Beware of Dividend Cuts for These 2 Oil Drillers

Offshore oil riggers are particularly susceptible to falling oil prices -- they work on relatively short contracts, incur high fixed costs, and typically carry lots of debt. In a last-ditch effort to shore up their finances,Seadrill and North Atlantic Drilling have already slashed their dividends.They may not be the only ones, though. Let's take a look at why two other rig companies --Ocean Rig UDW and Transocean -- may also be at risk.

Why riggers cut dividendsTheir equipment and technology may be complex, but oil riggers' business models are pretty simple. They hire shipyards to build rigs capable of drilling for oil beneath the ocean bottom. Once the rigs are built, the major oil companies -- think ExxonMobil, Royal Dutch Shell, and the like -- hire the riggers to drill oil. Rig contracts typically last a few months to a few years, and the rigger receives a set price for every day the rig operates.

But it's not all sunshine and rainbows. Oil riggers all do basically the same thing, so the industry is highly competitive. Chevron doesn't hire Seadrill over its competitors for its brand name. Further, building rigs is expensive and can take years, so these companies incur loads of debt, often before they even know what per-day rates their new rig will fetch when it comes online.

As it turns out, it costs nearly the same to own a rig whether it's drilling for a customer or sitting idle. When the oil cycle turns down and demand for rigs declines, riggers can be left with greatly reduced income but most of the same costs. Cash becomes precious. Any use of it that's not absolutely essential, such as paying dividends, can land on the chopping block.

This is precisely what happened at Seadrill and North Atlantic Drilling, both of which suspended their dividends in December.

Seadrill has undertaken an ambitious rig-building plan in recent years, and the oil price decline has hit right in its midst. Enormous shipyard bills and a dearth of work for new rigs has Seadrill taking every step in its power to wait out a precarious financial situation.

North Atlantic faces other headwinds. Its specialty focus on harsh environments allows the company to command premium rates during boom times, but expensive harsh-water oil is among the first to be cut when oil prices decline. And North Atlantic is heavily indebted. It owes $2.8 billion. For comparison, its market cap is just $380 million.

How dividend cuts harm investorsWhen a company eliminates its dividend, it's typically bad news for investors. First, of course, the dividend checks stop coming. Worse, the stock price may decline sharply, because the cut is a sign from management that all is not well. The day they slashed their dividends, Seadrill fell 5% and North Atlantic Drilling dropped 20%.

Beware of these two stocksThey were first, but Seadrill and North Atlantic are unlikely to be the only riggers to nix their dividends duringthis down cycle. The next may be Ocean Rig UDWand Transocean.

Source: S&P Capital IQ.

Each carries heavy debt loads and, therefore, spends a lot of cash on interest payments. Each also devote a hefty chunk of cash flow to paying dividends.

The figures above reflect the past 12 months, which were strong for oil riggers. As we plunge deeper into the trough of the cycle, EBITDA and cash flow will fall, and these businesses will find themselves more levered and distributing an even greater portion of cash flow to dividends.

It's bad timing for Ocean Rig UDW, which only initiated its dividend in May 2014 and is now in real danger of being forced to cut it. Because the dividend is new, the table above understates how costly it is for the company. Over the past two quarters (the only two reported since starting the dividend) Ocean Rig brought in $223 million in cash flow. It has spent $298 million maintaining its rigs and building new ones, plus another $50 million on dividends. Those numbers don't add up, and Ocean Rig has had to borrow more money to cover its expenditures. That can't go on forever, and it's easier to stop paying a dividend than to stop maintaining rigs or default on payments to shipyards.

The oil downturn also comes at an unfortunate time for Transocean, whose stock sports a juicy 18.6% yield. Though larger and less indebted than Ocean Rig UDW, Transocean faces even stronger headwinds. The company focuses on tough-to-drill, expensive oil fields -- the kind of drilling that gets shelved when oil companies reduce their budgets. Further, Transocean's interest and debt repayments totaled just $700 million in 2014; they'll amount to $3.4 billion over the next two years. And that's on top of $2.5 billion the company will owe shipyard as new rigs it commission in recent years are completed. It will become difficult to justify paying such a fat dividend when the company is squeezed to meet its contractual obligations.

Protect yourselfWhen a fire destroys a factory and a company needs all available capital to rebuild, management may prudently pause a dividend. The stock will suffer, but shareholders couldn't have seen it coming.

But some dividend cuts are foreseeable. Crashing oil prices and deteriorating financials spell trouble for oil riggers, and I think Ocean Rig UDW and Transocean are at particular risk of reducing or eliminating their dividends. Don't be enticed by their extra-large dividend yields -- they aren't likely to last very long.

The article Beware of Dividend Cuts for These 2 Oil Drillers originally appeared on Fool.com.

Alex Pape, CFA, has no position in any stocks mentioned. The Motley Fool recommends Atwood Oceanics, Chevron, and Seadrill and owns shares of Atwood Oceanics, Seadrill, and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.