One of the few areas of strength for Seadrill Ltd (NYSE:SDRL) is its contract backlog. That backlog is expected to help keep the company's head above water during the current storm in the offshore drilling market. However, recent news that it has lost a $1.1 billion contract with Petrobras (NYSE:PBR) is a really bad omen for the company as it suggests that the company's backlog might not be as strong as was once thought.

What's going on here?
In the company's third-quarter release it noted that subsequent to the quarters end that it received confirmation from Petrobras that it had approved the contract awards for Seadrill's West Tellus and West Carina drillships to be used in the Libra Field. This was a three year contract worth up to $1.1 billion. In addition to that, it also announced that Petrobras approved the contract extensions for the West Eminence and West Taurus semi-submersibles. These contracts were also for three years and upwards of $1.1 billion. We can see both awards, as well as some smaller additions to the backlog, on the following slide.

Source: Seadrill Ltd. Investor Presentation. 

It's this second announced contract with Petrobras that Seadrill is now removing from the backlog as the other contract has been signed and those drilling rigs will begin operations in the second quarter of this year. Basically, what happened is that the contract extensions were never signed before the recent upheaval at Petrobras. Now that the company has a new CEO and is digging into corruption issues Seadrill feels that it is unlikely to ever get ink on the extension because the price of oil has fallen dramatically since it announced the approval in November. It's view is that Petrobras will now try to renegotiate those contracts at a lower dayrate than the one that it previously agreed to in the renewal.

As we see in this next slide both floaters had dayrates above $600,000 under the previous contracts.

Source: Seadrill Ltd. Investor Presentation.

However, because of the dramatic drop in the price of oil it has taken dayrates down from the more than $600,000 that Seadrill was earning to less than $400,000. This makes it very likely that the beleaguered Petrobras is looking to get that new lower rate on a renegotiated contract extension.

What this means for Seadrill
Seadrill had expected these contract extensions to begin early this year. However, with the extensions now on hold it means the company won't be earning any revenue on these two vessels until work can be found. This could mean that Seadrill's revenue will be upwards of $300 million less than anticipated this year, which would make it that much harder for the company to pay down its debt and fund its massive newbuild program.

When the company slashed its dividend last quarter it did so under the assumption that it could use that $2 billion in cash flow that was guaranteed by its contract backlog to fix its balance sheet. Now, with the possibility of these ships being out of commission for the year it will give the company less cash flow to work with. That said, overall it's not a huge loss as these contracts are only 5% of the company's floater backlog and it still has $17.6 billion under firm contracts. However, the company clearly counted on the contract before it had ink on paper, which has now come back to bite it as Petrobras is now seeking better terms given its own problems.

Investor takeaway
The loss of the Petrobras contracts isn't good news as it couldn't come at a worse time for the company. Worse yet is that the company counted on contracts that apparently shouldn't have been counted on as Petrobras' word apparently isn't its bond. The question that remains is if the rest of the backlog can still be trusted or if there are other handshake deals or out clauses we don't know about that could mean that the backlog is smaller than investors had been led to believe. That's why this announcement seems like a real bad omen for Seadrill investors.