Seadrill (NYSE:SDRL), while sporting one of the youngest fleets in the industry, is hugely over-levered with $8.9B in net debt. By the middle of 2017, net debt/EBITDA will hit 7x, above its maximum level of 6.5x. SDRL previously amended this so there is likely no room left. The firm has $3.17B of debt due in the next 12 months and only $1.25B of cash on hand. If sponsors don't contribute $1-2B in capital, the equity will need to be restructured.
Seadrill also has over $4B in capex due through 2019 and this includes 14 newbuilds that are being delivered. None are contracted yet, which hurts Seadrill specifically as well as drags down future industry dayrates. Furthermore, while operators like Diamond Offshore (NYSE:DO) have been investing in their fleet through this downturn, SDRL and Transocean (NYSE:RIG) have been cutting capex to the bone. That leaves them in weaker competitive position once the cycle finally turns.
Why does the short opportunity exist? Value investors are focusing too heavily on P/NAV and historical trough multiples as a crutch rather than the future earnings power of the company. Trailing multiples (five-year to 10-year) are distorted as they are based on peak dayrates, which have been in free fall and will continue to decline unless supply is rapidly taken off the market. At current prices (just north of $3), the stock is trading at a mid-double digit forward EBITDA multiple.
Today, the majority of the industry is operating below cash break-even due to high expenses that will continue until drillers accelerate the process of cold-stacking and scrapping rigs. SDRL currently has 20% of its fleet cold-stacked and 25% of its floater/jack-up fleet is available, which are likely to be stacked as well. The firm has been unable to win new work in this depressed oil environment and Seadrill's backlog is declining quickly, from $8.0B in the prior quarter to $7.0B today.
Seadrill's problems (and the offshore industry writ large) are compounded by the fact that onshore drillers have continued to reduce break-even costs via technological progress. Street analysts estimate that around $50/bbl dormant shale activity begins to come back online and subsequently, this reduces interest in expensive deepwater activity. Credit Suisse estimates that deepwater needs $55 oil for brownfield (subsea tiebacks) and at least $60 for greenfield offshore projects. After OPEC's recent cut, I expect a ramp-up in North American shale drilling. Risks to the short position include a sharp spike in Brent prices ($60+), which would likely stimulate new offshore activity.
Outside of a spike in crude, a litany of catalysts exist to send both Seadrill lower, most of which are not priced in. These include more backlog cancellations in the vein of Petrobras (NYSE:PBR), or potential for impairments and writedowns. Total (NYSE:TOT) recently amended the West Jupiter rig's contract ($144m hit to backlog), which implies a 22% reduction in the previously agreed upon dayrate of ~$580kpd. In a rational industry, competitors like RIG would be removing supply, but their debt load incentivizes them to continue drilling in order to service their debt. This is another factor that extends the length of this down cycle.
As incremental offshore data comes out and continues to surprise to the downside, SDRL will re-rate lower with the equity tranche of similarly levered drillers rendered worthless. The most likely solution is a restructuring in 2017 where debt is termed out, covenants are amended, and shareholders receive zero or are subject to massive dilution. If one is interested in expressing a bullish view, then the distressed debt at 40 cents is a safer (albeit still risky) play with less volatility.
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. I have no business relationship with any company whose stock is mentioned in this article.