Analyzing The Impact Of The West Sirius Rig Cancellation

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Includes: BP, PACD, SDLP, SDRL
by: Power Hedge

Summary

The troubled offshore drilling sector has begun to see the cancellation of already operating rigs as BP cancels its contract for West Sirius.

The contracts that are used for offshore drilling rigs include significant protection for the drilling company including significant contract termination fees.

Seadrill Partners will be cold-stacking the rig, reducing costs.

The impact on both Seadrill's and Seadrill Partners' cash flows from this development should be negligible.

If this represents the first of further rig cancellations then the sector will see further pressure.

Late last night, I was laying in bed when my phone alerted me via the Seeking Alpha app that BP (NYSE:BP) had unilaterally cancelled the contract for the already operating West Sirius ultra-deepwater rig. The cancellation of such a contract is a very rare event, as such contracts typically require the exploration and production company to pay a termination fee to the offshore contractor as well as comply with various other provisions to protect the contract against the adverse effects of such an event. Now that this contract has been cancelled, we may be seeing the industry weaken further. However, the impact on the rig's owners Seadrill (NYSE:SDRL) and Seadrill Partners (NYSE:SDLP) will not be as great as many fear.

The West Sirius is a 2008-built semisubmersible drilling rig that is capable of drilling wells up to 37,500 ft. deep in up to 10,000 ft. of water. These specifications make the rig one of the most sophisticated and technically capable drilling rigs in the world, although it is still not as capable as the most advanced units owned by companies such as Pacific Drilling (NYSE:PACD). The West Sirius was originally constructed by Seadrill but was sold to Seadrill Capricorn Holdings LLC, a unit of Seadrill Partners, in December 2013. This transaction is important for reasons that will be discussed later.

Prior to the announcement of this contract cancellation, West Sirius was earning a dayrate of $535,000 per day. However, during the discussions over the cancellation of this contract, BP agreed to swap the contract terms for the West Capricorn and West Sirius. This effectively raised the dayrate of the West Capricorn to $535,000 ad reduced the dayrate of the West Sirius to $495,000. Thus, the amount of revenue that Seadrill Capricorn Holdings will lose once this rig stops operating is $495,000 per day, not $535,000. This cessation of operations will come when the rig completes drilling the well that it is currently drilling and demobilizes. This is expected to occur in May 2015.

The West Sirius has a complicated ownership structure that will directly impact how the cash flows from the rig will be affected by the cancellation of the rig's contract. The West Sirius rig is owned by a pass-through entity known as Seadrill Capricorn Holdings, LLC. This company is jointly owned by Seadrill Partners and Seadrill Ltd., with the latter entity owning 49% of the LLC and the former owning 51%. Thus, we can assume that Seadrill Partners owns 51% of the cash flow generated by West Sirius while Seadrill itself owns 49%.

So what exactly are the cash flows from West Sirius? Seadrill provides some insight into this in a recent presentation. In Seadrill's presentation at the Howard Weil Energy Conference held on March 25, 2015, the company provided this chart that shows all of the operational costs that it incurs in operating a typical floating rig:

Source: Seadrill Ltd.

As this chart shows, a typical floating rig has total operational costs, including debt repayment expenses, of $365,000 per day. If we then assume that West Sirius is a typical floating rig, then we can also assume that these would be the operational costs of that rig. Therefore, at a dayrate of $495,000, West Sirius will be generating total cash flows of $130,000 per day until the contract terminates in May. This works out to approximately $11.7 million per quarter, approximately 51% of which would belong to Seadrill Partners and 49% of which belongs to Seadrill.

However, Seadrill Partners will be cold-stacking West Sirius upon the termination of the contract. When an offshore drilling contractor cold-stacks a rig, it means that the company has shut down the rig and has put it into storage, usually a harbor, shipyard, or similar location. This is a cost reduction strategy that a company undertakes when it does not expect to be able to obtain a new contract for a rig for an extended period of time. Because of this, the company does not need to retain a crew or support personnel for the rig, reducing costs. Of course, other costs such as debt repayments remain.

As already mentioned and as I discussed in a recent article, when contracts are terminated early, the oil company is charged an early termination fee. This is also true in the case of BP's contract for West Sirius. Seadrill Partners did not disclose exactly what the early termination fee is. However, such fees are usually a set percentage of the remaining contract backlog as well as the oil company is expected to reimburse the offshore contractor for the costs of moving the rig to the location where it will be cold-stacked and shutting it down. In this case, the termination fee is somewhat significant as, when combined with the cost reductions due to the cold stacking of West Sirius, Seadrill Partners expects its cash flow to remain the same as it would have had if the rig remained operational until the end of its contract.

The market and the news media portrayed the cancellation of this contract as a negative development for Seadrill itself. However, in isolation this is unlikely to be the case. As already mentioned, due to the cold stacking of the rig and BP's payment of the termination fee, the impact on Seadrill Capricorn Holdings' cash flow over the remaining contract term will be minimal. In addition, Seadrill Capricorn's results are consolidated into Seadrill Partners' results. Seadrill itself does not consolidate the results of either Seadrill Partners or Seadrill Capricorn Holdings. Thus, the actual impact on Seadrill's finances will be negligible. The more significant concern is that this contract cancellation could be the first of more and, despite the inherent protections for the drilling companies in these contracts, should cancellations begin en masse, then companies in the industry could begin to see financial pressure.

It is interesting to note that as a part of this contract cancellation, BP also extended the contract term on West Capricorn. This is a positive development as it effectively locks in the money and cash flows generated by that rig's now higher dayrate of $535,000 until July 2019. Of course, this is only true if BP decides that it does not need to reduce its expenditures further and cancels that contract as well.

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.

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