I'm On The Wrong Side Of The Seadrill Trade

| About: Seadrill Limited (SDRL)
This article is now exclusive for PRO subscribers.

Summary

Higher oil, higher share price, and less dilution; that's where my long thesis rested.

But negotiations in the restructuring process are slipping, bondholders aren't going down without a fight.

Considering the recent PR from Seadrill management, it is more apparent now this may not end well for shareholders.

In my last article on Seadrill (NYSE:SDRL) I detailed why I was on the "other side" of the trade - the long side. My thesis revolved around the coming increase in the price of oil, the recovering stock price - which would reduce dilution - and well, dilution.

I anticipated higher oil prices in the coming months (still do). This would be a light at the end of the tunnel and lenders would be more negotiable as recovery became a near-term reality. This would bode well for the company as negotiations would move along with fewer unknowns.

However, the story of the week is bondholders; they are driving a hard bargain. Seadrill this week disclosed the process is more complex than expected and could be headed downhill quickly if it doesn't get a break through in the next two weeks, particularly with bondholders.

This sent the price of the stock down as much 30% on Tuesday. This collides with my second point of my thesis: the stock price in the face of dilution. If a capital raise were to occur today, with the price of the stock significantly lower than when my previous article was published, it would mean dilution of nearly 100% in order to reach the company's goal of $1B in new capital.

What's interesting is the price of the stock didn't collapse to penny status instantly. It's logical to say the stock has now taken into account a complete dilution and says the $1.80 range is fair value. Whether it continues to drift lower or not is another story, but it didn't fall through 52-week lows, at least not yet. However, the market typically overreacts in both directions so it's possible there is some let up in the selling pressure to come.

However, all of what I just said is not much comfort to current shareholders in the bigger picture of a looming Chapter 11 filing. My third thesis rested on dilution not wiping out current shareholders, contingent on the previous two points but this is now in severe jeopardy.

It's possible the stock has left the door open for a successful restructuring and without bankruptcy tactics, which would explain the large drop but not complete collapse of the share price, but my long thesis is nowhere near as water tight (some may argue it never was) as it was just a few months ago. So regardless of whether there is some reversal in shares as the market digests the news and takes in the coming announcements, a loss of 30% is not a valid indicator of a successful thesis. In fact, since it is based on news and not technical movements it can be considered a valid indicator of a failed thesis.

If Seadrill enters into Chapter 11 I am in no way a resource for bankruptcy proceeding knowledge; it's just not my expertise. Because of this, if Seadrill pulls the plug on shareholders and decides to journey into bankruptcy I cannot in good conscience recommend getting in shares for the near or long-term.

Now, since this decision is still to come there is a possibility, though slim, the company finds agreeable terms with all of its debt holders and restructures without wiping out current shareholders. Not being an executive on either side of the table I can't say anything is for certain but this could be a tactic Seadrill management is employing in order to expose the "bad guys" and those who won't negotiate - some dirty leverage perhaps. Does this change bondholders' tunes? I don't know. All I know, is tactic or not, the stock reacted as if the negotiations won't get better.

In the meantime would set myself up to exit, but maybe not exit just yet. Don't misunderstand me here: I'm not being bullish. I'm simply setting up an exit strategy, for myself and others. Selling covered calls until your shares get called away may be an example of executing this strategy to minimize losses. But the idea is to try to unwind your long position because I don't foresee things turning around suddenly unless oil rises 20% and new contracts start being negotiated - all in the next month.

I was expecting the time the company had before April would let oil rise which would ease the burden of predicting the offshore oil turnaround. It seems management is stepping up to play hard ball with bondholders or is finally admitting time is running short and oil isn't helping quickly enough. Either way, it's going to get messy quickly and shareholders are going to be the fodder for both parties. It turns out I was on the wrong side of the longer-term trade but managed to make out OK on the short-term with options.

If you'd like to be made aware of my opinion and analysis in the future on Seadrill, then I encourage you to follow me by clicking the "Follow" link at the top of this page next to my name.

Disclosure: I am/we are long SDRL.

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.