Analysts Debate: Is Seadrill Ltd. a Value or a Value Trap?

By Markets Fool.com

Image: Seadrill.

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Seadrill is one of those companies that evoke endless debate among even the most seasoned investors. The company is among the largest offshore drilling rig owners in the world, and when oil prices were over $100 per barrel it seemed like there was nowhere for Seadrill to go but up.

Of course, oil didn't stay at $100 per barrel, and Seadrill's stock took a beating as a result. So, is it time to bet bullish on this stock or is there more downside ahead? We asked two of our contributors with very different views on Seadrill to debate that question.

Travis Hoium (Bull Take): Let's start with the macro picture. There's no question the offshore drilling industry is going through some hard times, but I think low oil prices and the swoon in oil rig demand are temporary.

The amount of new oil and gas reserves discovered last year was the lowest in two decades, despite only 1% fewer new wells being drilled than in the year before. When new oil and gas is found, it's usually found offshore, particularly in ultra-deepwater. In short, oil and gas are getting harder to find, and offshore drilling will play a key role in supplying the world with energy for decades to come.

With that background set, I think oil prices will recover, at least to a level that makes offshore drilling attractive for oil companies. The industry needs oil to reach $70 to $80 per barrel to pick up drilling again. If drilling does increase and offshore contracts begin to open up again, Seadrill will be one of the top beneficiaries.

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Seadrill has one of the best fleets in the currently oversupplied oil rig market. Only one of its floater rigs was built before 2000, reducing the chance that it will have to cold stack or retire rigs, as competitors Transocean and Ensco have done. And when explorers are looking to hand out drilling contracts, those new rigs will be more desirable than aging rigs from Seadrill's competitors, even if they're at lower dayrates than in the last few years.

My bullish stance on Seadrill will require higher energy prices to play out as I predict, but if we look out two to three years I don't see how the industry can run profitably with oil between $50 and $60 per barrel. Eventually, supply will fall if the price stays that low, leading to higher prices and more activity in offshore drilling.

Image: Seadrill.

Jason Hall (Grumbly Bear): As a Seadrill shareholder, I'm not very concerned about the company's results for the rest of 2015. So far, its backlog of contracts seems to be holding up (with the very notable exception of the Rosneft deal), based on the company's high utilization rates of 93% for floating drillships, and 98% for jackups. But I'm not so sure that 2016 and beyond have as much potential for a recovery as many in the industry expect.

To start, Seadrill's new, modern fleet is not as much of a guarantee as many think. There are simply far too many offshore vessels operating today, and frankly that will lead to serious pressure on dayrates that I'm not convinced Seadrill can avoid. The company is on the hook for $4 billion for 15 newbuilds -- nine of which are scheduled for delivery this year -- so its cash flow is set to get pinched, right when its operating costs are going to start increasing again.

Onshore production is one of the main wild cards. Onshore drilling has ground to a halt in the U.S. this year, but there remains massive room to restart that activity quickly once demand pushed prices back up. Factor in easing of sanctions on Iran in coming months, and another million barrels per day of onshore production capacity could be ready to go before the end of 2015. That cheaper oil is not good for Seadrill or its offshore competitors.

Add it all up, and it's just too hard to predict a clear path forward for Seadrill right now.

Travis Hoium: While I agree that demand for offshore drilling rigs will be a question mark in 2016 and beyond, and that the industry is certainly oversupplied, that's why the new fleet is so important. While competitors such as Transocean, Noble, and Ensco stack or retire rigs to take supply off the market, Seadrill can keep its fleet active. It might have to accept lower dayrates than it got in 2014 or 2015, but an active fleet is better than an inactive one.

But the risks Jason brought up are definitely real, so investors will need to be rewarded for taking a risk on Seadrill. And that's where I see a great risk/reward profile. In the last year, Seadrill reported $2.73 per share in earnings, meaning the stock trades at 4.6 times trailing earnings. If, as I'm predicting, earnings don't plummet in the next two to three years, and maybe even grow, the upside for investors is incredible. It's easy to see how Seadrill's stock could double -- and if oil prices rise over $100 per barrel, three times or four times is possible.

Seadrill is a risk, no doubt, but with a strong strategic position and a high reward potential, it's a risk I'm willing to take.

Jason Hall: I'll concede that in the long run, Seadrill's best-in-class fleet will certainly be an asset. Long term,the safest and most capable vessels will be required to get to that offshore oil and gas. And, yes, on a price-to-earnings multiple Seadrill shares look compelling.

But that ignores the fact that the company's free cash flow has been negative for most of the past two years. The suspension of the dividend will help, but cash flow risk could be seriously compounded by the newbuilds the company is on the hook for over the next year, corresponding by some accounts with what could be the worst offshore market in years.

That means billions of dollars in obligations for which Seadrill will either have to cough up cash or take on more debt, or (likely) a combination of both, right when much of its current fleet will be coming off contract.

Did I mention the company paid almost $500 million in interest expense last year? That amount is almost certain to rise.

Investing risk boils down to the probability of permanent loss of capital. As a Seadrill shareholder, I think eventually the market will rebound and the company will endure. I'm just not compelled to believe the worst is over yet.

Too many things still have to go right, and that means too many "ifs" for me to call this a good value. The hardest thing about investing is knowing when to do nothing. I think now is a time to sit and watch. Not buy, and not sell. I'd rather miss the bottom and have more certainty about the offshore environment than buy what could turn out to be a value trap.

Seadrill is a risk no matter how you slice it
While Jason and I (Travis here) disagree on Seadrill's future, no matter how you look at the stock it's a big risk for investors. The company needs higher oil prices to be profitable, and anyone betting on the stock must keep in mind that this is the long-term driver of Seadrill's performance. If oil hovers near $50 for the next five years, Seadrill might be doomed.

The article Analysts Debate: Is Seadrill Ltd. a Value or a Value Trap? originally appeared on Fool.com.

Jason Hall owns shares of Seadrill. Travis Hoium owns shares of Seadrill. 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.