What: Shares of offshore drilling contractor Seadrill (NYSE:SDRL) were throttled on Friday, falling $0.70, or better than 5%, to close at $12.32 after the company updated its contracts with Petrobras (NYSE:PBR), and following a subsequent price target reduction from research firm Cowen & Co.
So what: The impetus that really sent shares of Seadrill reeling on Friday was the announcement that it was cutting $1.1 billion worth of contracted orders from Petrobras out of its backlog. The reason for giving up on these orders is a scandal at the Brazilian oil giant which could take months to completely uncover. As Seadrill's management team noted, "Due to the recent developments within Petrobras, [Seadrill] no longer believes the contracts will be concluded in the time frame or on the previously approved commercial terms."
Following word of this backlog cancellation, research firm Cowen & Co. trimmed its price target on Seadrill to $10 from a prior target of $12, however it did keep its "market perform" rating unchanged.
Now what: The question that investors really need to ask here is just how important these Petrobras contracts were to its overall valuation, and whether the worst could be behind Seadrill.
To be clear and upfront about my bias on this one as a shareholder of Seadrill, I do believe we've seen the worst and I'm not certain shares of the company deserve that aggressive of a price target to the downside.
If you look at Seadrill's third-quarter results from November it was sporting a backlog then of roughly $20 billion. Although it could be difficult at today's oil prices to grow that backlog, losing in the neighborhood of 5.5% of its backlog probably isn't going to merit a haircut of another 19% from Friday's close. In fact, Seadrill has enough contracts in place that it'll remain healthfully profitable through 2017, giving oil prices plenty of time to rebound off of their lows.
Seadrill is also working with one of the newest fleets in the offshore drilling business. With an average age of approximately five years Seadrill's fleet carries with it exceptional efficiency that'll practically ensure its rigs get contracts before those which are 10, 20, or even 30 years old. Not to mention, state-of-the-art rigs command better dayrates than older rigs, meaning more cash flow for Seadrill.
Of course, there's still risk here. If oil prices were to remain low for an extended period of time (say through 2017) Seadrill's debt obligations could become very burdensome even with its suspended dividend.
For now I remain a Seadrill shareholders with high expectations and don't anticipate cancelled contracts becoming a regular occurrence.