Seadrill's Potential Debt Time Bomb: 3 Vitally Important Things Investors Need to Know Now

By Markets Fool.com

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West Alpha Semi-Submersible rig. Source: Seadrill.

A lot of people criticized Seadrill for its previous excessively generous dividend policy, which saw the company finance its ambitious new build program with debt so it could funnel the majority of its operating cash flow toward the now eliminated sky-high payout. Well, it turns out that such critics were right, because now Seadrill's former "dividends first" policy is coming back to haunt it as the company faces one of the most severe industry downturns in years while holding a potential ticking time bomb of debt.

Find out three troubling facts that all Seadrill investors need to know to make an informed decision about whether to invest in the stock or merely continue holding shares..

Seadrill's liabilities are bigger than you think
According to its most recent 20-F filing with the SEC at the end of 2014, Seadrill had $13 billion in total interest-bearing debt.

However, back in January it agreed to ensure $2.6 billion of debt held by its subsidiary North Atlantic Drilling . After the a $4 billion deal with Russian oil giant Rosneft was delayed by two yearsSeadrill will almost certainly have to assume the interest payments for these liabilities.

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To make matters worse, Seadrill still owes rig builders $5 billion for 15 new builds it has scheduled to be delivered between 2015 and Q1 of 2017, 13 of which have yet to secure contracts. If Seadrill fails to make payments and defaults on these new build contracts, it potentially stands to forfeit the shipyard payments it's made thus far -- up to $1.6 billion.

Debt covenant breeches are a possibility
Seadrill's debt covenantsrequire a debt/EBITDA ratio of 4.5 or less, a level that Citi analysts believe may be breached in 2015 or 2016 because of the large contract cliff it's facing. For example, 62% of Seadrill's UDW rigs -- including those yet to be delivered by the end next year -- will need to secure new contracts by the end of 2016.

Any UDW rig that can't find work will need to be idled or even potentially cold stacked -- a form of storage that costs $110,000 to $120,000 per day in maintenance fees -- which not only hurts cash flow but also lowers EBITDA and thus raises the debt/EBITDA ratio and increases the risk of a covenant breach.

Worse still,Seadrill Partners -- Seadrill's MLP -- which has $3.65 billion in total debt and a very high debt/EBITDA ratio of 5.3, has done some of its borrowing as a joint borrower with Seadrill.

That means that should Seadrill Partners default on its own debt covenants, it could trigger cross-default provisions in Seadrill's own debt agreements. That might move up the repayment dates of its debt obligations, and might even result in a loss of some of Seadrill's rigs to its creditors.

That's because, according to its latest 20-F filing, 75% of Seadrill's debt -- $9.8 billion -- is secured by liens against its drilling rigs.

Accommodating relationship with bankers may only go so far
Don't get me wrong: Up until now Seadrill's bankers have been very accommodating, even going so far as to defer loan installment payments until the industry recovers, and Citi's analysts expect that, at least in the short term, this amiable relationship should mean short-term debt covenants will be renegotiated at favorable terms for Seadrill.

However, should the recovery outlook for offshore drilling continue to be pushed back -- Seadrill initially expected a recovery to occur in late 2015 or 2016 but is now saying a recovery isn't likely until 2017 -- creditors may lose patience, potentially making longer-term covenant renegotiations and debt refinancing more difficult.

Takeaway: Seadrill's massive debt is a house of cards that threatens long-term returns
I think Seadrill is likely to survive this industry downturn. However, if the severity and length of the offshore drilling downturn continues to worsen, then Seadrill and its subsidiaries face a massive and complex debt structure that threatens any substantial recovery in either their share prices or ability to restart or increase their dividends. Long-term investors who wish to buy or hold shares of any Seadrill-affiliated stocks must be well aware of these risks and adjust their diversified portfolios accordingly.

The article Seadrill's Potential Debt Time Bomb: 3 Vitally Important Things Investors Need to Know Now originally appeared on Fool.com.

Adam Galasowns units in North Atlantic Drilling and leadsThe Grand Adventuredividend project, which owns North Atlantic Drilling and 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.