Offshore Drilling: Deteriorating Market Conditions Mean Dividends May Have Further to Fall

By Markets Fool.com

Recently I explained how Transocean's latest earnings conference call suggested a tough 2015 ahead for the company and fellow offshore drillers such as Seadrill , Ensco , andDiamond Offshore .

Continue Reading Below

With SeaDrill already having suspended its dividend and Ensco, Transocean, and Diamond Offshore having slashed theirs by 80%, 80%, and 86% respectively, how likely are further dividend cuts? Let's take a look at two quotes from SeaDrill's and Ensco's latest earnings conference calls to see what the short-term future of this industry's dividends may hold.

Market conditions have deteriorated at a shocking pace

"The sharp decline in commodity prices that our industry has witnessed, accelerated even further toward the end of the last year, concurrent with customers completing that capital budgets for 2015. Most have announced significant CapEx cuts, and the severe fall-off in customer demand is unprecedented compared to what we've seen in prior cycles." -- Carl Trowell, president and CEO, Ensco, emphasis is from me.

Given that the recent dividend suspensions and cuts have been a result of rapidly deteriorating market conditions this quote from Ensco's CEO doesn't bode well for the safety of what's left of the industry's dividends. The "unprecedented fall-off in demand" likely refers to the fact that global demand for offshore rigs has fallen to such an extent that 24.3% of ultra-deepwater-- or UDW, rigs, the industry's most profitable rig type -- are without work.

Consequently, day rates have plunged from as high as $660,000 to under $400,000. With a slew of UDW rigs set for delivery in 2015 and 2016, day rates are likely to continue dropping if oil prices remain suppressed in those years.

Continue Reading Below

Contract backlogs are falling and cancellations are rising

"The company is confident that its contract terms are enforceable. However, it may be willing to engage in discussions to modify such contracts, if there is a commercial agreement that has been official to both parties. In the event of early termination, for the customers' convenience, an early termination amount is typically payable to Seadrill." -- Per Wullf, president and CEO, Seadrill.

Wullf's comment was likely meant to calm investor concerns over Seadrill's recent removal of $1.1 billion of contracts from its backlog when Brazilian oil giant Petrobras demanded renegotiation of two extensions for the West Taurus and WestEminence semisubmersible rigs. Given how far dayrates have fallen since the extensions were agreed upon in November, Seadrill stands to lose up to 40% of its previous estimated contract value,or about $440 million.

Given that a strong contract backlog is one of the strongest safety factors protecting this industry's dividends, shrinking backlogs, both from contract expirations, and terminations, are a major concern. For example, Transocean just announced that its backlog has shrunk for two consecutive years, from $28.8 billion at the end of 2012to just $21.2 billion at the end of 2014. Transocean's backlog shrank by an alarming 22% in the last yearalone as the company wasn't able to find replacement work for rigs whose contracts were expiring, or the value of new contracts was substantially lower than in the past due to plunging day rates.

What's more, some oil companies have canceled contracts entirely. In 2014,Statoil canceled five rig contracts-- two with Transocean and one with Diamond Offshore ; its latest, on Nov. 21, resulted in a $350 million early cancellation charge.Meanwhile, Diamond Offshore disclosed in a recent SEC filing it has been contacted by three oil companies regarding the likely termination of six rig contracts.

Further contract terminations are possible if oil prices remain suppressed for another few quarters, further exacerbating the global rig glut that will grow even worse as new rigs are delivered in coming years. Seadrill alone has 18 newbuilds, mostly UDWs, set for delivery through 2018. While the company is delaying delivery of these rigs as long as possible, the glut of new, state-of-the-art UDW rigs could further depress dayrates for the industry's most profitable rig type for several years unless oil prices rebound to levels that increase long-term demand from oil companies.

If such a scenario does occur I think offshore drillers such as Transocean and Diamond Offshore might have to join Seadrill in completely suspending their dividendsin order to preserve cash and strengthen their balance sheets.

Takeaway: Offshore drilling industry downturn is far worse than previously thought
Given the combination of a global oversupply of rigs, the large amount of new rigs set to be delivered in coming years, and oil prices that threaten to make offshore drilling unprofitable -- Reuters estimates the average global breakeven price for offshore drilling is between $54 and $60 per barrel -- we may see further offshore driller dividend cuts in 2015 and 2016. While I remain bullish on the industry's long-term prospects, current and prospective investors should view these stocks as supremely undervalued "deep value" investments. As such, you should own them only as part of a diversified portfolio and not expect significant price appreciation for several years until oil prices recover to more sustainable levels.

The article Offshore Drilling: Deteriorating Market Conditions Mean Dividends May Have Further to Fall originally appeared on Fool.com.

Adam Galashas no position in any stocks mentioned, however, he does leadThe Grand Adventuredividend project, which owns SeaDrill in several portfolios.The Motley Fool recommends Seadrill. 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.