Diamond Offshore Drilling (DO)

The long term outlook for deepwater drilling is still positive despite the pullback in oil prices and credit market turmoil. Diamond's $11.5 billion backlog contributes to a high earnings outlook. As of December 2008, the company has more cash on its balance sheet than debt. Looking forward, analysts expect cash flows in excess of $1 billion in 2009 and 2010.

Standard & Poor's announced in February that Diamond Offshore Drilling (DO) will be added to the S&P 500 index at a yet to be determined date. Although the stock did not appreciate much after the announcement, it held up well and also benefited from a rise in oil prices towards the end of February. When compared to its peer Transocean (RIG), Diamond Offshore has a much stronger balance sheet and better operating margins, providing an interesting way to get exposure to oil without investing in the actual commodity.

Diamond Offshore is the world’s second-largest driller by market capitalization, right after Transocean Ltd. (NYSE: RIG). It has 31 floating rigs: nine sophisticated deepwater semi-submersibles, one drill ship for very deep water, and 21 other semi-submersibles. In addition the firm owns only 13 jack-up rigs, of which only seven are in the Gulf of Mexico.

What I like about Diamond Offshore is its conservative, shrewd management and its commitment to shareholders. The latter is especially ensured because of the situation of its controlling company, the New York conglomerate Loews Corp. (NYSE: L), which owns 54% of the Diamond Offshore’s stock.

Loews, run for half a century by the Tisch family, initially acquired Diamond Offshore’s assets in an opportunistic transaction in 1992. It then sold 30% of the company to the public in 1995 and later acquired Arethusa (Offshore) Ltd. in 1996, using stock, a move that reduced its participation to the current 54%. Since that time, Diamond Offshore has been using its ample cash flow to repurchase shares from public hands.

Diamond Offshore, also referred to as DO, has been managed very wisely. As the world’s No. 2 contract driller, DO has concentrated on the higher-priced equipment, that is, the semi-submersible rigs, which operate in deep waters. And deep water, which require that higher-priced equipment, is where the biggest action is.

And since the specialized deepwater equipment is all taken, DO’s mid-depth equipment benefits because it can be adapted for use on bigger projects.

DO has minimized its exposure to jack-up rigs (those that rest on the ocean floor) and especially to work in the Gulf of Mexico, which has more competition and lower daily rates.

No wonder that DO’s fourth-quarter results handily beat analysts’ consensus estimates of $2.34 per share by posting operating earnings per share of $2.53. Revenue also beat expectations, showing a 1% increase over the prior quarter. The company also realized higher day rates and higher utilization rates.

These are all indications of strong management execution. What is impressive about DO is that the company used the run-up in oil prices last year to enter into long-term contracts at very high prices, registering an impressive $10.3 billion backlog. That gives Diamond Offshore a great earnings visibility going forward.

DO has recently entered into longterm contracts with various companies for several of their rigs, including Ocean Worker, Ocean Yatzy, Ocean Winner, Ocean Alliance, Ocean Victory and Ocean America. The first four semisubmersibles will be engaged in contracts worth upwards of $2.3 billion with Petrobras Energia Participaciones SA (PZE) in Brazil. Ocean Victory has a six-month commitment with Callon Petroleum Company (CPE) worth $91 million. Ocean America has been entered into a Letter of Intent detailing a year-long commitment worth $175 million.

Rising energy prices due to increasing demand for fossil fuels in the developing world and continuing unrest in Nigeria are again making offshore drilling profitable. Analysts expect the deepwater drilling sector to grow faster than the overall oil and natural gas drilling sector, and Diamond Offshore is poised to benefit from the inevitable rise in commodity prices as fossil fuels become more scarce.

Additionally, Diamond Offshore company stock is shielded from daily fluctuations in the price of oil and natural gas because the company signs long-term agreements with oil companies. This gives Diamond Offshore a high degree of visibility into future earnings.

About 90% of the company's rigs are now being utilized. Within the next few months, several key contracts for drilling jackups and semis will expire. Diamond's performance is largely dependent on whether it can secure additional contracts and maintain a high utilization rate. The outlook is promising as oil prices are on the rise and the drilling industry is expected to grow in the remainder of 2009 and into 2010.

Shares of deepwater drilling stocks gained 20%-25% from their March 2009 lows as the price of crude oil increased, but they continue to be undervalued. Cuts in oil production by OPEC and the inevitable increase in the demand for crude oil due to economic growth in developing countries will put positive pressure on the price of crude oil. Barron's has estimated that oil commodities prices will reach $60-65 by the end of 2009 and average $65-70 in 2010. Deepwater drilling companies benefit from higher crude oil prices because the oil companies to which they lease their rigs pay higher day rates for oil rigs when crude oil prices are higher. Even if crude oil prices are slow to rebound, Diamond Offshore Drilling and other deepwater drilling companies have backlogs that will will generate revenue for up to three years.

The outlook for Diamond Offshore is also promising because of opportunities in the general and competitive environments. As oil becomes more scarce, oil drilled from deep ocean drilling rigs will become an increasingly important source of oil reserves. Additionally, with a limited supply of oil rigs with deep ocean drilling capabilities, the three main competitors in the industry-Transocean, Diamond, and Noble-will be able to set high day rates and negotiate favorable contracts with oil companies seeking access to offshore rigs.