Seadrill (NYSE:SDRL) has been the hands-down loser among the major underwater drillers, with a share price that has declined by more than 76% in the past year. The Company has had the triple whammy of a high debt load (SDRL is the most leveraged of the major drillers), the misfortune to contract with Rosneft (through a subsidiary) prior to hard sanctions being imposed on Russia and deceptive investors about the sanctity of the dividend (20% price drop after "violating the trust" and suspending the dividend).
In 2015, SDRL has traded in-line with Noble (NYSE:NE) and Transocean (NYSE:RIG) as the largest drillers share price rises and (mostly) falls with the price of oil.
It is beautiful lucid that oil prices will need recover to 2014 price levels in the near future and even $50/barrel is at risk of being a "pleasant" memory. Currently, oil prices are in a "race to the bottom", with poor countries with mismanaged economies and threats to political leadership like Iraq, Nigeria and Venezuela pumping every barrel they can while Saudi Arabia is actively trying to drive US shale producers out of business. Russia also needs oil, especially with heavy sanctions continuing for the foreseeable future.
It appears likely that sanctions against Iran will (at least partially) terminate. The Wall Street Journal reported Iran's deputy oil minister, Mansour Moazami expects production to increase by more than one million barrels per day, from 1.2 million barrels to 2.3 million barrels. Anticipation of Iranian oil has crushed whatever oil price recovery occurred in Q2; WTI closed on July 24 near $48/barrel. Michael Lynch, President of Strategic Energy & Economic Research noted in a Bloomberg article that, "Once Iran increases output, $50 could easily become the ceiling for WTI."
E&P (exploration and production) companies are compounding problems on the demand side for underwater drillers, cutting formerly scheduled and contracted projects. Only Shell (NYSE:RDS.A) appears to be plowing ahead with new drilling projects, and in RDS.A's case, the projects are green-lighted more for political than for financial reasons. However, E&P firms will need to replenish reserves. Expect some E&P firms, as the prices of dayrates and other production costs have plummeted, to "bargain shop" by the end of 2015 and in the first half of 2016.
I was curious as to which driller would provide the best upside in a recovery scenario, using 2017 or 2018 as the timing of the recovery. SDRL, due to its high leverage and low current valuation is my pick for most potential reward (with a significant amount of risk). In this analysis, I assumed that through a combination of reduced rig provide (especially) floaters and increased demand (as E&P firms eventually will have to replace reserves) that the market recovers and achieves a level of equilibrium. If oil recovers (and I am certainly not making any projection on the price of oil), the timing could be accelerated.
The below chart is the "standard" chart I use to evaluate the various drillers. You will note SDRL currently trades at the lowest multiple to 2016 earnings, has the highest debt load and is relatively well contracted through 2016.
Sources: Yahoo!, TDAmeritrade, FINRA via Morningstar, Atwood, Diamond Offshore, Ensco, Noble, Transocean and Seadrill
Beyond the absolute number of rigs, it is important to consider which have a strong likelihood of being contracted/re-contracted. While drilling dynamics may change, it is usually acknowledged that newer rigs are preferred, from both a safety and efficiency perspective. In the current supply-rich environment, the number of new/newer floaters should be considered as opposed to the absolute number of floaters. It is more and more unlikely that "old" rigs will be re-contracted. Some drillers, most notably Transocean stubbornly cling to (and pay high operating expenses) for rigs that are unlikely to ever be re-contracted. The below chart considers the fleets of the respective underwater drillers. I considered a new/newer floater (including drillships and semi-submersibles), to have an original depth capability of 10,000 feet or to have been manufactured this century.
In a scenario that assumes an eventual scenario, I believe SDRL would offer the highest potential reward. Please note that SDRL also has an above-average level of risk, as best demonstrated by the non-investment grade debt rating and junk-bond yield the Company's 2020 bond "pays".
To conduct my analysis, I tried to peer ahead and determine what SDRL might see like. To do that, I first looked at performance from 2012-2014 (SDRL 20-F; all dollars in millions).
The above performance is based on floater day rates of near $500,000 and jackup dayrates of about $150,000. Utilization was in the mid-90's. To determine what the "next stage" might look like, I assumed a discount in dayrates and contracting would lead to average rig performance falling by 30%, driving gross margins down to about 28% (I do assume some cost reductions offset by lower contracting success). The $700 shown below is a 30% discount off of a base of $1,000, and does not symbolize any particular performance. Gross margin is now 28% (a 30 point drop from 2014's 58%). For every $1,000 of revenue SDRL received under average contracts, my assumption is it will get $700 and keep $196.
I modeled three separate scenarios. The "Recovery" scenario assumes all rigs are delivered (34 floaters vintage 2000 or newer and 24 jackups), are contracted at average rates of $375 for the floaters and $120 for the jackups, assuming historical uptime with 20% of the fleet idle. The 28% gross margin is utilized in this scenario. The second scenario, "Normal", assumes a semblance of market balance and 42% higher revenue from the alike fleet (the math is recovery revenue divided by 0.7). This is a combination of historical dayrates (not zenith dayrates) and an idle rig rate closer to 10%. The third scenario called "Good" reflects a bit of a scarcity in rigs (from current scrapping activities and a catch-up in E&P activities) and simply is 15% more revenue than the second scenario.
Please note that none of the three scenarios is implied to be "accurate"; they are each meant to be demonstrative of a rough future, and possibly an evolving, SDRL.
The last piece of the analysis revolves around valuation. It is admittedly imperfect as it (OTCQB:ALSO) contains several sweeping assumptions. First, it utilizes the current enterprise value as a base line. I recognize that debt will be incurred for the new builds included in the revenue forecasts and debt balances will also be reduced as payments are made. The lack of a specific date for the previous scenarios also complicates making estimates (that would imply a non-existing precision). Similarly, I avoid attempting to calculate depreciation, interest or taxes. Instead, I assume that net income is 50% of EBITDA (the percentage for the trailing twelve months is 56%). Finally, the valuation exercise provides a multiple range and does not discount to today (in theory, provided an investor believed SDRL would be worth $30/share in two years, he/she might discount back by 20% per year to adjust for risk in determining a "fair" price today) as the values are a valuation exercise not a price projection.
As the chart suggests, SDRL could (considering the many assumptions inherent) rally 4x-5x from current prices in a recovery scenario. Personally, I do believe SDRL will survive the current driller recession. The Company has a new fleet, has demonstrated good relationships with both shipyards and lenders and has a management team that is skilled at reacting to a dynamic surroundings (though admittedly, tone deaf with respect to shareholders). Further, although a controversial figure, the Company's largest unmarried shareholder and Chairman, John Fredrikson may provide "comfort" to third parties such as lenders and shipyards.
As the charts suggest, under a scenario where prices are quasi-permanently impaired (Recovery), due to a combination of excess supply or reduced demand, SDRL is worth less than its debt. Under a "Normal" scenario, SDRL achieves a value under a moderate valuation assumption in excess of current value (though significantly below valuations of a year ago). Finally, if there is a "snap-back" (Good scenario) due to a combination of reduced supply and increased demand (the E&P firms tend to play "follow the leader"), there is a possibility of significant appreciation over today's prices.
So while caveat laden and based on many gross assumptions, it is my opinion that SDRL offers the highest upside among the drillers (and a reasonable measure of risk). The approximate timetable to achieving the scenarios is approximately two-to-three years.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NE over the next 72 hours. (More...)I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose inventory is mentioned in this article.
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