The undervalued stock of Seadrill Ltd, an offshore drilling contractor, is currently trading at its 1-year low (see graph below) creating an opportunity for investment.
Capital spending cuts by oil companies are likely to be short-term, but now the outlook of oil drilling companies is dark.
Outlook of oil demand, prices, and ultra-deep water oil production is positive for the coming years after the current short-term weakness.
Seadrill's (NYSE:SDRL) 1-year low has made the stock undervalued based on its TTM P/E of 6.8× in comparison to the industry average TTM P/E of 12.1×. In this article, I will determine whether or not the stock is a good buying opportunity at its current price level and explore what has caused the stock to decline to cheaper price levels.
Let us begin with a discussion on the reasons behind the sell-off of the company's stock.
What has caused the Stock to Decline So Far?
Weak Outlook for the Drilling Industry & Oil Companies' Capital Spending Cuts
The cuts in the capital spending plans of major oil companies have made investors wary of oil drilling companies. However, investors are failing to determine the reasons behind these spending cut announcements and the fact that they are not likely to last in the long run.
Higher levels of capital spending by energy companies due to the shale boom in North America during the past four years has caused shareholders to pressure energy companies to pay more in cash returns rather than capital spending. This is a cyclical pattern, and energy companies are now focusing more on achieving higher efficiency for existing operations and preserve cash flows. Additionally, there is another factor that investors regard as a driver of the decline in capital spending by oil companies, and that is the future decline in oil prices. Here, I would disagree with the investors because, as you can see from the following chart, the demand and price forecast for oil in the coming years will rise.
According to the International Energy Agency, the demand for oil will be higher in 2014 in comparison to previous estimates, as global economic growth will recover. The global oil consumption will rise by 1.4 million barrels/day or 1.5% to a record 92.7 million barrels/day or around 95,000 barrels/day more than what was forecasted last month. Seadrill's management is also optimistic concerning the long-term growth fundamentals of oil demand and prices. With the demand and prices favorable, the energy companies need to increase drilling activities and supply more to cater to the growing demand.
Additionally, it is projected that ultra-deep water oil production will rise from its present number of 1 million barrels/day to around 5 million barrels/day in the next 6 years. I will discuss how this factor will benefit Seadrill in the next heading.
I agree that the impact of this cut in capital spending by energy companies, though short-term in my opinion, is likely to have an impact on the average day rate that oil companies pay for deep-water rigs (rigs that dig down to depths of more than 4,000ft). The pay rate is now an average of $500,000/day. Even though the rates have not yet fallen, in case they do, Seadrill is in a better position to bargain due to the updated products and services it provides to its customers.
High Tech Rigs are the Company's Strength
Seadrill is in a better position than its peers because of its total floater utilization rates (see graph below).
Source: Credit Suisse 2014 Energy Summit
This is due to the company's younger and more diversified fleet. The following chart compares Seadrill's average floater age to its competitors.
Source: Credit Suisse 2014 Energy Summit
This provides the company an edge over its competitors as customers now demand better performance and safety from new equipment, and the proportion of more than 7500 feet water depth rigs has increased from 12% in operating water depth to 85% in new-build water depth.
Source: Credit Suisse 2014 Energy Summit
This reflects the fact that higher demand for ultra-deep water fleets counter the fear of an oversupply of rigs, and the companies with newer ultra-deep-water fleets will not be affected by the increasing supply of rigs in the sector due to the rise in demand for that specific category of equipment.
The company's fleet status report reflects that a majority of Seadrill's rigs are sixth-generation ultra-deep-water rigs that are capable of fetching the highest day rates. The demand for these rigs will stay high even if the supply of overall rigs rises in the coming years.
