And yet I remain optimistic. The shares have fluctuated mightily with the price of oil, but are down more than 30% from their highs of last winter, when enthusiasm for this John Fredriksen project was just hitting its peak as SeaDrill dramatically increased its size by winning a takeover battle for Smedvig. Oil and rig rates have not gone any lower since then, at least in broad terms, but the market optimism has certainly declined, especially in Oslo, where SeaDrill trades.
The case for SeaDrill continues to be made by investment banks. I wrote a while back about UBS and their upgrade of SeaDrill, an upgrade partly focused on the point that SeaDrill may be able to return up to 8.5 billion to shareholders over the next six years.
And a few days ago another bank, Merrill Lynch, reiterated their upgrade for these shares. The analyst's argument focuses on what makes SeaDrill (SDRL) unique: That they will have a huge portion of their high-quality rig fleet available to sign contracts during what is expected to be a long period of climbing rig rates over the next three years. Fully half of SeaDrill's fleet is not yet contracted for 2008, and I expect we'll see lucrative deals for those units in fairly short order.
Merrill puts the compound annual growth rate for earnings at 127% from 2006 to 2009 based on these assumptions, and estimates that the shares are trading at a 2009 PE ratio of 3.9. I know it's pretty ridiculous to go out that far on earnings estimates, but the trend in rig rates is fairly clear and the shipyards are pretty much all booked through 2009, so any new rigs that will hit the water between now and then are accounted for.
That pretty closely mirrors the argument I've made in favor of SeaDrill shares over the past six months, though unlike UBS, Merrill didn't make a point of emphasizing the tendency of Fredriksen-owned companies to return cash to shareholders (himself included) with generous dividends. I continue to think that there is great potential in SeaDrill's ability to sell their rigs on long term lease-back deals, as they did in what seemed to be an exploratory move with Ship Finance Limited (another Fredriksen company) just last month.
The general strategy for Frontline (FRO) has been to take high-cost assets and sell them off to investors (Ship Finance Ltd), with very long term leases back to the operating company (Frontline) that provide very low lease rates relative to current market rates and a profit-sharing kicker for the investors. That enables Frontline to turn a profit as long as tanker rates remain above a certain level, without having all their cash tied up in owning these extraordinarily expensive ships. The investment company gets a steady return on their investment, the potential for profit sharing, and the ability to depreciate these expensive assets.
That strategy has every chance of working with SeaDrill, I continue to think. It's a similar business, with very expensive long-lived assets that are in high demand currently but have volatile rates of return.
And if Fredriksen and Tor Olav Troim can apply the financial engineering to the rig industry with SeaDrill that worked so well in the tanker business with Frontline, I expect to enjoy a nice ride on their newest wealth-creation vehicle.
This is my largest single individual stock holding, and it's also the one I might need to be most patient with, as I wait for their newbuildings to hit the water between now and 2009 and start earning the extraordinary day rates that I expect them to continue to command. Until then, the PE ratio is not going to be any great shakes, but the prognosis for patient investors looks very good to me.