There's certainly a lot of debate in today's market about the future of offshore drilling stocks. A sell-off in the past six months has left the industry devastated, and no one really knows when business will return to normal.
I recently took a look at the three best reasons to buy Seadrill Ltd. (NYSE:SDRL), and while I think the risk/reward profile is good, there are plenty of reasons to be bearish on the stock. With that in mind, here are the three best reasons to ditch Seadrill's stock and run for the hills.
One of the alarming revelations in recent weeks is that backlog may not be as it appears. During the third-quarter earnings call, Seadrill Group said it had $24 billion in backlog, and by the fourth-quarter call, that number had fallen to $17.2 billion.
One of the reasons backlog dropped was a revelation that Petrobras never signed a $1.1 billion contract Seadrill thought it had secured in November 2014. There's also questions surrounding subsidiary North Atlantic's $4.25 billion of contracts with Rosneft, which may be in trouble because of low oil prices and sanctions on Russia.
The fact that the backlog is in question at all highlights the fragile place the oil industry is in today. Companies may soon want to renegotiate offshore drilling contracts and may renege on contracts altogether. Offshore drillers are going to begin feeling the pain of that pressure, and Seadrill started to crack this past quarter.
High debt levels
Seadrill's $12.6 billion in long-term debt and $3.5 billion in yard installments due in the next two years put the company in a precarious position. If offshore drilling revenue doesn't recover enough to provide cash flow to fund debt and newbuilds, there's a possibility an equity offering will be needed.
The worst-case scenario is that Seadrill could be facing bankruptcy if the oil market gets bad enough. I think we're a long way from that happening, but if oil prices stay near $50 per barrel for two years or more, there won't be many oil producers looking to drill new wells offshore, especially in deep water where Seadrill is focused and where drilling is more expensive.
Debt is a risk for any company, but with the offshore drilling market as bad as it is, the risk is especially high for Seadrill.
Oil may never get back to $100 again
If oil recovers to $100 per barrel, the upside for Seadrill is tremendous. But what if it never recovers?
It's not as crazy a thought as it might have been just a few years ago. I've argued that OPEC may have a multi-year battle on its hands to squeeze out shale and other marginal producers in the oil business. If OPEC stays resolved, it could take all of the wind out of the sails of offshore drillers and leave the industry in ruin.
To make matters worse, alternatives to oil like electric cars and natural gas trucks are gaining traction. It's possible that global oil consumption will peak in the next year or two, which would be terrible for future price growth.
It's not out of the realm of possibility that oil never hits $100 per barrel again, and if it doesn't, Seadrill's upside will be limited. If you don't think oil will jump significantly in coming years, it's definitely a good reason to get out of the stock.
Seadrill is a risk no matter what
Whether you're bullish on Seadrill or not, there's no question that this is a high-risk stock that depends a lot on increasing oil prices to pay off for investors. The sheer debt load means that the downside is literally bankruptcy if conditions get bad enough. I don't think we'll get there, but knowing the risks is important for any investor, and Seadrill is full of them.