Another factor that supports the high demand for ultra-deep-water rigs is the fact that the oil and gas companies are more apprehensive about the environmental risks that can result in legal proceedings and heavy penalties for the companies involved. The Macondo disaster in 2010 triggered a larger demand for safer rigs. Accordingly, these companies are prepared to pay higher day rates for the younger and safer rigs. Seadrill has addressed this demand by borrowing to build the youngest fleet among its large-cap rivals, putting the company in a superior position. Therefore, even if the day rates around Seadrill begin dropping, Seadrill will still be able to obtain top-dollar contracts for rigs that will complete construction in the year 2014. This has strengthened the company's backlog and provided it with a competitive edge over its rivals.
Bringing in Strong Backlog
Seadrill has a $20.2B backlog and 98% of Seadrill's capacity has been booked for FY 2014, while 72% of its total capacity has been booked for FY 2015. This includes contracts for West Saturn and West Jupiter as commercial terms for the contracts have been established and break-up charges are agreed upon if the task fails to meet regulatory approval.
Beyond the year 2015, I believe there will be good business and growth opportunities as the offshore market is likely to recover from the present short term issues. The company's management has also pointed out a few projects that have been delayed to 2015 and 2016 as shown in the following table. Hence, the provision of services to complete those projects later on should support the company's top line.
The table above shows that the Gulf of Mexico has started attracting major offshore drilling projects. The company's opportunities in the Gulf of Mexico are discussed in the following paragraph.
Gulf Oil Boom
With forecasts of another Gulf Oil Boom once the activity in the Gulf of Mexico is projected to reach pre-Macondo levels, Seadrill Ltd is seen as a company with assets that make it well-positioned to take advantage of the possible opportunities.
The oil and gas activity in the Gulf of Mexico during the current year is predicted to reach levels seen before the Macondo well blowout incident. This means big news for rig companies, but the ones that actually have the ability to take advantage of this recovery are the ones that have the young and high-tech fleets like Seadrill.
The reason the Gulf will require more high-specification rigs is the fact that 91% of the most recent oil discoveries in the Gulf have been made in the deep-water regions, and there is little space to compromise environmental safety when drilling a well at water depths as low as 10,000 feet.
Currently, there are 58 rigs working in the Gulf of Mexico, and 17 new floaters are reserved to be delivered to the area until Q1 2015, reflecting the fact that the activity in the area will continue gaining strength. However, companies will ultimately be required to increase their capital expenditures in order to substitute depleting reserves.
For Seadrill, the current competitive edge of the company assures its future growth due to its technologically advanced fleet.
The Company's Debt Burden and Concluding Remarks
Additionally, investors are also concerned about the company's debt exposure in times of a potential fall in rig day rates. I have already addressed the concern of a possible decline in rig day rates in the discussion above and how the company will avoid being affected by it. So, here I would like to discuss how the company is putting effort into improving its liquidity and cash flow position.
Seadrill has taken actions to face the short-term slowdown in the sector. The company has delayed its own capital expenditures and turned its focus towards strengthening its own balance sheet. Seadrill is moving its assets to its subsidiary, Seadrill Partners (NYSE:SDLP), and the cash generated from these moves will be utilized to reduce the company's debt and increase its future dividends.
Since banks are more apprehensive about the company's ability to meet interest payments on loans in comparison to the loans themselves, the following chart illustrates the forecast of growth in the company's EBITDA for the coming years. This will enhance the company's ability to hold and reduce its debt burden.
Seadrill has projected a P/E ratio of 12 times, but it is presently much cheaper, and my analysis indicates that the negative impact is less than what the market has priced in the company's stock. Currently investors seem to be shorting their positions based on the expectation of declines in demand for drilling activities. In my opinion, when the stock is cheap and the company has strengths and opportunities to generate return for its investors, it is a good entry point for a long-term investor. The long-term prospects of the industry as well as Seadrill remain bright. The company has shown through its strong backlog that it has the ability to negotiate contracts for its new rigs in addition to possessing a strong bargaining position to have high day rates. The decline in capital expenditure of oil companies will soon be back to its previous levels or grow as oil demand and price fundamentals are strong for the coming years. Hence, long-term shareholders, or rather investors with patience, can see the current price levels are a good point to jump in.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.