poses in the last six months alone. As oil prices have dropped, stocks have tumbled, whether there's been a drop in earnings or not. Seadrill (NYSE:SDRL) has been hit as well, following crude oil prices as they've dropped through the floor.
What risks remain with Seadrill? There are three major reasons Seadrill's stock could continue to fall well into 2015.
Oil prices continue to fall
The immediate concern for Seadrill stock is certainly the price of oil. It seems like oil couldn't possibly fall any further, but the commodity could continue to fall well into 2015, leading explorers to pull back on capital spending, like offshore drilling. If that happens, the stock will continue to get crushed.
What's interesting about this is that the fall in oil prices leads to speculation that future demand will be low, not necessarily bad near-term results; we saw that in the third quarter, when Seadrill reported $842 million in proforma EBITDA, second highest in its history.
It'll take time for low oil prices to hit Seadrill's bottom line, but if oil continues to fall, the stock will slide whether short-term profits fall or not.
Offshore drillers hold onto hope for old rigs
Demand is a risk for Seadrill stockholders in the future, but so is supply. A large percentage of the offshore drilling fleet is aging and could be scrapped, especially if demand is low, but if that doesn't come true, it could drag down contract rates for everyone.
According to Seadrill competitor Ensco, 56 out of 297 offshore floaters are over 35 years old, and that number will grow to 71 in the next three years. In the jackup market, 57 of 404 rigs are over 35 years old, and that will grow to 162 rigs in three years. In theory, if demand for offshore drilling rigs is low and dayrates fall, these rigs should be scrapped and newer, more capable rigs should win contracts.
This makes sense in theory and if old rigs are indeed scrapped, we could see supply of older offshore rigs fall. This could keep the market from being vastly oversupplied in coming years as new rigs are built. But rig owners may not be eager to take losses scrapping older rigs and if they keep them in the market, they'll push dayrates lower. That's a huge risk for Seadrill, who has 16 new rigs being delivered in the next two years and could be forced to lower dayrates, lowering margins.
Financing markets dry up
While lower demand or higher supply in the oil market would weaken Seadrill, financial markets are needed just to keep the company afloat. At the end of the third quarter, Seadrill had $13.1 billion in long-term debt, and it'll need to go back to the market for more financing in 2015. Over $1 billion of debt matures next year, and over $1.5 billion in yard installments are also due.
The recent suspension of Seadrill's dividend was directly related to this need of cash from the financial markets. Even if oil remains weak, Seadrill will have enough cash to pay for operations and debt, but it wouldn't likely be able to pay for all of its obligations and a nearly $2 billion annual dividend. So, it chose to ax the dividend rather than risk rising interest rates.
However, if for some reason investors are no longer interested in Seadrill debt, or financial markets lock up, as they did in 2008, the company could be in serious trouble. That's why Seadrill's cash flow and balance sheet is worth watching over the next year. Strengthening the balance sheet and building a less risky company will be important, especially if energy markets don't pick up.
Travis Hoium manages an account that owns shares of Ensco and Seadrill. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill. 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.