On Monday, June 2, 2014, offshore drilling giant Seadrill (NYSE:SDRL) announced that it had secured a contract for the West Jupiter drilling rig. I briefly discussed this in an earlier article but believe that this development deserves a much more in depth analysis. I apologize for the delay in getting this analysis published but will hopefully be able to make this worth the wait.
The West Jupiter is an ultra-deepwater drillship using the Samsung SHI S12000 design, which is currently under construction at the Samsung Heavy Industries Shipyard in South Korea. This rig will, when completed, be one of the most capable rigs in Seadrill's fleet or in the world as a whole as it is capable of drilling wells up to 37,500 feet deep in up to 12,000 feet of water. Only the most capable ultra-deepwater drillships, such as those operated by Pacific Drilling (NYSE:PACD), have greater technical capabilities than the West Jupiter as some of those rigs are capable of drilling wells that are up to 40,000 feet deep. These high technical specifications should allow the West Jupiter to command a higher dayrate than older, less capable rigs and the contract that the rig was awarded proves this assumption to be correct.
The contract that was awarded to the West Jupiter calls for French oil major Total (NYSE:TOT) to pay Seadrill a total of $1.1 billion over a five-year period to use the rig. This works out to be approximately $602,700 per day over the contract duration. This is the amount that this rig's new contract will add to Seadrill's revenues each and every day that it operates. However, it is important to note that this figure is not entirely dayrate. This is because the $1.1 billion contract total includes the mobilization fee, which is merely a reimbursement of the costs that Seadrill will incur in moving the rig to its contractually-assigned location. Thus, the mobilization fee does not truly represent new money coming into the company that it did not have before in the same way that dayrate does. Unfortunately, Seadrill did not state how much of that $1.1 billion is the mobilization fee so we cannot make a definitive statement regarding the rig's dayrate at this time. However, we can come up with an estimate of the dayrate by looking at other contracts in which a drillship was moved from South Korea to Nigeria, as is the case here.
On July 19, 2013, Seadrill announced that it had secured a contract valued at $150 million for six months of operation for the West Tellus drillship. Admittedly, the $150 million total also included the mobilization fee. However, in this case, Seadrill disclosed the dayrate for the rig. According to the company's fleet status report, the West Tellus travelled from South Korea where it was constructed to China and worked for approximately two to three months and was then moved to the West African nation of Liberia where it works today. The total contract value spread out over the 180-day contract term works out to a total contract revenue of $833,000 per day. However, the rig's dayrate was $610,000 while it was working in China and $635,000 in Liberia. The difference between the contract revenue and the dayrate is the total of the mobilization fee and any performance bonus. Unfortunately, we have no way of knowing what the performance bonus was so there is no way to calculate exactly what the mobilization fee was. We can make some assumptions though in order to derive an estimate. Here are the assumptions that will be made:
- The rig spent an equal amount of time in China and in Liberia.
- The rig received no performance bonus. Therefore, the entire difference between the calculated daily revenue and the actual dayrate is the mobilization fee.
As we are assuming that the rig is spending an equal portion of its time in China and in Liberia, we can average the two dayrates together to determine the average dayrate that the rig received over the contract term. This figure is $622,500. Thus, the mobilization fee appears to be the difference between this figure and the average daily contract revenue due to the second assumption. This figure is approximately $210,500 per day. If this figure is then extended out over the full term of the contract, we get a total mobilization fee of approximately $37.9 million.
We can assume that the mobilization fee for the West Jupiter is somewhat similar to this. The two contracts are not identical of course, so some factors that determine the cost of moving the rig will likely differ. First is that the West Tellus was moved from South Korea to China and then to West Africa. The West Jupiter is only being moved from South Korea to West Africa without the intermediate stop. Secondly, the final destination of the West Tellus was Liberia, not Nigeria as is the case with the West Jupiter. While both nations are located in West Africa, that does not mean that the costs of moving the rig to the country and getting it set up in the country's waters are the same or even similar. The two nations most likely have different regulations in place which will affect the company's costs one way or the other, either by increasing the costs of moving the rig to Nigeria versus Liberia or decreasing them. However, with all of that said, we are only looking for a rough estimate here and so the calculated approximately $40 million figure provides such an estimate.
If we assume that the mobilization fee is $40 million then this brings the total value of the West Jupiter's contract down to $1,060 million over five years excluding the mobilization fee. This gives the rig a dayrate of approximately $581,000. This is still respectable but it is nowhere near the $600,000 and greater dayrates that Seadrill was receiving throughout 2012 and 2013.
It is worth noting that despite the differences between dayrate and the mobilization fee, Seadrill still records the two as one item in its financial statements. Furthermore, it amortizes the mobilization fee over the contract term. Therefore, instead of reporting the estimated $40 million mobilization fee in one quarter, the company will spread it out over the entire five-year period and record $22,000 in revenue per day over the five-year contract term. Because of this, the difference between the mobilization fee and the dayrate are largely academic, but investors are still advised to be familiar with the distinction.
