4 Things Diamond Offshore’s Management Thinks You Should Know – Motley Fool

When it comes to offshore rig companies lately, you really need to grade on a curve, because the entire industry is suffering. With that in mind, Diamond Offshore Drilling's (NYSE:DO) results lately have been surprisingly positive. It has been able to keep its earnings afloat with some steep cost-cutting, but it has also been able to find work for rigs. That's something we haven't seen much in this industry lately.

On the company's most recent conference call, management tooted its own horn a bit thanks to those new contracts, but it also provided some interesting insights into what the market for offshore rigs will look like in the coming years. Here's a selection of quotes from Diamond CEO Marc Edwards that will help investors better understand the offshore industry today.

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Probably the hardest thing for offshore rig companies right now is finding new work for their respective rigs. While some companies have been able to tout a few small and short-term contracts, Diamond has been able to secure several long-term contracts. Using this conference call to take a victory lap, Edwards highlighted the contracts Diamond secured in the first quarter of the year:

[W]e commenced two new contracts for our sixth-generation assets, the Ocean GreatWhite and the Ocean BlackRhino, and additionally, we secured a new term contract for our third generation asset, the Ocean Patriot, as well as securing 2 new short-term contracts for the Ocean Monarch. Overall, I'm pleased with these results as it demonstrates our ability to employ all of our sixth-gen assets and find new work for a variety of asset classes while at the same time maintaining a relentless focus on cost management and increased operating efficiency.

Some of these contracts won't be showing up in current results because they are either extensions for rigs already working, or they are in the yard for maintenance work. What is more important is that it extends the time that Diamond's current revenue is protected by long-term contracts. That in and of itself is something few rig companies have today.

The woes of deepwater drilling have been almost exclusively been blamed on the advent of shale drilling and how quickly the latter has moved down the cost curve. Some financial pundits have declared offshore drilling is dead. While the evidence seems to support this idea -- shale drilling in North America has been going like gangbusters, while deepwater drilling has ground to a near-standstill -- Edwards gave a more nuanced approach that should give investors some comfort:

[F]ull life cycle project [net present values] can in many circumstances deliver better returns offshore than onshore, and the real issue here is the timing of the cash flows. While oil prices languish at their current levels, we spend direct investments onshore. However, we are now seeing many [integrated oil companies] rehabilitating their deepwater portfolios and options with a view as to when to bring sanctioning back over the horizon. Nonetheless, it is important express caution here due to the time lag from project sanctions to the actual commencement of drilling activity. But when current industry investment is at such unsustainable levels, we are finally starting to see discussions in relation to deepwater portfolios. It is clear that deepwater economics continue to improve through project standardization and simplification while competing [shale] costs are now trending back up.

For cash-strapped producers, the choice today is pretty obvious. A 10% return you can get three weeks from now is much more attractive than a 30% return you won't get for another three years. Once their balance sheets are in better shape, though, chances are they will start to swing for those greater returns that can be found in the offshore environment.

Up until a few years ago, the drilling industry in general suffered mightily from an old-school, heuristic approach to the entire business -- from rig design and construction to repair and maintenance schedules. Thankfully, though, this trend is starting to come to an end. By now, just about every company has started using a more standardized design for rigs that makes replacement parts that much easier. According to Edwards, Diamond is taking the next logical step and updating the way in which it handles maintenance and replacing parts through data analysis:

[W]e began implementing our new risk-based asset management system, which enables predictive maintenance. This system has been under development for over 18 months, and we are now ready to implement it fleetwide. And with this solution, Diamond Offshore will utilize data analytics to manage rig maintenance across our entire fleet for improved reliability and lower operating costs. This approach moves away from the drilling industry's traditional reliance on time-based rig maintenance and embraces leading practices often found in high-reliability industries such as aerospace and power generation.

This isn't the first stab at new thinking for Diamond when it comes to a more advanced approach to equipment maintenance. Last year, Diamond signed a deal with General Electric (NYSE:GE) where Diamond sold its blow-out preventors back to GE and now leases them back from General Electric with incentive bonuses for less maintenance downtime. The idea is that it puts more skin in the game for General Electric, which motivates it to use a more data-driven approach to repair and maintenance. Diamond benefits because a rig works more days within the duration of a contract, and makes it more likely to receive performance bonuses from the producer. Hopefully, it will be able to do something similar with this new asset management system.

Diamond has been one of the companies that aggressively scrapped or sold older rigs that were less relevant in today's offshore drilling market. As a result, it has one of the more capable fleets -- which explains why it is getting work while others struggle to get contracts. Even after all of the rig scrapping that has gone on in recent years, Edwards thinks that a lot more will be done:

So there's generally a reluctance, I think, to actually grasp the nettle and start scrapping some of the early generations sixth-[generation] rigs, the ones that came out in '08, '09, '10, for example that are sitting at the back of the deli line in terms of desirability and many of our peers simply just can't afford to take the impairment of those rigs due to, as I mentioned, breaking their debt covenants and as a result they're just sitting out there. I think ultimately, however, if we truly take a look forward to this recovery, which will be somewhat drawn-out, I think that many of those sixth-generation rigs that are cold-stacked today, that are of the early generation of the sixth-gen category will not see the light of day again simply because as each year passes, your activation costs come up too high and therefore, they will effectively be de facto scrapped.

This is bad news for companies with lots of these sixth-generation rigs that were made in the past 10 years, but can't find work. One of the reasons they have been hesitant to scrap these newer rigs is many of them are still held for a high value on balance sheets, and to scrap them would involve even more asset impairments that could make some rig companies violate their debt covenants. Eventually, these rigs will either go away, or the market will eventually rebound enough that even these rigs will find work. Whatever the case, those companies with these kinds of rigs in their fleets are likely to suffer for a while.

Tyler Crowe owns shares of General Electric. The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.