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Diamond Offshore Drilling, Inc. (NYSE:DO) rents drilling rigs to gas and oil companies mostly in the Gulf of Mexico and Asia and is the second-largest contract driller by market capitalization.^[1] From 2005 to 2008, the company's revenues increased nearly three fold, as the worldwide demand for energy and geopolitical conflicts in oil-rich nations drove up the price of oil. However, oil prices plummeted after a peak of about $140 per barrel in July 2008 and stabilized at about $75 per barrel as of December 2009.^[2] Falling oil prices reduce the revenue generated by oil companies and thus make drilling in deep-water locations prohibitively expensive. Declining demand for oil has had an adverse effect on the offshore drilling industry because lower oil prices reduce day rates earned by offshore drilling rigs. Additionally, declining interest in offshore drilling and oil exploration reduces contract activity.

Though Diamond Offshore Drilling has seen the effects of the economic downturn, it is partially shielded from decreasing day rates because most of its drilling rigs are contracted through 2010. Diamond owns one of the largest drilling fleets in the world (a total of 46 drilling rigs), and continues to rent its drilling rigs at steady dayrates. In the first quarter of 2009, the company's average dayrate for high specification floater rigs was $360,000 per day, compared to $386,000 in the fourth quarter of 2008.^[3]

One mostly uncontrollable factor for DO or any other company involved in offshore drilling in the Gulf of Mexico is the threat of hurricanes, which occur most frequently from June 1 to November 30. Hurricanes can shut down drilling rig production for several days and also cause significant damage to rigs.

Company Overview

Diamond Offshore Drilling (DO) rents drilling rigs to gas and oil companies. DO earns revenue through dayrates collected by its rigs as specified in its contracts with oil companies. Dayrates and utilization rates have fallen slightly as the demand for offshore drilling has declined, mainly due to the falling price of crude oil.^[4] For example, the average dayrates for high specification floaters fell from $386,000 in the fourth quarter of 2008 to $360,000 in the first quarter of 2009 and utilization rates for jack-ups have plummeted from 92% to 73% over the same time period.^[5] The upkeep and upgrades of rigs make up most of Diamond Offshore's operating expenses.

DO's Revenue and Net Income, 2005-2008^[6]

Diamond's rigs are used to find new oil or gas deposits, or to prepare existing deposits for production. ^[7] DO owns one of the largest drilling fleets in the world, a total of 46 ships, including 30 semisubmersibles, 15 jack-ups and one drillship.^[8][9]

• Jack-ups are stationary units that operate at water depths of up to 400 feet, so they are more commonly used in shallower waters, like the continental shelf of the Gulf of Mexico. DO's jack-ups earned average dayrates of $131,000 in the first quarter of 2009, and 73% of DO's jack-ups were utilized during the first quarter.^[10]
• Semisubmersibles are floating units that can operate at water depths of up to 10,000 feet. The most advanced, high-specification floaters, which can drill at over 4,000 feet, earned average dayrates of $360,000 in the first quarter of 2009. Earlier generation semisubmersibles, which drill up to 4,000 feet, earned average dayrates of $283,000 in the first quarter of 2009.^[5]
• Diamond owns one drillship, the Ocean Clipper, which can operate at water depths up to 7,500 ft and can drill down to approximately 25,000 feet.^[11] Drillships are self-propelled and are positioned over a drill site with an anchor or a dynamic-positioning system, similar to a semisubmersible.^[12] As of January 2009, the Ocean Clipper was stationed off the coast of Brazil.^[12]

Fourth Quarter 2009 Summary

Diamond Offshore reported fourth quarter net income of $276.1 million, down 5.9% from $293.3 million in the same period a year earlier.^[13] Revenues in the fourth quarter were $890.8 million, down 1.4% from $903.2 million a year earlier.^[13]

Diamond management claimed net income in the fourth quarter was adversely affect by increased tax expenses, foreign exchange differences preventing DO from utilizing tax credits, and a bad debt expense related to receivables for a rig in Egypt.^[13] The sale of the jack-up rig Ocean Tower slightly offset losses in the fourth quarter.^[13]

