Offshore Drilling: Why I'm Willing to Hang on to Seadrill Ltd.'s Stock

By Markets Fool.com

There has been much moaning and groaning about the recent plunge in energy stocks, but none of these grumblings come close to the frustrations of Seadrill shareholders who've been walloped by a displeased marketin recent months.

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SDRL Chart

SDRL data by YCharts.

Ouch.

As a Seadrill shareholder, I will admit that this major drop in share price and the recent suspension of the company's dividend have really shaken my confidence in the offshore rig owner. I have even considered selling,since I had fallen in love with that big payout that's now just a memory. Before anyone sells a stock, though, you should carefully examine why you bought shares in the first place to determine if the investment thesis has drastically changed. So let'sreexamine the reasons I bought the stock to help makea better judgment call on whether now is the time to sell Seadrill.

Reasons for buying Seadrill
Before I go too far into this, I should explain my situation as an investor. I'm still pretty young, and I can afford to sit on a stock for a long time in anticipation of some long-term trends. This might not be your personal position, so this might not be completely relevant to you. When making any investment, be sure to know your investment time horizon so you can make the proper decision. If you learn only one thing from this article, it should be that.

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With that out of the way, the biggest reason for buying Seadrill in the first place was its assets. The company has far and away the highest specification and youngest fleet of its diversified peers.

Company Average Age of Stationary Fleet (Jackups and Platforms) (in Years) % of Jackup Fleet Less Than 10 Years Old Average Age of Floating Fleet (in Years) % of Floater Fleet Less Than 10 Years Old
Seadrill 4.8 97% 5.7 90%
Transocean 11.5 36% 22.9 20%
Ensco

27.7

11% 13.3 48%
Diamond Offshore

33.4

14.2% 25.5 18%

Source: Rig Fleet Status reports, authors calculations.

There are some clear benefits to a young fleet, such as a premium for contracts and generally higher utilization, along with a long-term benefit that could make that fleet even more valuable down the road. About half of the global offshore rig fleet today is over 30 years old, and while Seadrill and some other companies are undertaking aggressive newbuild programs, the number of rigs coming online is considerably smaller than the number of rigs that are reaching the end of their economic lives.

The age ranges of mobile offshore drilling units over a 20-year span.Source: Epeus Consulting.

This is significant to Seadrill because zero rigs in its fleet are nearing the age of retirement. In fact, Seadrill is the only major drilling company that does not have rigs likely to retire in the next 10 years. As it completes its newbuild program it will have an even greater market share of new, high-specification rigs that will be needed for more complex drilling programs that will eventually be undertaken to replace the decline in oil production from other regions.

Source: Epeus Consulting.

A major turnaround in rigs?
One popular theory these days is that Seadrill's management was too ambitious with its newbuild program, to the point that it is stretching the company thin financially. There is some evidence to support this, such as the $6 billion in newbuild commitments over the next two years and another $6 billion in debt maturities that will need to be paid down or rolled over at favorable rates.

However, there is another way to look at this ambitious expansion: Management saw the state of the global rig fleet, and estimated that an aggressive newbuild plan would be needed to meet the demands for oil over the next 20-30 years. It's not hard to imagine the company's brass foreseeing that these few years would be a struggle for everyone as this turnover takes place. Long term, though, its assets will be the ones left standing, assuming the company's finances can stay afloat.

While this theory is marred by sinking oil prices and the clear glut of rigs, there is some evidence that it is starting to bear fruit. Compared to its peers, the company has much more of its fleet contracted out throughout 2015, and to some degree into 2016 as well, as seen in the pie charts on these two investor presentation slides.

Source: Seadrill quarterly earnings presentation.

What's changed?
I was originally concerned that the company was paying out a bit too much for a dividend and that its debt situation was a little sketchy. Suspension of the dividend took care of one of those issues,although I am going to miss that highyield.But freeing up $2 billion per year in cash commitments should help to pay for some of these major newbuilds without Seadrill needing to tap the debt markets as much as it has previously, or do some fancy accounting tricks such as dropping down partial ownership of a rig to Seadrill Partners .

A major point towatch with this company isits ability to generate contracts for its rigs. In this past quarter, Seadrill secured four new contracts for floating rigs that are about to come online, three new jackup contracts for newbuilds, and a 145-day extension for a floating-rig contract that was due to expire at the end of this year. It's not monumental progress when you consider that there are 13 rigs that will need contracts in 2015,but these are steps in the right direction.

The only other major development since Ipurchased is the slump in oil prices, andno one seems to know when that will end. Yes, an extended slump in prices would certainly eat into the chances of new contracts and probably result in lower dayrates, but two things are keeping me from being a nervous wreck over a supply glut of oil:

  • It is very possible that this slump in oil prices will accelerate the retirement of older oil rigs, and Seadrill's competitors will bear the brunt of this problem.
  • Every minute of every day, every oil-producing well around the world is producing less than it did previously. The 500 or so super-giant fields produce 60% of the world's oil, and their total average decline rate is 6.5%. This means that every year we need to bring on another 3.9 million barrels per day just to replace those fields, and that doesn't include the other 30 million barrels per day that decline faster than those fieldssuch as U.S. tight oil. A couple years of slowed capital expenditures could easily bring the oil market right back to where it was.

What a Fool believes
Seadrill is nowhere near a perfect stock -- this recent price tumble is clear evidence of that. However, the reasons for the tumbling stock price don't really connectwith my original investment thesis, so I'm not ready to cut bait with this company yet. As long as it can maintain a decent contract win rate, I'm willing to ride out the storm and watch other companies' rigs fall out of favor.

The article Offshore Drilling: Why I'm Willing to Hang on to Seadrill Ltd.'s Stock originally appeared on Fool.com.

Tyler Crowe owns shares of Seadrill. You can follow him at Fool.com under the handle TMFDirtyBird, onGoogle+,or on Twitter@TylerCroweFool.The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.