Seadrill's Pemex Contract Increases Financial Flexibility Going Forward

| About: Seadrill Limited (SDRL)

Last week, I published an article on Seeking Alpha entitled, "Seadrill Appears Able To Sustain Its Dividend As Long As Industry Weakness Is Short Term". I must admit, my timing with the release of this article was especially bad. In this piece, I expressed concerns about the fact that Seadrill (NYSE:SDRL) had seven jack-up rigs listed in its fleet status report whose contracts were scheduled to expire in 2014 with no replacement contracts. A few hours after this article was published, Seadrill announced that it has secured five new jack-up contracts with Mexico's Pemex. Admittedly, this deal could alleviate many of the concerns that I expressed in that article. However, the situations is complicated somewhat by the fact that Seadrill will be selling each of the five rigs that have secured contracts to a joint venture in which Seadrill will have a 50% stake.

First, allow me to take a few minutes to discuss the terms of this deal. Pemex has awarded contracts to four of Seadrill's jack-up rigs. These four rigs are West Oberon, West Intrepid, West Defender, and West Courageous. Each of these contracts is for a firm term of approximately six years over which time each of the four rigs will generate approximately $360 million. This works out to a dayrate of roughly $164,380. This dayrate is relatively in line with the dayrates that similar jack-up fixtures have received over the past year. I will discuss more about what this may mean later in this article. Additionally, a fifth rig owned by Seadrill, Prospector 3 (now renamed West Titania), was also mentioned in the contract announcement. This rig has a similar contract outstanding that is currently being processed for approval. Once this contract is awarded, which is expected to happen in the second quarter, West Titania will have a similar contract to the other four rigs which have already been awarded contracts. In my previous article, the West Titania was one rig that I singled out as a concern because its construction is scheduled to be completed in the first quarter of 2014 but it had not secured a contract at that time. Therefore, the awarding of this contract is very encouraging and completely removes this concern.

One of the biggest concerns that investors in the offshore drilling industry have had in recent months has been the slowdown of contracting activity. This has altered the industry's supply-demand dynamic from one in which there were insufficient rigs available to meet the demands of exploration and production companies to one in which the supply of rigs is adequate to meet the demands of their customers. This has resulted in some dayrate pressure, at least in the eyes of industry analysts, because oil companies no longer need to aggressively bid against each other in order to secure the services of the rigs that they need. However, as I discussed in a two article series published in December (part one and part two links), not all rigs are equivalent. Despite what analysts say, the slowdown has affected the low end of the market much more strongly than the market for modern, high-specification rigs like the ones that Seadrill operates. This deal with Pemex provides proof of that. At an average dayrate of $164,000 per day, the dayrates on these five contracts are not significantly lower than the dayrates that Seadrill was receiving for similar rig contracts during the offshore drilling boom. This is a very good sign as lower dayrates would likely mean lower cash flow and significant reductions in cash flow could begin to put pressure on Seadrill's ability to pay its dividend.

This deal has reduced the number of jack-ups that Seadrill owns that do not have replacement contracts to start work on once their current ones expire this year. According to the company's most recent fleet status report, Seadrill has six jack-ups that are coming off of their current contracts in 2014 but do not have a replacement contract. These six rigs are the West Telesto, West Prospero, West Vigilant, West Ariel, West Cressida, and West Tucana.

Rig Contract Start Contract End Dayrate
West Telesto December 2013 October 2014 $156,975
West Prospero July 2013 March 2014 $170,000
West Vigilant November 2013 November 2014 $167,000
West Ariel July 2013 March 2014 $170,000
West Cressida November 2010 August 2014 $129,500
West Tucana September 2013 October 2014 $167,000

Two of these rigs will see their contracts expire in March so it is especially important for Seadrill to secure new contracts for these rigs relatively quickly in order to avoid the loss of cash flow from them that will occur when the rigs' current contracts end. These two rigs are the West Prospero and the West Ariel. Fortunately, it does appear that Seadrill can afford to carry these two rigs should their contracts expire without new ones being secured. However, the preferable situation would certainly be the announcement of new contracts for these rigs. Seadrill did not mention either of these rigs in either its fourth quarter results announcement or its fourth quarter conference call, but I am confident that the company is actively working to secure replacement contracts for these rigs so hopefully any resulting idle time will be kept to a minimum.

One of the interesting things about this deal with Pemex and one thing which all investors should keep in mind is that Seadrill will not be receiving the full amount of either revenues or cash flows from any of the five rigs included in the deal. However, it will also not be incurring all of the costs of operating them. This is because Seadrill will be selling all five of these rigs to a company called SeaMex Ltd. which will be the company that receives all of the rigs' revenues and cash flows. SeaMex Ltd. is a joint venture between Seadrill and Fintech Advisory, an investment management firm, in which each company owns a 50% stake in SeaMex. Therefore, Seadrill will presumably be receiving half of the cash flow that the five jack-up rigs generate. So, how much would this be?

Seadrill has been including a chart in many of its industry presentations that shows the economics of both jack-ups and ultra-deepwater floating rigs and the costs of operating each. Long-time readers may remember this chart as I have referred to it several times in the past.

Source: Seadrill

As the chart shows, it costs Seadrill approximately $60,000 per day to operate one jack-up rig. However, Seadrill has been providing the same operating expense estimate for nearly two years. Therefore, it stands to reason that the company's costs have actually increased somewhat over that period due to inflation as well as wage inflation resulting from a shortage of skilled rig crews. For the sake of being conservative, I will increase this cost figure by 6% to account for two years of these cost pressures. I freely confess though that this cost estimate is probably too high. This estimate would bring the costs of each rig to $63,600 per day assuming that SeaMex incurs roughly the same costs that Seadrill does (and there is no reason to assume that it would not). Therefore, SeaMex would produce roughly $100,400 per day of pre-tax cash flow from each of these two jack-ups.

Seadrill states in the chart above that its tax expenses are approximately 4% of revenue. There is no reason to doubt Seadrill on this figure as other offshore drilling companies, such as Pacific Drilling (NYSE:PACD), have provided similar estimates for their own tax expenses. Therefore, SeaMex would have a tax expense of approximately $4,016 per day per rig. This would result in an after-tax cash flow of approximately $96,400 per day per rig to SeaMex.

Presumably, SeaMex will pay out all of its cash flow to its owners in the form of dividends. This would result in Seadrill receiving its proportionate share of approximately $48,200 per day per rig. Admittedly, this is much less than the company would earn if it owned the rigs outright. However, Seadrill will receive approximately $488 million for giving up the claim to half of the cash flow generated by the five rigs. This will result in the company recording a gain on sale in the first half of 2014. This $488 million will also improve the company's financial flexibility.

Seadrill has a large number of new rigs that are scheduled to leave the shipyard in 2014. This improved financial flexibility could certainly come in handy considering this. This is because of the way these rigs are being financed. When Seadrill first began the construction of one of these rigs, the company paid the shipyard that is constructing the rig 20% of the construction cost of the rig. The remaining 80% of the construction cost is due when the rig is delivered. Given the cost of constructing an ultra-deepwater or jack-up rig, this remaining 80% balance due on all the company's new rigs represents a significant financial commitment that will cost Seadrill a great deal of money this year. This $488 million, while not enough on its own to match this commitment, will improve the company's ability to meet this expense without needing to take on more debt to cover the balance due on all of these new rigs.

Disclosure: I am long SDRL, PACD. 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.

Additional disclosure: I am short call options on SDRL.

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