For 2009, DO reported net income of $1.4 billion, up 7.7% from 2008.^[13] Revenues were up 2.9% from 2008.^[13]

Third Quarter 2009 Summary

Diamond Offshore reported net income of $1.1 billion in the nine months ended September 30, 2009, up from $1.02 billion in the year prior.^[14] Its net income for the third quarter alone was $364.1 million compared with net income of $310.5 million in the third quarter of 2008.^[14] Revenues for the quarter were $908.4 million, compared with revenues of $900.4 million for the third quarter of 2008.^[14] For the third quarter of 2009 Diamond Offshore also announced a special dividend of $1.875 per share, in addition to a regular dividend of $0.125 per share.^[14]

Diamond Offshore has beat analyst estimates despite continuing weakness in energy demand. Weak demand for energy affects Diamond's performance because many of its customers are independent gas and natural gas companies. Due to falling oil prices in 2009, oil exploration budgets were trimmed and demand for drilling rigs declined. However, Diamond Offshore's extensive contract backlog has mitigated the effect of weak demand and will partially shield it from economic conditions at least through 2009.^[14] Still, Diamond Offshore has had to deal with issues such as customer credit problems, customers attempting to renegotiate or terminate contracts, customers seeking bankruptcy protection, declines in dayrates for new contracts, and declining utilization of idle equipment, which could continue to pose challenges in for Diamond Offshore in the future.

For example, in December 2008, Diamond Offshore recorded a $31.9 million provision for bad debts because one of its customers in the United Kingdom filed for bankruptcy.^[15] Additionally, during the second quarter of 2009, one of Diamond Offshore's customers sought short-term financial relief for a six-well, one-year contract beginning in May 2009. Diamond amended the contract and now the customer is obligated to pay $75,000 per day and the remainder through a 27% net profit interest in five oil and gas producing properties.^[15] These payments are contingent on the production of oil from these wells and on energy prices.

DO Sales Breakdown by Region as of 2008^[16]

DO Sales Breakdown by Rig Type as of 2008^[17]

Key Trends and Forces

New state and federal legislation favors the offshore drilling industry

Senators John Kerry, Lindsey Graham, and Joe Lieberman have drafted legislation that would boost the supply of domestically produced oil and natural gas, both on- and offshore. The legislation is intended to maximize tax revenue for states that opt to drill oil.^[18] Although offshore drilling was a controversial topic, especially during the 2008 presidential campaign, the government is beginning to move forward legislation that will benefit the offshore drilling industry.

At the state level, legislation is also helping to move forward offshore drilling projects. In California, Governor Arnold Schwarzenegger is planning on addressing California's $20 billion budget deficit in part by allowing new oil drilling from an existing platform off the coast of Santa Barbara.^[18] This move will likely loosen California's stance towards offshore drilling and pave the way for future offshore drilling projects in California.

The global financial crisis limits investment in new drilling projects

Limited liquidity in credit markets resulting from the global financial crisis has reduced the amount of funding available for Diamond Offshore Drilling's business operations worldwide. Offshore drilling is a capital intensive business, and with limited credit options, DO is under pressure to finance its capital projects with cash flow instead of debt. The latest construction projects DO completed were the $186.8 million upgrade of the Ocean Monarch rig and the $266.3 million construction of two new jack-up drilling units, the Ocean Scepter and the Ocean Shield.^[19]

Though Diamond Offshore is partially shielded from the credit crisis, a number of its contracts expire in 2009 (like contracts for Ocean Monarch, Ocean Titan, and Ocean Guardian). The company's ability to favorably renew these contracts or sign new contracts will depend on market conditions.

Diamond Offshore has an aggressive growth strategy during economic downturns

When the price of oil climbed to $140 in mid-2008, drilling companies invested heavily in new drilling rigs. However, the swift drop in energy prices and the credit crunch led these companies to default on construction payments. Drilling rigs that were ordered by drilling companies were then put to auction at heavily discounted prices. Ocean Courage was one of the drilling rigs up for auction. Diamond Offshore purchased the Ocean Courage for about $400 million in early 2009.^[20] If Diamond Offshore had placed the order at the height of the market in 2008, it would have waited three years for delivery and the price would have been more than $700 million.^[20] Ocean Courage is now stationed in the Gulf of Mexico.

