For months, Petrobras has been postponing the execution of a new contract with Sete, which was created to manage the construction of rigs by Brazilian shipyards. The company’s senior management believes it is best to abandon the project. With little option, Sete’s partners are studying whether to file for corporate reorganization.

Petrobras’ best option would be to lease the rigs from abroad, where chartering is cheaper. The problem is that, without the Brazilian rigs, it will be very difficult to reach the local content percentage promised in the auction. Because it is expensive, this equipment accounts for a large share of this account.

For noncompliance with local rules in the pre-salt fields, Petrobras could incur fines between $R20 billion to $R30 billion ($5 billion to $7.5 billion). Whether those fines would inure to the benefit of Sete Brasil or its vendors like National Oilwell Varco (NYSE:NOV) is unclear.

The Situation

Reeling from a corruption scandal that has cost billions, Petrobras has cancelled supplier agreements in order to stem cash burn. Sete Brasil has a contract to build 29 drill ships for Petrobras and has missed payments or made slow payments to the shipyards and suppliers it has contracted with.

Petrobras may have no other choice but to cancel its drill ships package. With oil prices below $40, the economics of deep sea drilling projects may be much lower than they were when oil prices hovered above $100. With $130 billion in debt at junk levels, Petrobras is the world’s most-indebted oil company. About $90 billion of that debt is dollar-denominated; the recent Fed rate hike which sent the Brazilian real above R$4 to the dollar did not help its cause. Petrobras recently cut its five year capex plan by 40% to $130 billion; its reticence to close the $20 billion drill ships deal is consistent with efforts to cut capex.

Potential Impact On National Oilwell

National Oilwell has equipment packages with four shipyards contracted to build the rigs. In Q3 the company’s $3.31 billion in revenue was off 15% sequentially, and fell shy of the $3.48 billion analysts were expecting. NOV is down about 45% over the past year due to the free fall in oil prices and oil & gas E&P. The company’s one saving grace is its $9.2 billion backlog; about $3 billion of its backlog is related to the Petrobras drill ships package.

I previously estimated National Oilwell’s Petrobras-related backlog could be cut by $1.8 billion (about 60%). If Petrobras abandons the project altogether, the entire $3 billion backlog could be wiped out. In addition to the quarterly decline in the backlog of about 10%, a potential $3 billion hit would be disastrous for the stock. Whether the company could receive an early termination fee would also be questionable. First of all, National Oilwell’s contract is with Sete Brasil which may not have the funds pay a fee. Secondly, it is not unusual for national oil companies like Petrobras to negotiate supplier agreements that allow for cancellation for convenience.

Conclusion

About 30% of National Oilwell’s backlog is related to Petrobras, which could be in jeopardy. Avoid NOV.