Key Takeaways From Seadrill's Q1 FY16 Conference Call

| About: Seadrill Limited (SDRL)

Summary

Despite the ongoing oil price recovery, market conditions will remain weak for the foreseeable future.

Overcapacity will remain a huge problem for the time being.

Still no material details about the company's upcoming financial restructuring.

Shareholders are facing very material dilution.

Higher oil prices might help Seadrill to negotiate better terms.

Seadrill (NYSE:SDRL) today released its Q1/FY16 results which came in largely in line with expectations. The company benefited from cost cutting initiatives and strong operating efficiency, but Seadrill's backlog actually continues to melt down fast, down another 15% quarter over quarter to just $4.3 bln. For the Seadrill Group including consolidated entities like for example Sevan Drilling or North Atlantic Drilling (NYSE:NADL) and unconsolidated companies like Seadrill Partners (NYSE:SDLP) and Seamex, the backlog number was $9.1 bln, also down roughly 15% from the preceding quarter.

With the market for offshore exploration projected to remain in the doldrums for the foreseeable future, backlog will decrease further going forward and the number of idle rigs will continue to go up.

Unfortunately management had very little to offer for its badly stricken shareholders with regard to some potential light on the horizon as things are still getting worse in the industry as evidenced by the latest slew of contract cancellations that hit the industry over the last few months.

The company's commentary on the short and medium term market outlook actually reads almost as discouraging as it could be:

The offshore drilling market remains challenging. Despite the increase in oil prices from the 12 year low of $27 per barrel during the first quarter, prices remain 60% below their 2014 highs. Short term supply disruptions have had effects on the oil price, indicating the market is closer to a supply demand balance than it has been for some time.

Focus from our customers remains on "balancing the books" in 2016 and 2017 with respect to revenue and planned expenditures.

Major oil companies continue to cut activity levels for 2016 and 2017 and appear to have more rig capacity already under contract than they require, severely affecting new demand and leading to contract renegotiations and terminations. New fixtures continue to be primarily extensions, often blend and extend agreements. A more sustained period of recovery and price stability is needed before we expect to see increased demand from oil companies.

During the conference call, management openly admitted to the very real threat of even more contract cancellations by customers going forward, as most major oil companies are still looking to downsize their offshore exploration exposure.

Of course management also repeated its usual "we are optimistic about the longer term outlook" language, so investors with strong stamina might find some comfort in the following remarks from the conference call:

While the market will remain challenging, there are some leading indicators that leave us optimistic in the longer term. First, there is a growing consensus that we will move towards an oil production supply demand balance late in 2016 or early in 2017, a sentiment that is supported by the fact that short-term supply disruptions are having on commodity prices. Second, the significant and sustained cost in drilling activity during this downturn are having an effect both in terms of increased decline levels in existing fields and delays in new production both online. Ultimately these will need to be overcome to increase drilling in the future.

And lastly, the sustained downturn continues to encourage the cold stacking and scrapping activity that will be needed to rebalance the drilling market.

With regard to required scrapping activities, management actually stated that another 40 floaters will have to be retired in order to move this market segment back into balance, a number that seems impossible to achieve in my view given that the task of scrapping more rigs would actually be on the company's competitors which already retired close to 60 units since 2014. Given that a rig can be cold stacked these days at very low costs, often materially below $10,000 per day, there's very little incentive for Seadrill's peers to give up on major earnings potential by committing to further material scrapping activities. While there will be some more rigs leaving the fleet going forward, the number will be nowhere close to the requirement of 40 floaters stated by Seadrill's management.

With marketed utilization in the floater fleet currently at 56% compared to 60% for the jack-up fleet, it will be a long way for both segments to regain at least some pricing power, given that historical evidence indicates a requirement for utilization levels to approach 90% in order to cause any movement in dayrates. Over the course of 2016 utilization rates are actually expected to come down even further with some hope for stabilization at all-time low levels in 2017 and a potential increase in 2018. Remember that an increase in utilization levels is not expected have a positive effect on dayrates until the oversupplied state of the market abates which could take several more years to materialize.

Overall the recent rally in oil prices has done very little for the offshore drilling industry so far and is moreover not expected to meaningfully improve business conditions short or even medium-term.

Given the issues stated above, shares of major offshore drilling companies like Transocean (NYSE:RIG), Noble Corp. (NYSE:NE) or Ensco (NYSE:ESV) have materially underperformed when compared to the recent increase in oil prices, while more speculative names like Atwood Oceanics (NYSE:ATW) and particularly Ocean Rig (NASDAQ:ORIG) have recovered more strongly from the lows set earlier in the year - on the other hand the shares of these companies had previously dropped much more severe compared to their large cap peers.