As investors, we need to be concerned with the effect that this rig's contract will have on the company's profitability. Fortunately, we can figure this out. In order to do so, we need to know how much it costs to operate the rig. Seadrill itself provides this figure in this chart from the company's presentation at the Credit Suisse 2013 Energy Summit:
As this chart shows, it costs Seadrill approximately $170,000 per day to operate a floating rig such as the West Jupiter. It is worth noting, however, that Seadrill has been using this same chart with only minor changes in various presentations that it has given over the past few years. Furthermore, the company has not used it at all in any presentation that it has given in the past year. Thus, it would be quite reasonable to ask if these figures are still accurate.
To determine this, we can look at the per rig operating costs of one of Seadrill's peer companies, Pacific Drilling. In a presentation to investors dated May 12, 2014, Pacific Drilling included a slide that showed its projected forward profitability. One of the assumptions that Pacific Drilling used in its model is that the latter company would incur total costs of $200,000 per day to operate one of its rigs. This figure is higher than Pacific Drilling's actual direct rig-related operating expenses, which were $183,800 in the first quarter. However, the reported direct rig-related operating expense does not include such costs as shore-based administrative support or services that are shared among all the company's rigs such as the costs of providing an information technology infrastructure. The costs of providing these services do not necessarily directly increase with the size of the company's fleet and are therefore not incremental costs. It does appear, though, that Pacific Drilling's $200,000 per day estimate included these costs. As Pacific Drilling's entire fleet consists of sixth-generation drillships like the West Jupiter, we can assume that Seadrill's costs of operating its rig will be comparable to Pacific Drilling's costs of operating one of its rigs. Thus, the incremental costs of operating West Jupiter are somewhere in the $170,000 to $200,000 per day range with the most reasonable estimate being in the middle of this range. Therefore, to estimate the incremental profitability of the West Jupiter's new contract, we will assume that it costs Seadrill $185,000 per day to operate this rig.
West Jupiter will thus generate a dayrate of approximately $581,000, total contract revenue of approximately $602,700, and will cost Seadrill approximately $185,000 for each and every day that it operates. This results in the rig generating total pre-tax cash flow of $396,000 per day if the mobilization fee is not included and $417,700 per day if the amortized revenue from the mobilization fee is included. It is important to keep in mind that this is pre-tax cash flow but Seadrill, like all companies, has to pay taxes. In order to determine the amount of taxes that the company must pay, we can refer to the chart provided above. In this chart, Seadrill states that its tax payments average 4% of revenues. Unlike in the case of operating expenses, this figure is in line with similar estimates provided by Seadrill's peers. This would be approximately $23,000 per day for every $581,000 that West Jupiter generates in dayrate. The figure would be just over $24,000 if the mobilization fee is included in revenue but as the chart above does not include the mobilization fee (only dayrate), I will not include it in the final calculation. Thus, after paying taxes, the West Jupiter should generate approximately $373,000 per day in cash flow for each and every day that it operates. This works out to approximately $33.9 million per quarter or $135.6 million per year. As the West Jupiter had no former contract, all of this represents new, incremental cash flow.
It is unlikely that West Jupiter will generate this much cash flow, however. This is because this projected cash flow figure assumes that the rig will not experience any downtime. In reality though, offshore drilling rigs are extremely sophisticated pieces of machinery that require regular maintenance to continue operating properly. This maintenance requires that the rig experience some amount of downtime for which it is not paid dayrate. Thus, in order to truly project the rig's cash flow, we need to predict how much downtime the West Jupiter is likely to have. There are two ways that we can do this. The first is by using the figure that Seadrill has historically used to project its rig downtime. In several previous contract announcements, Seadrill has stated or implied that it expects to achieve 97% of the theoretical maximum revenue from its rig contracts. This clearly assumes that the company expects its rigs to spend 3% of their time out of commission undergoing maintenance. Assuming that the West Jupiter will also spend 3% of its time out of commission undergoing maintenance and other repairs, then it will generate approximately $32.9 million per quarter or $131.6 million per year in cash flow.
The second way that we can estimate the rig's downtime is to use the uptime figures that the other rigs in Seadrill's fleet actually achieved and assume that the West Jupiter will achieve similar uptime. In the first quarter of 2014, Seadrill's floater fleet achieved 91% uptime but this was lower than normal due to operational problems and major repairs on three of its rigs. Excluding these three rigs, Seadrill's floater fleet achieved 95% uptime in the first quarter. If we assume that the West Jupiter will also achieve 95% uptime then it should generate approximately $32.2 million in cash flow per quarter or $128.8 million per year in incremental cash flow.
Disclosure: The author is long SDRL, PACD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.