I woke up a few days ago with an interesting idea about how investors can continue to generate cash flow off of Seadrill's (SDRL) stock plus participate in the upside potential once the offshore drilling industry returns to a state of normalcy, which unlike many market participants, I do believe will happen over the next few years. The way to do this relies upon the use of options, more specifically, the selling of put options.

Investopedia defines a put as,

"An options contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date."

In essence, a put option is an insurance policy against a stock declining in value. The buyer of a put option will make an upfront payment to the seller of the put option in exchange for the seller agreeing to buy the stock at a specified price. In this case, I am suggesting that readers may want to consider selling put options on Seadrill in exchange for an upfront premium.

The best put options to consider selling in this case would be LEAP options, which are options whose expiration dates are more than one year away. The reason for this is that it is somewhat unlikely that the offshore drilling sector will turn around before 2018 for reasons that I have discussed at length in other articles and which will be discussed briefly later in this one. However, the stock prices of Seadrill and the other drilling companies may begin to turn once the industry begins to show some signs of improvement, which could come beginning in 2017. There are January 2017 put options available on Seadrill, so these are the ones that we will discuss in this article.

This chart shows all of the available put options on Seadrill that expire on January 20, 2017 as well as their prices as of the time of writing:

Source: Yahoo! Finance

An investor that chooses to sell one of these options will immediately receive the amount listed under "Bid." Selling this option will also obligate the investor to purchase shares of Seadrill at the strike price should Seadrill's stock price be below the strike price on January 20, 2017. It is also worth noting that each of the prices listed in the chart are for a single share of stock. However, a standard option contract is for one hundred shares of stock. Therefore, an investors that sells a single contract with a $10.00 strike price today will immediately receive $2,950 in cash and may be required to purchase 100 shares of Seadrill stock for $10.00 per day, spending a total of $10,000, in January 2017. Therefore, excluding the time value of money, we can see that this investor will make money as long as Seadrill's stock trades for more than $7.05 on January 20, 2017. Even more conservative plays would be selling the $5.00 strike price puts or the $8.00 strike price puts.

The biggest risk of this play is that Seadrill's stock price will decline further going forward. However, this seems unlikely as the stock is already being priced for the possibility of a financial disaster in the near future. One such disaster would be that the company will be unable to roll over its debt. Indeed, Seadrill's outstanding debt payments total $2.309 billion in 2015 and $1.458 billion in 2016. Seadrill's operating cash flow in 2014 was $1.574 billion, an amount which by itself is insufficient to completely pay off all of the debt payments that will be required this year. However, as Seadrill notes in its fourth quarter 2014 report, both the bank lending and ECA markets continue to be receptive to Seadrill credit. In fact, as one commenter on one of my recent articles notes, many Norwegian banks have been going out of their way to assist drilling companies in remaining solvent. For example, DNB ASA recently stated that it is willing to suspend loan installments for offshore drilling clients to help them make it through the turmoil in the industry. It seems likely that other banks will follow suit. While Seadrill has not yet needed to exercise an option like this, it does provide further confidence that the company can weather the crisis.

Another event that could drive the stock price down further going forward is if Seadrill is forced to issue equity in order to raise the money needed to finance itself over the next few years. This would dilute and possibly substantially dilute the existing shareholders and thus result in each share of stock representing a smaller ownership stake in the company. However, I do not believe that Seadrill will be forced to take this step due to the aforementioned willingness of banks to continue to finance the company.

As I mentioned earlier in this article, Seadrill's stock may begin to turn as soon as the offshore drilling industry begins to improve. One of the chief causes of the malaise in the industry is the large number of new rigs that are leaving the shipyard at a time when oil companies are tightening their exploration and development budgets and thus reducing the demand for these rigs. Offshore drilling contractors will respond to this rig oversupply as they always have - by scrapping older rigs. We have already begun to see this. On April 4, 2015, Transocean (RIG) announced that it will be scrapping eighteen rigs and Diamond Offshore (DO) announced that it will be scrapping six rigs. This pattern is likely to continue as those currently operating older rigs come off of their current contracts, although it will take a few years for the oversupply to be worked out of the market. Nonetheless, the stock price of the drilling companies, including Seadrill, will likely rise at the first sign that conditions in the industry are improving. Even if this does not happen by 2017, it will likely happen shortly thereafter and thus even if the put is exercised and the investor selling the put is required to purchase Seadrill's stock, it will be at a very cheap effective price (especially when the premium received is considered) and primed to profit as the industry does improve.