Frankly speaking I had to go over Seadrill's (NYSE:SDRL) recent short news release regarding an 18-month contract extension for the drillship West Tellus several times until I came to the conclusion that there indeed were no printing errors involved.
The news has been already discussed by fellow contributors "Anthony Ruben" (negative) and "Fun Trading" (positive) but I think at this point it is imperative to provide some more color on this most recent "blend and extend"-deal and its far-ranging negative implications for the industry going forward.
So what happened ?
On Wednesday, Seadrill published a short press release stating the following:
Seadrill Limited ("SDRL" or "the Company") has been awarded an 18 month contract extension for the drillship West Tellus by Petroleo Brasileiro SA ("Petrobras"), commencing in April 2018 and securing work for the unit through the end of October 2019. The total backlog for the contract extension is approximately $164 million.
As part of the agreement to extend the West Tellus, the Company has agreed to a dayrate reduction on the current contract effective from February 26th, 2016, resulting in a $132 million reduction in backlog.
The net effect of this agreement is a $32 million increase in backlog.
So the company was able to secure 18 months of additional work for the West Tellus resulting in a slight net backlog increase of $32 mln.
In return the current contract dayrate of $467,000 was retroactively reduced to $300,000, effective from February, 26th, which still allows for a substantial cash contribution margin on an operating basis over the total life of the contract.
At first glance this doesn't look too bad given the current state of the industry, but investors need to take a closer look at this deal.
The crucial point here is the miniscule net backlog addition which looks far worse than previous "blend and extend" deals signed by Petrobras (NYSE:PBR) with various contractors. Netting out the backlog lost from the reduced dayrate and the backlog added by the 18-month extension Seadrill effectively agreed to the West Tellus, a modern 6th generation drillship, working for a dayrate below $60,000 with regard to the 18-month extension term. Investors should notice that the daily cash operating costs for a drillship of this class are estimated to be between $130,000 and $150,000 so the contract extension will actually cause substantial cash losses for Seadrill.
So Seadrill's decision to accept highly unfavorable contract terms obviously has some very discomforting implications:
- Seadrill obviously does not expect the business environment to pick up in any way until 2020 given the acceptance of a meaningful extension term until the end of the decade at a dayrate calculating to a -60% cash operating margin.
- In fact the company seemingly expects a further significant deterioration of business conditions going forward as otherwise Seadrill could have simply left the existing high-margin contract in place, given its rather long residual term until Q2/2018.
- The company has another drillship under pretty similar terms currently contracted to Petrobras, the West Carina, which might now face an equally poor "blend and extend" agreement.
- The agreement puts even more pressure on Seadrill's short term cash flows and liquidity position, further underscoring the urgent need of a comprehensive debt restructuring.
- As Petrobras obviously has the power to force Seadrill into unprecedented highly unfavorable contract terms, they might not stop at this point so peers with meaningful Petrobras exposure might face similar "agreements" going forward.
- The agreement has the potential to alter future industry "blend and extend" negotiations in a significant way as this type of deal does no longer represent a win-win-situation for both parties. Actually Petrobras emerges as the sole winner here, contracting a latest generation drillship for 18 additional months of exploration at a mere $32 mln compared to roughly the tenfold price paid three years ago while at the same time getting an immediate and material cash flow relief. Suffice to say, Seadrill in return is bearing the entire burden of this deal with regard to the associated cash flow and margin pressures.
Even with no pick-up in offshore drilling demand one would have assumed that Seadrill would be able to find work for the West Tellus in 2018 for at least double the dayrate now contracted with Petrobras for the 18-month extension given the fact that the downside in dayrates is usually limited to cash operating costs minus potential rig stacking expenses. In other words, rig operators would be generally willing to accept some cash losses on a contract as long as the alternative stacking costs would be estimated to be even higher. But at a dayrate below $60,000 the only reasonable choice would usually be to stick with the original contract terms for the time being and hope for oil prices to show further recovery in the meantime.
While this move would be somewhat more understandable if Seadrill would instead have addressed a rig scheduled to roll off contract within short notice like e.g. the West Orion, which is currently contracted to Petrobras until July 2016, it is hard to make any sense out of management's decision here. Particularly not, when looking at the recent remarks of Transocean's (NYSE:RIG) CEO, who at least envisioned a pick up in exploration activity during 2018 and a potential dayrate recovery during the 2019-2020 time frame.
Granted, good relations to the world's largest offshore drilling contractor are of paramount importance, but agreeing to highly unfavorable contract extensions for rigs currently scheduled to work for at least another two years clearly lies beyond my imagination unless Seadrill is expecting nothing short of Armageddon for the next several years.
This newest "blend and extend" agreement is just another indication of the potential shape of things to come with regard to the offshore drilling industry. Obviously Seadrill management is expecting a future business environment even beyond my extremely bearish imaginations.
Investors should continue to avoid the industry as a whole until there will be at least some light at the end of the tunnel and particularly Seadrill which is currently working on a comprehensive financial restructuring presumably to be announced within the next three months. Current equityholders should not assume the company's largest shareholder, John Fredriksen, having anything to give away at that time.
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.