Diamond's growth strategy is to acquire assets during downturns when iron is priced at a discount. Diamond has been known to acquire drilling assets at discounted prices at auction during economic downturns. The company also buys rigs that other companies fail to see value in. For example, Diamond purchased the rigs Ocean Vanguard and Ocean Patriot for $65 million each when other drilling companies believed those two units would never operate again.^[20] Those two drilling rigs have since generated $200 million in value each.^[20]

Diamond also upgrades units when possible instead of purchasing new units. Diamond upgraded the semi-submersible rigs Ocean Baroness, Ocean Rover, Ocean Endeavor, and Ocean Monarch. Each upgrade took less than two years and each upgraded rig earned the same dayrates as a new rig.^[20]

The economic feasibility of deep water oil exploration is affected by crude oil prices and day rates

Higher oil prices makes it more economically feasible to drill for deposits in deeper and more remote waters. The average drilling rig day rates, which are driven by demand for offshore drilling contracts by oil companies, are between $200,000 to $300,000 for rigs that can operate at water depths of 1500-4000 feet. As more advanced rigs can charge higher rates for longer periods of time, DO has followed a policy of continually upgrading their rigs instead of building the same ones. As of February 2009, DO had ten rigs that could operate at over 4000 feet in water depth and 20 more that could operate at up to 4000 feet in water depth.^[21]

However, the price of oil has fallen from a record high of almost $150 a barrel in July 2008 to around $70 a barrel as of September 2009, which has caused dayrates to fall significantly.^[22] Though contract activity has declined since the global financial crisis began, DO is partially shielded from decreasing day rates. Most of DO's offshore drilling rigs are contracted through 2010, so the short term effects on DO are further buffered by existing contracts. Oil producers that are most affected by declining oil prices operate in the North Sea and the shallow regions of the Gulf of Mexico, two regions in which contract activity has slowed most significantly.

Increases in crude prices not only encourage gas and oil companies to drill for more oil, but rising prices also enable these companies to invest in the exploration of new deposits. Prior to the global financial crisis, an increase in the demand for oil in regions such as China had sustained increasing gas and oil prices. This increase in oil prices drove increased demand for drilling rigs.

In the third quarter of 2008, however, oil prices plummeted due to the financial crisis. Oil trading companies stored the most oil in inventory in 20 years, totaling 80 million barrels aboard 35 supertankers and several smaller tankers.^[23] However, demand for oil in developing countries such as China and India has the potential to raise oil prices in the future.

Severe weather conditions can damage offshore rigs and delay oil drilling

Offshore drilling is adversely affected by severe ocean weather conditions. Storms can delay or even terminate the operation of a rig and rig utilization is usually much lower during hurricane season in regions such as the Gulf of Mexico. In 2005, hurricanes Katrina and Rita ripped through the Gulf of Mexico, and the company recorded a $33.6 million casualty gain for removal of one of their jack-ups, the Ocean Warwick, which was damaged by the hurricanes. Other damages to DO's ships and facilities amounted to $2.6 million. Hurricane season in the Gulf of Mexico is from June 1 to November 30.^[24]

After Hurricane Ike in 2008, Diamond's Ocean Tower drilling rig lost its entire drilling package and derrick. The projected cost for the repair of the rig, $2.6 million with accrued salvage costs of $3.7 million, was below the windstorm insurance deductible.^[25] In 2008, Diamond's insurance deductible was $75 million per occurrence with an annual deductible of $125 million.^[25]

Competition

The drilling industry is highly competitive and the the cyclical nature of the oil industry subjects companies to intense pricing competition during cycles of low demand and high supply of rigs. Companies that manage to retain the highest utilization rates are more able to experience longevity in the industry. High utilization rates means that rigs are contracted and making money. If rigs are not contracted, not only are they not earning revenue, they are costing the company resources needed to store these ships. DO has one of the highest utilization rates in the industry.

