Seadrill: West Leo Contract Extension Provides Further Evidence Of Offshore Drilling Strength

| About: Seadrill Limited (SDRL)

Bermudan offshore drilling contractor Seadrill Ltd. (NYSE:SDRL) announced on Thursday, January 17 that it has received a contract term extension from Tullow Oil (OTCPK:TUWLF) for the use of the West Leo ultra-deepwater drilling rig. This contract extension is for a two year period during which time the rig will remain in West Africa performing drilling operations. Overall, this contract extension expands Seadrill's revenue backlog and increases the company's earnings visibility as the rig will now be under contract until May 2018.

The West Leo is one of the newest rigs in Seadrill's fleet. The West Leo is a 2012-built harsh environment ultra-deepwater semisubmersible drilling rig that is capable of drilling wells up to 35,000 feet deep in up to 10,000 feet of water. The rig immediately began operating in the West African nation of Ghana on its first contract with Tullow Oil. The contract with Tullow Oil for this rig calls for an escalating dayrate. From April 2012 until May 2013, West Leo is collecting a dayrate of $525,000. However, the rig will begin earning a dayrate of $625,000 beginning in May 2013. The rig will continue to collect this higher dayrate until the termination of its original contract in May 2016.

Seadrill provided details of the contract extension that it received in the extension announcement.

"The potential contract revenue for the extension is estimated to [be] approximately $450 million based on 97 percent utilization and includes a performance bonus arrangement. This brings the total estimated contract value to $1.13 billion."

It is unclear whether or not Seadrill included its expected revenue from the performance bonus into that $450 million estimate. The wording that was used in the announcement can be interpreted either way. If it does, then the actual revenue earned from this extension could be more or less than $450 million even if the rig manages to achieve 97% utilization. If it does not, then the actual amount of revenue produced by this contract extension will also certainly be more than $450 million unless the rig suffers significant downtime which does not seem likely. It sounds to me, however, that Seadrill's $450 million estimate does include the amount of money that the company expects to collect under the performance bonus arrangement.

The estimated $450 million that Seadrill expects to generate from this transaction at 97% utilization works out to approximately $635,500 per day. That would represent a dayrate just slightly above the previous $625,000. This could indicate that Seadrill's $450 million estimate does not include the performance bonus but this is by no means certain. What is certain here is that this contract extension is indicative of the current strength of the offshore drilling sector and that this extension will reward both Seadrill and its investors.

I published an article here on Seeking Alpha last week that discussed the strength in the offshore drilling market. In this article, I discussed the current demand-supply dynamics of offshore rigs and how dayrates of new, modern ultra-deepwater rigs have been rising due to customer demand for these rigs outstripping supply. The West Leo is one of the most modern operating rigs in the world today and so it would be affected by these same trends.

This contract extension extended Tullow Oil's original contract by two years, from 2016 until 2018. Furthermore, the company was willing to extend the contract at a fairly high dayrate. There are only two reasons why Tullow Oil would want to do this and both reasons are quite favorable for anyone invested in offshore drilling contractors:

  1. Tullow Oil needs the rig for its development plans and realizes that it may have difficulty getting one at a later date.
  2. Tullow Oil believes that dayrates will continue to rise going forward and so is attempting to lock in its dayrate now.

Both of these reasons would lead to rising revenues and profits for offshore drilling companies. This is good for investors in these companies for obvious reasons.

This contract extension also adds approximately $450 million to Seadrill's already substantial revenue backlog. This represents guaranteed income to the company. This translates into guaranteed cash flows and profits, from West Leo at least, and this guarantee extends out until May 2018, or more than five years. This helps predict Seadrill's earnings going forward as we now know what revenue will be generated by the West Leo for the next half-decade.

As Seadrill stated in its announcement, the total amount that the company expects to generate off of West Leo is $1.13 billion. This is more than enough to pay Seadrill back in full for the costs that it incurred to acquire the rig. Seadrill acquired the West Leo along with the West Pegasus in a deal in January 2011 with Seadragon Offshore. Seadrill paid a total of $1.2 billion for both rigs so therefore the $1.13 billion expected contract revenue is more than sufficient to reimburse Seadrill's costs in obtaining the West Leo alone.

Disclosure: I am long SDRL. 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 stock is mentioned in this article.