On a more anecdotal note, Seadrill's CEO, like most of his peers, also commented negatively on the recent $65 mln purchase of the drillship "Cerrado" by Ocean Rig, as reported by Bloomberg:

"A rig like this, that hasn't worked for a year, that's had different owners, it would probably be very hard to justify to pay more than was paid for it -- and it was probably too much, to be honest," Wullf said. "When you look at stacking cost, classing, reactivation, financing and all that stuff, then I'd rather take a distressed asset from a shipyard."

"In the current market, the asset represents a pure liability."

That said, let's now turn to the all-important topic for Seadrill's shareholders, the company's upcoming comprehensive financial restructuring:

Unfortunately the conference call did not provide any material new information with this regard. Management tried to assure investors and analysts that things are all going according to plan so far and moreover cautioned to view the recent small debt-for-equity exchange as kind of a blueprint for the upcoming restructuring:

Mark Morris (NASDAQ:CFO):

Yes, I mean we are on the schedule. (..) Originally, we said that we would communicate our plans by the mid-year which we're also ahead of that. I think we have indicated that we would actually conclude everything by the mid-year. So our plan though has been to try within 2016 to conclude everything and you're right, although I mean look there are a number of moving pieces here in terms of looking at the -- dealing with the banks first and then the bondholders and obviously, when we think about the recapitalization piece, any new money we may be considering. In respect of the recent private exchange, I mean again, it is what it was a private exchange, it's more of a tactical move, we've approached by a particular bond holder who had expressed some interest on the basis that we thought an exchange made sense. It was done undertaking under a 3(a)(9) basis. Is it a fundamental of our refinancing plans? No. Is it tactical and opportunistic? Yes.

And so I think that sort of covers that piece. Where we are at the moment, look there are a number of milestones set out, we are currently in discussions with our banking group and when we've concluded those, we'll obviously and have got agreement of lot to be conditioned on the other two parts of the system happening, we will then move on to the other pieces. But we're currently in discussions with them and when we thought of our position, something that we can announce, we will of course bring that back to marketing, keep you informed.

At least CEO Peter Wulff had something to add in a phone interview with Bloomberg:

The plan has entered its second phase with full backing from the board, led by Fredriksen, and should be finalized by the end of the year, the CEO said. Analysts from banks including Nordea AB and DNB ASA have estimated the final agreement will include at least $1 billion in new equity.

"Our package of course includes some new capital in some form," Wullf said. "The analysts have guessed pretty well" on the scope of the capital need, he said, declining to provide more specifics.

I already outlined potential restructuring scenarios in previous articles, so interested investors might want to take a closer look.

Moreover, when looking at the majority of the comments on recent articles published on Seeking Alpha discussing the more volatile and fundamentally weaker names like Seadrill and Ocean Rig it looks quite clear, that the downfall of the offshore drilling industry over the last 18 months has caused a considerable turnover in the shareholder base of some companies as many institutional, yield orientated investors have exited their holdings with seemingly mostly unsophisticated retail investors in combination with traders and some aggressive hedge funds having taken their place.

So with regards to Seadrill, judging by their comments, many investors obviously haven't even taken notice of the looming financial restructuring or at least have no idea of the potential implications for the company's equity and share price.

The restructuring will actually require major concessions by the creditors currently ranking the highest in the company's capital structure - the banks. Moreover Seadrill's largest shareholder, Norwegian-born shipping tycoon John Fredriksen, is expected to provide material additional support in form of a large cash injection or at least by successfully addressing the company's outstanding bonds and subsequently convert them into equity.

So with both banks and bondholders being forced to relinquish some of their claims, a positive outcome for the equityholders, who are actually the very last in line in the company's capital structure, looks highly unlikely at this point.

Major dilution will be almost a given with John Fredriksen actually being incentivized to convert debt or purchase new shares at the lowest possible price in order to maximize his stake in the restructured company.

That said, I don't expect current shareholders to be entirely wiped out at the end of the day (although still a possibility) but to suffer very material dilution of up to 90% going forward.

Bottom line:

Almost regardless of a potential further recovery in oil prices, industry conditions are still expected to get worse before eventually getting better at some point going forward. Seadrill management did not try to sugarcoat the issue on the conference call.

At least stronger oil prices might help the company to negotiate more favorable terms for its upcoming comprehensive financial restructuring but given the unquestionable requirement of major concessions by both the company's banks and bondholders, Seadrill's already badly stricken shareholders will most likely have to pay the price here given their ranking at the very low end of the company's capital structure.

Until then I continue to expect Seadrill's stock to trade as an option on oil prices for the time being - as already witnessed for quite some time now. Alongside most of their peers, the shares will predominantly serve as a playground for traders and speculative retail investors for the foreseeable future.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.