Sdrl West Navigator
Seadrill's operating results were in line, but the risk of less work in 2016 weighs heavily on it and its peers. Image source: Seadrill. 

Offshore oil and gas drillship operator Seadrill Ltd (NYSE: SDRL) reported third-quarter earnings on Nov. 24, including $1.8 billion in impairments and asset writedowns. And while its operating results weren't great, they were more or less solid. 

However, the offshore drilling business remains a mess of low demand, too many vessels operating, and little to indicate that will change overnight. Factor in the nature of the business -- i.e., today's business is a product of contracts signed years ago -- and the outlook is grim. Let's take a closer look at Seadrill's financial and operating results and see what we can learn about the company's performance and the outlook. 

The results 

 MetricQ3 2015Q3 2014Change (YOY)
Revenue $985 $1,293 (23.8%)
Net Income  ($1,900) $190 (1,000%)
EPS ($3.70) $0.31 (1,193.5%)

Revenue and net income in millions. 

Because of the huge $1.8 billion in non-cash impairments Seadrill took in the quarter, we need better context to judge the operating results:

Metric Q3 2015Q3 2014Change (YOY)
EBITDA $546 $635 (14%)
Adjusted Earnings $136 $635 (78.6%)
Operating Income ($291) $461 (163.1%)

In millions. Adjusted earnings excludes $1.8 billion non-cash impairments.

As you can see, factoring out the one-time, non-cash impairments makes the operating results look -- well, if not better, then much less worse. However, it's important to consider the implications of those impairments. While they are non-cash in nature, meaning that the company didn't actually lose any short-term capital, the long-term implications are simple: The value of the company's assets -- including its stake in Seadrill Partners (NYSE: SDLP) -- was reduced, because those assets are now expected to produce smaller revenue and profits going forward.

Seadrill Partner's own results help bear this out. The subsidiary saw revenue climb 10% to $457 million and operating income rise 2% to $209.4 million, but it was entirely due to an asset drop-down from Seadrill in the second quarter. Factor out that increase in the fleet size, and reduced dayrates at one vessel and increased idle time at another would have pushed revenue and distributable cash flows lower for the quarter. 

That can't and shouldn't be ignored, because it's tomorrow (as in 2016) that's the big risk to Seadrill today. 

What happened in the quarter 

  • Seadrill group (includes its stake in Seadrill Partners, North Atlantic Drilling, Sevan, and others) consolidated backlog declined from $14 billion at Q2 end to $12 billion. Seadrill's own backlog declined from $7.54 billion to $5.98 billion from the second quarter, a 21% drop, largely related to the loss of the $1 billion contract for the West Mira with Husky, when Seadrill cancelled the contract with the shipbuilder. 
  • Seadrill and shipbuilder Cosco agreed to defer delivery of the Sevan Developer semi-submersible for six months, to April 2016. 
  • Seadrill is currently obligated for $3.9 billion in final payments for 14 newbuilds. 10 of these vessels are still scheduled for delivery in 2015 and 2016.
  • The global floating vessel fleet is starting to contract, with more than 44 vessels having been scrapped over the past 14 months. Seadrill estimates that the industry needs 180 to 200 working vessels to support current and expected demand. Factor in the newbuilds on order, and management says another 40-plus vessels need to be scrapped to reach equilibrium in this category.
  • The larger jack-up vessel category has seen less scrapping activity, but has more than 130 older vessels either currently idle or rolling off contract in the near term, which management says are ideal candidates to be scrapped. However, there are 125 newbuilds on order globally, so it's going to take a balance of delayed newbuilds and scrapping in order for the jack-up category to balance. 
  • Total interest-bearing debt fell slightly to $11.4 billion, with $1.6 billion due in the next 12 months. 
  • Total cash increased from $918 million to $1.18 billion. 
  • Operating costs declined, and management said about one-third of the $600 million in operating cost savings over the past 12 months would be sustainable, while the rest were largely deferred costs. 

Looking at the current and short-term environment 
Seadrill continues to benefit this year from its big backlog of contracts, but faces serious choppy waters going forward. And while its modern fleet is a valuable asset, the company remains heavily leveraged because of its new fleet. 

This stands in contrast to other drillers with a mix of new and old vessels, which can significantly reduce their operating expenses by idling or even scrapping parts of their fleet, while Seadrill doesn't own a single vessel that it can afford to idle. Factor in the current state of oversupply in the offshore industry, and this asset may be a liability as well, heading into 2016. 

As things stand today, Seadrill and its affiliates have eight currently operating vessels not under contract, and another five with contracts expiring by July 2016. That's not including the 10 newbuilds due before the end of 2016, none of which have contracts lined up. Notwithstanding a rebound in oil prices, a major increase in scrapping activity, or (more likely) a balance of both, the company probably hasn't seen the worst just yet. 

Final thoughts 
The section above isn't intended to make things seem worse than they are, but it's a not-so-subtle reminder that Seadrill's situation won't change until the market does. Its operating and cash flow results each quarter are mostly a product of old contracts, and investors must pay very close attention to the company's steps to further reduce expense, delay its obligations to accept (and pay for) new vessels, and secure new business. 

Eventually the offshore market will turn, because the planet's biggest oil and gas reserves are located there. But to benefit from that recovery, Seadrill has to navigate the downturn effectively, and it could get harder to do so before the cycle turns for the better. 

Jason Hall owns shares of Seadrill. The Motley Fool recommends 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.