Seadrill's Blend And Extend West Tellus Contract Costs Company +/- $90 Million In Gross Margin

| About: Seadrill Limited (SDRL)

Summary

SDRL extended the West Tellus contract 18 months.

By accepting a lower day rate ($300,000 vs. $497,000) over a longer term, SDRL nets the same revenue and earns about $90 million less in margin.

While not a good deal for SDRL, the alternative of Petrobras canceling contracts would have been worse.

On March 23, Seadrill (NYSE:SDRL)announced what it bravely called a "contract extension" for its drillship, the West Tellus. Some commentators thought the deal good news, while the market demurred, sending SDRL down almost 10%.

The new deal, whose counterparty is the beleaguered Brazilian firm Petrobras, extends the term of the contract from April 2018 to October 2019. However, the day rate, retroactive to February 26, is reduced from a profitable $497,000 to $300,000. While some celebrate the extension as a win-win "blend and extend" deal, further analysis shows the deal will not create any incremental revenue. In fact, precious cash will be delayed, negatively impacting SDRL's revenue (and by extension, cash flow).

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As SDRL's costs will not change, the company will have to spend about $100 million more to earn essentially the same revenue.

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The logical extension of the same revenue (over a longer period of time) with higher costs is a deterioration in gross margin (percent and dollars).

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So why would SDRL agree to a "bad" deal? The only logical conclusion is SDRL sacrificed $90 million of gross profit (including about $70 million in 2016) to maintain contracts on the West Carina ($484,000 day rate through May 2018) and Sevan Brasil ($424,000 day rate through July 2018). Petrobras has been playing hardball with its drilling "partners" and SDRL likely did not have the stomach for a fight nor want to risk cancellation of multiple (still) lucrative contracts.

Upon final analysis, the announcement of the West Tellus "extension" is certainly not good news. However, put in context, one can understand the logic and gamesmanship that is going on in the industry and the reason SDRL management would consent to a "bad deal." As any driller contracted with Saudi Aramco will tell you, the same game is being played (though with different moves) throughout the industry.

I continue to hold a stake in SDRL, more as a call option on the industry than as a "traditional" investment.

Disclosure: I am/we are 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.