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The use of leverage is quite common in the offshore drilling industry, largely due to the enormous capital costs required to construct an offshore rig. For example, it costs approximately $600 million to construct a new ultra-deepwater drillship and approximately $200 million to construct a high specification jack-up drilling rig. Very few organizations can directly finance such massive capital projects out of pocket so that leaves just one option: debt. This debt is then used to purchase capital assets that generate sufficient cash flows to pay down the debt and deliver a profit.

This is also true with virtually any investment made with debt. The same risks that apply to other leveraged firms also apply to offshore drillers. If, for whatever reason, a drilling rig is unable to generate sufficient cash flows to cover all of its expenses, service its debt, and still turn a profit then financial trouble will ensue. While the industry as a whole is quite strong right now with a tight supply-demand balance holding up dayrates and rig cash flows, this may not always be the case. There are also factors other than industry cycles that can negatively affect cash flows from any given rig. As a result, there is greater risk in investing in drilling companies with greater leverage.

Here are the major offshore drilling companies along with their respective levels of short- and long-term debt. All information is pulled directly from the respective company's latest quarterly report.

(click to enlarge)

Source: International Hedges

As you can see, Seadrill (NYSE:SDRL) is by far the most highly leveraged of the major offshore drilling companies. It has a total debt to equity ratio of 1.95, easily trumping the second most indebted company, Transocean (NYSE:RIG). This is largely due to Seadrill's strategy of rapid growth funded by debt. Seadrill also pays out the majority of its operating cash flow to investors in the form of dividends. This has given the company a dividend yield of 9.41%, which is also by far the highest of any of these companies. Seadrill also has a massive newbuild program containing twenty-four rigs supported by all of this debt. This most likely gives the company the greatest growth potential of any of these companies.

Seadrill's debt will be reduced by $780 million sometime this month due to the sale of its tender rig division to SapuraKencana Petroleum. As a part of that deal, all of the debt from that division will be transferred to SapuraKencana. While this transaction will reduce Seadrill's debt and debt to equity ratio, it will also reduce the company's operating cash flow. However, the new rigs coming online through the aforementioned newbuild program should be able to make up for this and even grow the company's cash flow over the next few years. I discussed this in greater detail in a recent article.

Seadrill is thus a high risk/high reward stock when compared to the others on this list. On the flipside, we have Ensco (NYSE:ESV) and Noble (NYSE:NE) which are nowhere near as heavily levered as Seadrill. Both of these companies also have newbuild programs with which each will deliver growth. Neither program is as aggressive as Seadrill's nor is either company constructing enough rigs to see the same level of fleet growth that Seadrill will. These companies represent more conservative growth picks than Seadrill but still certainly have the potential to reward investors.

Even Seadrill has relatively low leverage compared to some of the smaller companies in the sector. For example, Vantage Drilling (NYSEMKT:VTG), which I have analyzed before, has $31,250,000 in short-term debt (including the current portion of long-term debt) and $2,710,559,000 in long-term debt. This gives the company a total debt load of $2,741,809,000. This compares to total shareholders' equity of $568,485,000. Thus, Vantage Drilling has a total debt-to-equity ratio of 4.82. Clearly, Vantage is much riskier than Seadrill due to its debt load.

There are some other small offshore drillers that also have substantial debt loads. One example is Sevan Drilling (OTCPK:SDRNF). Sevan Drilling has $140.8 million in short-term debt (including the current portion of the company's long-term debt) and $717.9 million in long-term debt. This gives the company a total debt load of $858.7 million. The company has $662.4 million in shareholders' equity. This gives the company a debt-to-equity ratio of 1.29. This is lower than both Vantage Drilling and Seadrill but higher than any of the other major drilling companies.

Seadrill is actually paying lower carrying costs on its debts than its similarly leveraged peers and that reduces the company's risk compared to other, smaller offshore drilling companies. Seadrill's interest rates are based on LIBOR plus a margin and in most cases, this margin is rarely more than a few percentages. The company paid $91 million in interest during the fourth quarter. This works out to an annualized interest rate of 3.07% which does seem somewhat low but nonetheless illustrates just how low Seadrill's average interest rate really is. Let's compare this to Vantage Drilling. Vantage Drilling's senior debt consists of 11.5% notes, 7.5% senior notes, a term loan at LIBOR plus 5%, convertible notes at 7 7/8%, and a revolving credit agreement at LIBOR plus 4.5%. Seadrill quite obviously pays much lower interest rates than Vantage Drilling does and this allows the company to carry a higher debt load before encountering financial difficulties.

In general, these companies all took on this debt in order to finance the construction of their fleets. For this reason, the more highly leveraged companies in this sector tend to have higher growth potential than less levered names. This is not always true, however. Pacific Drilling (NYSE:PACD), Ocean Rig (NASDAQ:ORIG), and Atwood Oceanics (NYSE:ATW) all have reasonable growth debt levels and solid growth potential. In short, it is important not to let a high debt level alone scare a prudent investor away from a given offshore driller. It is important to look deeper. However, more levered companies are certainly riskier so it is important to be aware of that as well.

Disclosure: I am long SDRL, OTCPK:SDRNF, PACD. 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.

Additional disclosure: My long position is Sevan Drilling consists of the Norwegian shares on the Oslo Bors and not the American OTC shares.

Source: A Comparison Of The Debt Levels Of Offshore Drilling Companies