Seadrill: High Dayrate On West Freedom Contract Continues To Show Industry Strength

| About: Seadrill Limited (SDRL)

On Thursday, July 11, 2013, Seadrill Ltd. (NYSE:SDRL) announced that it has secured a contract for the West Freedom jack-up rig from a consortium consisting of Italy's Eni (NYSE:E) and Spain's Repsol (OTCQX:REPYY). The contract is for a firm period of thirty months and has a maximum contract revenue of $222 million inclusive of an $8.5 million mobilization fee.

The West Freedom is a benign environment jack-up rig built in 2009. The rig is capable of drilling wells up to 30,000 feet deep in up to 350 feet of water. This makes the rig one of the least technically capable in Seadrill's fleet as the company has numerous jack-ups that are capable of operating in 400 feet of water or greater. In fact, 350 feet of operation is the minimum for Seadrill's jack-up fleet (although there are other rigs in the fleet that have the same specifications as West Freedom). Generally, the most capable rigs will command higher dayrates than less capable ones and therefore this is a very good sign for the premium jack-up market.

As already stated, the total potential revenue for this new contract, excluding the mobilization fee, is $213.5 million over a period of thirty months. This works out to a dayrate of approximately $234,000. This dayrate is substantially higher than any other benign-environment jack-up in Seadrill's fleet (the closest to this value are the three rigs owned by Asia Offshore Drilling). It is also well above the rig's current dayrate of $155,000. As Seadrill's costs of operating the rig will not increase by nearly the amount of the dayrate increase, it should see higher cash flows and profits once the rig begins its work on the new contract around the end of September 2013. Seadrill should thus see the increased profits from this contract beginning in the fourth quarter of this year.

The company provides information that can be used to calculate the profit increase that it should see due to this new contract. In its presentation at the Howard Weil 41st Energy Conference on March 21, Seadrill included this chart that shows the economics of operating three different classes of offshore drilling rigs:

According to the company, it costs approximately $60,000 per day to operate a jack-up rig. Seadrill has used this chart in several presentations over the past year and a half so it stands to reason that the actual cost has increased from the time that this chart was originally made due to inflation. Additionally, the cost of hiring a crew for the rig has also increased over the past year due to insufficient skilled personnel available in many regions of the world. Therefore, I will increase the figure on the chart by 3% to account for this. This brings the daily cost of operating a jack-up rig up to approximately $61,800. Therefore, the rig should generate approximately $172,200 of before-tax cash flow per day under the new contract. This works out to a maximum of approximately $62.85 million per year. It is unreasonable to assume that the rig will generate that however, since maintenance and other downtime will be required over the contract term to keep the rig operating properly and it is generally not paid for this downtime. Seadrill's jack-up rigs historically spend about 3% of their time in these unpaid activities. This brings the estimated annual pre-tax cash flow for the rig down to approximately $60.9 million per year. The chart above states that the company incurs total taxes of about 4% of the revenues generated on a per rig basis. If we assume that to be true in the case of West Freedom then the company will pay approximately $3.4 million in taxes annually. This brings the estimate of the company's cash flow from this new contract to $57.5 million annually.

This is not all new cash flow, however. West Freedom is already generating cash for Seadrill under its current contract. The rig's current $155,000 dayrate works out to approximately $56.6 million per year in total potential revenue. For this calculation, I will assume that the $60,000 daily operating expenses figure from the chart above is correct. This will result in the most conservative estimate of the company's incremental cash flow from the new contract. This would give the rig approximately $95,000 per day in pre-tax cash flow or roughly $34.7 million in annual pre-tax cash flow. In the previous paragraph, I also made the assumption that the rig will spend approximately 3% of its time offline engaging in non-revenue generating activities. This brings the estimate of the rig's pre-tax cash flow down to approximately $33.6 million. As noted in the previous paragraph, taxes are approximately 4% of revenue. Thus, Seadrill would pay approximately $2.3 million in taxes per year on this rig. The West Freedom thus currently generates approximately $31.6 million per year in cash flow currently.

Therefore, it appears as though the new contract will increase the company's cash flow by roughly 25.9 million per year. As of the company's most recent quarterly report, Seadrill had 469,129,874 shares outstanding. The per share incremental cash flow from this new contract is thus $0.055 per share.

In previous articles, I have discussed the strengthening market for the shallow-water offshore environment. This largely parallels the similarly strengthening ultra-deepwater market environment but the shallow-water market recovery following the industry downcycle of 2008-2010 began much later. However, this contract proves that there is strength in the shallow-water market.

First, this contract is somewhat longer than is normal for benign-environment jack-ups. Only a few years ago, contract lengths were typically under one year. Seadrill itself notes this, stating in its quarterly report,

"There is a clear trend that jack-up contracts are signed earlier and have longer terms than they had a year ago. We have seen several contracts in the market executed with contract duration between three and seven years."

This contract is for thirty months so it is clearly not three years. However, the contract also gives the customers an option to extend the contract for an additional six months. If exercised, this would make this a three-year contract, just the type that Seadrill's management says is becoming more common in the market.

Second, the dayrate on this contract is significantly higher than most benign environment jack-ups. Other than this new contract, AOD I, AOD II, and AOD III have the highest dayrates out of any benign environment rig in Seadrill's fleet. These three rigs have dayrates of $180,000 for three years and then the customer has an option to extend the contract for another year at a dayrate of $205,000. All three of these rigs are identical in this regard but the contracts have different effective dates. However, none of the $200,000+ dayrates take effect until 2016. This one clearly begins earlier. This contract also carries a much higher dayrate than the three Asia Offshore Drilling jack-ups.

This all points to a tightening supply-demand for jack-up rigs. Due to this, oil and gas companies are willing to pay more money for and commit to longer periods of time than before to secure the rigs that they require for their shallow-water development goals.

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.