The hammer of low oil prices hasn't dropped yet for offshore drillers, but it's on the horizon, and everyone sees it coming. Seadrill (NYSE:SDRL) was the first to realize this, and despite strong cash flows expected through 2015, it cut its dividend to $0 last year just to try and stay afloat. Transocean (NYSE:RIG) also cut its annual dividend from $3 to $0.60 per share because of the downturn.
Ensco (NYSE:VAL) always touted itself as one of the more financially sound companies in the industry, with a strong balance sheet, high margins, and a safe dividend payout ratio. Until recently, many thought its dividend was safe. But the reality of today's oil market is that cash is king, and there's no room for extravagant dividends.
Ensco finally relented, reducing its dividend 80% to $0.15 per share this quarter. It's a sign of the times in offshore drilling, and it may be a sign of bad things to come for Ensco.
Oh, how times have changed
In the third-quarter 2014 earnings release in October, Ensco's management was largely upbeat about the company's future. Sure, oil prices had fallen to near $50 per barrel, but there was a widespread belief that prices would recover quickly and business would be back to usual before long. Management touted a recent $1 billion order as evidence that drilling wasn't dead, and that it was proud of investments the company was making in upgrading its fleet. CEO Carl Trowell said:
While market conditions for floating rigs have become more challenging, we believe the fundamental drivers of long-term demand for newer, more technologically-advanced floaters remain favorable.
That narrative has changed. The fourth-quarter 2014 release took a very different tone from the very beginning. The first two line items were a $2.998 billion, or $12.93 per share, non-cash goodwill impairments and $925 million, or $3.77 per share, in non-cash asset impairments. These non-cash charges are taken when a company is holding something on its balance sheet at a much higher value than it's actually worth. Goodwill is added when an acquisition is made, basically filling the gap between what you paid for the asset and what its book value is, so when a company impairs goodwill, it's basically admitting it overpaid for that asset.
But that was hardly the worst news for investors. This time, CEO Carl Trowell said:
Given the severe downturn in the offshore drilling markets, we believe it is prudent to improve capital management flexibility and reduce expenses. First, we have decided to reduce our quarterly dividend to $0.15 per share. Second, we are decreasing our offshore employee base as we cold stack rigs. Third, we are reducing offshore discretionary compensation and onshore support costs. And fourth, we are actively negotiating with vendors and suppliers to lower costs, while maintaining or improving quality.
Cutting costs is great, and reducing the dividend will help the balance sheet, but the alarming comment was about cold stacking rigs. By cold stacking an offshore drilling rig, the rig is being taken out of service because you think it will be out of work for so long that there's no reason for keeping a staff or having it ready for service. It's like shutting down a production plant. The plant is still there, but no one is home, and it would take a lot of expense to get it up and running again.
The good news is that retirements and cold stacking is happening across the industry. If the oil market improves, new rigs should be able to attract strong dayrates. That gives Ensco upside if oil markets improve, but that's a big "if" at the moment.
On top of cold stacking older rigs, newbuild rigs are being delayed or cancelled, which may help the oversupply problem long term, but it shows the dire straights of the industry in the short term.
It's a tough time to be an offshore driller
Just three months ago, it seemed like the downturn for offshore drillers would be short-lived. Contracted backlog, like the $9.7 billion Ensco has today, would tide each company over for a year or two until market conditions improved, and then it would be back to business as usual. But the downturn could be protracted for longer than that, and offshore drillers have been forced to batten down the hatches.
While I think it's the right move for Ensco to cut its dividend, or even eliminate it for the time being, investors haven't been receptive to dividend cuts, and this week's reaction was no different for Ensco.
Seadrill was the first to slash its dividend, primarily because it's the most highly leveraged of the major offshore drillers. Transocean was next, and even a diverse fleet of offshore rigs couldn't keep the dividend afloat. Ensco hasn't been able to escape the fate, either.
It's a sign of the times in offshore drilling, and if oil prices stay low for too long, it could be a fight for survival.