DO’s biggest competitors include:

• Transocean (RIG) is based in the U.S. and is the world's largest offshore drilling contractor. It has a fleet of 147 ships, ranging from shallow water jack-ups to the highest-specification deepwater drilling rigs.^[26]
• ENSCO International (ESV) has a fleet of 46 rigs, 44 of which are jack-ups. It has one ultra-deepwater semisubmersible and one barge rig.^[27]
• Noble (NE) has a fleet of 56 rigs: 3 drillships, 3 submersibles, 13 semisubmersibles, and 37 jack-ups.^[28]
• Pride International (PDE) has a fleet of 56 rigs: 2 drillships, 12 semisubmersibles, 28 jack-ups, 3 tender-assisted rigs, 1 barge rig and 10 platform rigs. PDE also has 7 land-based rigs.^[29]

Market Share

Of DO's fleet, only 35 are actively drilling according to http://www.rigzone.com. Here is a comparison of DO's market share of active rigs and its major competitors:

^[35]

References

1. ↑ Seeking Alpha: "Diamond Offshore Drilling's Investors Will Be Rewarded for Their Wait"
2. ↑ Energy Information Administration: Crude Oil Spot Prices
3. ↑ Yahoo Finance: Diamond Offshore Drilling Consolidated Statements of Operations
4. ↑ (DO) Form 10-K, Fiscal year 2006, "Delving into the Deep", p.12
5. ↑ ^{5.0 5.1 5.2} Yahoo Finance: Diamond Offshore Drilling Consolidated Statements of Operations
6. ↑ Google Finance: DO Income Statement
7. ↑ http://www.diamondoffshore.com/ourCompany/ourcompany_offshorebasics.php
8. ↑ (DO) Form 10-K, Fiscal year 2006, "The Fleet", p.3, pp.15-17
9. ↑ http://www.diamondoffshore.com/ourCompany/ourcompany_offshorerigbasics.php
10. ↑ http://www.diamondoffshore.com/ourFleet/documents/November262007web.xls
11. ↑ Diamond Offshore: Our Fleet
12. ↑ ^{12.0 12.1} Reuters: Diamond Offshore Drilling
13. ↑ ^{13.0 13.1 13.2 13.3 13.4 13.5} Business Wire: "Diamond Offshore Drilling, Inc. Announces Fourth Quarter 2009 Results" 4 Feb. 2010
14. ↑ ^{14.0 14.1 14.2 14.3 14.4} Diamond Offshore Drilling 10Q 3-Q 2009
15. ↑ ^{15.0 15.1} 10-Q Diamond Offshore Drilling, Inc. For the quarter ended September 30, 2009. "5. Financial Instruments and Fair Value Disclosures" p. 15
16. ↑ Form 10-K, Fiscal year 2008, "Notes to Consolidates Financial Statements", p. 71
17. ↑ Form 10-K, FY 2008, Item 6 "Selected Financial Data" p. 23
18. ↑ ^{18.0 18.1} Sumfolio: "Offshore Drillers Could See Upside"
19. ↑ DO 10-K 2008 "Drilling and Other Property and Equipment" p.70
20. ↑ ^{20.0 20.1 20.2 20.3 20.4} Diamond Offshore: Rigamarole Spring 2009, No. 28
21. ↑ Diamond Offshore Annual Report FY 2008, "Our Fleet", p.3
22. ↑ Bloomberg Energy Prices
23. ↑ Seeking Alpha: "A Tradable Bottom in Oil?"
24. ↑ About: Atlantic Hurricane Season
25. ↑ ^{25.0 25.1} Diamond Offshore Drilling 2008 Annual Report, Item 1A: Risk Factors, p. 10
26. ↑ http://www.deepwater.com/fw/main/default.asp
27. ↑ http://www.enscous.com/default.aspx
28. ↑ http://www.noblecorp.com/about/aboutfrX.html
29. ↑ http://www.prideinternational.com/rigfleet/type.htm
30. ↑ RIG 2008 10-K
31. ↑ NE 2008 10-Q
32. ↑ Diamond Offshore Drilling 2008 10-k
33. ↑ RDC 2008 10-K
34. ↑ ESV 2008 10-K
35. ↑ http://www.rigzone.com/data