Getting Rigged Up For Deep Sea Dividends

| About: Seadrill Limited (SDRL)

It's not uncommon for oil companies to pay dividends. Most of the big names do…

Like Exxon Mobil's (NYSE:XOM) 2.66% yield, Chevron's (NYSE:CVX) 3.14% andPetroChina's (NYSE:PTR) 3.39%.

Big names, maybe, but those yields are little better than middling.

Always on the search for high (but safe) yields, I uncovered one driller that's large, aggressively expanding, and sharing the bounty to the tune of an 8.17% annualized yield.

But, as always, high yields raise red flags.

Let's take a look at Seadrill (NYSE:SDRL) to see if its hefty payouts can stand the test of time…

Expanding the Fleet

Seadrill is a big player in the ultra-deepwater drilling business, owning more rigs of this kind than any company except Transocean (NYSE:RIG).

Its fleet is one of the newest, most advanced in the world, and it's expanding.

Demand for energy is anything but slowing. And while we're not running out of oil by any means, it's getting increasingly harder to find nearer the ocean's surface.

In other words, drilling companies have to drill deeper, and produce more rigs capable of doing so.

To meet this need, Seadrill has grown its fleet quickly, from 11 rigs in 2005 to 33 rigs in early 2013. At present, 19 more are under construction, with an announcement that the company ordered four additional ultra-deepwater rigs for delivery in 2015 at a cost of about $2.4 billion.

This is typical for Seadrill, which has a highly leveraged balance sheet and has been aggressive in the past with its expansion activities.

And it has a board chairman with a history of pushing such aggressive, leveraged expansion…

Seadrill's biggest shareholder and board chair, John Fredriksen, is also the billionaire behind Frontline (NYSE:FRO), an oil tanker that followed, under his direction, much of the same strategies that Seadrill currently follows.

Also like Frontline, Seadrill has a large dividend payout… For now, at least.

Dividend At Sea Risk

When a company gets weighed down under too much debt, the dividend can start looking shaky.

You see, Seadrill has grown so quickly because, unlike some competitors, it attempts to get the cash flow out of its rigs up front, rather than over the rigs' 30- to 40-year lifespan.

Instead of using cash flow from its existing fleet, the company uses debt to build the rigs along with sales and leaseback agreements to generate cash immediately.

But financing this way can be risky.

The debt is secured by its fleet, which means Seadrill would be forced to sell rigs if it needed cash to pay down debt. And such assets are hardly liquid.

In other words, before any sale signs go up on the company's rigs - which would be a drastic measure - the dividend would get cut first in order to free up cash flow.

And with a dividend payout ratio of a whopping 149%, this is less than a hypothetical situation and more of a looming danger.

To make matters shakier still, Seadrill has only been paying the dividend for three years, which isn't much history to go on.

Bottom line: The whole dividend show could come to an end at Seadrill if the aggressive moves and leveraged balance sheet negatively affect earnings. Add to that a recent management shakeup, with the CEO resigning after less than one year at the helm, and that 8% yield starts to look like a trap.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.