Seadrill: A Breakthrough Or A Disaster?

| About: Seadrill Limited (SDRL)
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Summary

I discuss the latest Seadrill contract extension.

Day rate numbers may vary depending on how you calculate and which questions you ask.

I believe there's only one possible evaluation of the contract effect on Seadrill.

Seadrill is in trouble

Jan Peeters I - Stormy Sea. Source: Wikimedia Commons

Seadrill's (NYSE: SDRL) latest contract attracted a lot of attention here on SA. Fellow contributor Fun Trading stated that the new contract or contract extension was a positive and should be celebrated. On the contrary, Henrik Alex called the contract a disaster for the industry.

I recently applied the lower-for-longer day rate scenario for Seadrill and used day rates of $250,000 for semis and drillships. Now, with this new and important piece of information, it's time to reevaluate my previous thoughts.

So, what was the day rate for West Tellus?

There are two ways how you may look at the problem. The first one is to calculate the reduced day rate for the previous contract and the new day rate for the contract extension. You will get a day rate of $300,000.

The second way to evaluate the contract is to divide the net effect on the backlog on the number of added working days, which will leave the previous day rate intact but the new day rate will be roughly $58,000. The numbers are very different and the reaction is also different depending on which method you use.

Naturally, bulls will point to the $300,000-day rate and tell that this was a win for Seadrill. After all, this day rate is above bearish expectations for this part of the industry cycle. Bears will point to the day rate of $58,000 - a number that does not require much commentary. In my view, the correct answer depends on what question you ask.

If you are interested in what exact day rate Seadrill got for an extension of the contract - the day rate is $58,000. The company had a contract in place with a good day rate, but decided to prolong the contract at the expense of the day rate.

If you are interested in what day rate would West Tellus get on the market if it was bidding for a new job and won - the day rate will likely be significantly higher than $58,000. However, it looks that my previous $250,000 day rate estimate for new contracts could have been optimistic rather than pessimistic.

Why did Seadrill sign the contract?

At first glance, the contract makes no sense at all. Why go for a blend and extend contract if your additional day rate is $58,000 and you lock your rig for 18 months? If we assume stacking costs of around $35,000 per day and operating costs of $130,000 (I think I'm using rather optimistic numbers), the rig would have been better off waiting for a new job. Under current contract, West Tellus will be losing $72,000 per day instead of losing $35,000 per day if it were warm stacked.

The difference between two options is $37,000 per day, which accrues to $20.3 million over the 18-month period. Even if stack costs are higher for West Tellus, the decision still makes no sense. After all, the rig would have had 18 months to get a new job. The initial contract ended in April 2018, so the rig had time to search for the job up until 2020 before the decision to stack would bring more losses than the decision to extend the contract. Is Seadrill so bearish on the industry that it does not believe that West Tellus will be able to find work until 2020 after it finished working for Petrobras (NYSE: PBR)?

In my view (and this is speculation, of course), Petrobras threatened to cancel the existing contract and the terms of cancellation were not favorable to Seadrill. This is the only possible logical explanation why Seadrill agreed to this losing blend and extend deal. Otherwise, Seadrill's actions make no sense at all.

What does the new contract mean?

One might argue that Petrobras is a very special case and that other oil companies won't be pressing that hard. I agree that Petrobras is a thing of its own, but I believe that other oil producers will take advantage of their contracts if they have an opportunity. The current state of the offshore drilling industry, when it faces pressure from the lack of new contracts and from internal oversupply problems, gives all the good cards to oil producers.

In my view, other contract renegotiations might follow. If West Tellus was under pressure, West Carina, which also works for Petrobras, could also be renegotiated. In my view, this is a very bad precedent with potentially wide-ranging implications.

Other oil producers may evaluate the Petrobras case and adjust their negotiation strategy accordingly. Deepwater offshore drilling is on the expensive part of the cost curve, so, if oil remains below $50 or even $60 per barrel for a long time, oil producers will try to squeeze every penny of their offshore drilling costs.

How to evaluate this news for Seadrill?

I often read both bull & bear thesis on the companies I follow and often agree that the opposite side's case has its merit. The evaluation of Seadrill's new contract is one of the rare cases where I absolutely do not understand the bullish reaction.

The previous contract was a disaster, but the new one is a full-blown Armageddon. The worse scenario would be to work for Petrobras for free. The news is bearish for both Seadrill and the industry. I expect that we will see similar renegotiations in the 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.

Additional disclosure: I may trade mentioned stocks.