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Diamond Offshore Drilling, Inc. (NYSE:DO)

Q1 2008 Earnings Call

April 24, 2008  10:00 am ET

Executives

Les Van Dyke - Director, Investor Relations

Lawrence R. Dickerson - President and Chief Operating Officer

Gary T. Krenek - Senior Vice President and Chief Financial Officer

John L. Gabriel - Senior Vice President, Contracts and Marketing

Analysts

Ian Macpherson - Simmons & Company International

Jeff Tillery - Tudor Pickering & Co. Securities

Tom Curran - Wachovia Capital Markets, LLC

Doug Garber - Fbr Asset Investment Corp.

Wagar Syed - Tristone Capital Inc.

David Smith - J.P. Morgan

Arun Jayaram - Credit Suisse

Daniel Boyd - Goldman Sachs

William Sanchez - Howard Weil Inc.

Geoff Kieburtz - Citigroup

[Ola Silor] of Morgan Stanley

Operator

Good morning. My name is [Natasha] and I will be your conference operator today. At this time I would like to welcome everyone to the Diamond Offshore Drilling first quarter 2008 results conference call. (Operator Instructions)

It is now my pleasure to turn the floor over to your host, Les Van Dyke, Director of Investor Relations. Sir, you may begin.

Les Van Dyke

Good morning and thank you for joining us. With me on the call today are Larry Dickerson, President and Chief Operating Officer, Gary Krenek, Senior Vice President and Chief Financial Officer, and John Gabriel, Senior Vice President, Contracts and Marketing.

Before Larry begins his remarks I should remind you that statements made during this conference call may constitute forward-looking statements and are inherently subject to a variety of risks and uncertainties that could cause actual results to differ materially from those projected. Forward-looking statements include but are not limited to discussions about future revenues and earnings, capital expenditures, industry conditions and competition, days that drilling rigs will enter service, as well as management's plans and objectives for the future. A discussion of the risk factors that could impact these areas and the company's overall business and financial performance can be found in the company's reports filed with the Securities and Exchange Commission. Given these concerns, investors and analysts should not place undue reliance on forward-looking statements. The company expressly disclaims any objection to release publicly any updates to any forward-looking statements to reflect any change in the company's expectations or any changes in events, conditions or circumstances on which a forward-looking statement is based.

With that, I will turn the meeting over to Larry.

Lawrence R. Dickerson

Thank you, Les. Let me open with the statement that last night at midnight we took the liberty of the Ocean Shield, our 350-foot new-build jackup under construction at Keppel FELS in Singapore. That rig was delivered, depending upon how you measure it, probably six to eight weeks later than when we first believed we would get the rig when we placed the order for a variety of reasons, but substantial performance on our commitment date. Because the rig was turnkey, there was very little increase in cost except for some time-related cost such as capitalized interest and certain shore-based so our expected final delivery cost will be within a 5% overrun of our initial commitment amount, so we're very pleased with that.

We also announced in our fleet status report that we have accepted a five-month approximate commitment for the rig for an initial job in Indonesia. We had announced some time ago that our initial job would be a one-year commitment in Australia at a very nice rate, however to facilitate certain operator preferences between the two customers we agreed to go ahead and begin with this lower-rate job as a fill-in job in Indonesia. We think that will be good for all the parties involved, however it will slide some of the higher day rate earnings term out of 2008 and 2009, but again, we're pleased with that.

But we're scheduled to have tugs show up in Singapore and depart about the 15th of May to go on contract, so we're pleased with that. We'll continue to commission the rig. We're pleased with the state and happy with that particular upgrade.

The Ocean Scepter, which is a sister unit being built at Keppel FELS' Brownsville, Texas facility is about five weeks away from a similar delivery. We have not announced a job on that, but I can tell everyone that we are in advanced stages of negotiation for an international term job. We are just not at liberty for a variety of reasons to disclose who that is, where the location would be or what that rate is as well. But again, we're very comfortable with the prospects for that new-build jackup as well.

Additionally, we announced in the fleet status report that we've signed a two-year extension on the Ocean Guardian with its existing customer in the North Sea. The existing job ran through July 2009, so this will now take it out through July 2011. We announced the rate in the mid 380s, which I think there'd been a similar posting of a similar rig in the North Sea at about that rate - certainly a step up from our present rate - and we're pleased with that as well.

Finally, I'll just remark in the quarter we saw continued improvement in the Gulf of Mexico jackup rates, certainly moving back towards high utilization of the ready fleet, and we've seen renewals continue to be at modest rises from well to well. But because it's a very short-term market, the cumulative effect of that is to re-price the fleet at much higher rates than what we thought the prospects were based upon rates in effect in the end of the fourth quarter, when we had a number of stacked rigs. So again, we're pleased with that.

Other than that, that will conclude my opening remarks. Obviously, John Gabriel and the rest of us can comment further on various other markets to your questions. I'm sure we'll get some dividend questions. But I'm going to turn it over right now to Gary Krenek, Chief Financial Officer, to give some additional guidance on financial numbers.

Gary T. Krenek

Thanks, Larry. I have just a couple items that I'd like to mention to you this morning before we move on to the Q&A portion of the call.

As before, I'm not going to reiterate all the numbers from our press release, but suffice to say that our first quarter results for contract drilling revenues, which were $770 million, net income, which was $291 million, and earnings per share that were $2.09, again set all-time quarterly highs for Diamond Offshore.

Looking at the specifics behind those numbers, we gave out some pretty detailed guidance as to what to expect for contract drilling expenses in the first quarter in our last conference call, and those numbers came in pretty close to what we expected. The Ocean Patriot survey costs did come in about $3 million above expectations, and overall costs for our various international rigs were up another $3 million due to the further decline in the U.S. dollar.

We do hedge much of our foreign currency requirements, and our quarterly results include a $2 million gain on those foreign currency contracts. But due to accounting rules, we're not allowed to net those gains and losses. As such, contract drilling expenses include the extra $3 million of costs associated with the currency and the $2 million gain is included below the line, below operating results, down in the other income and expense line.

Depreciation expense ended up a little more than we had anticipated for the quarter at $69 million, and we expect it to be around the same amount again in Q2. Depreciation expense will then increase to $72 to $73 million in the third and fourth quarters of this year as a result of the new-build jackups Scepter and Shield coming online at that point.

With respect to contract drilling expenses in the upcoming quarter, the per day cost that we gave by rig class in our last conference call still applies. In addition to those normal daily operating costs we expect to incur a combined total of $17 to $20 million in additional survey and related costs for the Guardian, Drake, Ambassador, General and Clipper surveys, which will all be performed either totally or partially in Q2. And unless the U.S. dollar strengthens, we will again expect to incur $3 to $5 million additional cost in our international operations and we will also incur an additional $2 million related to completing the mobe of the Ambassador back to the United States from Mexico.

One final note with respect to drilling expenses, we will incur approximately $5 million in the second quarter for amortized mobe expenses that had been previously deferred. As always, this expense will be offset by amortized mobe revenues that had also been deferred.

Now if you do the math on all this correctly, it should result in expected contract drilling expenses of $300 to $310 million for the second quarter. Having said that, this estimation will change if there is a change in our rig survey timing. I'd like to take this opportunity to remind everyone that we file an updated rig status report on our website every two weeks. Changes in survey downtime dates, contract rollover dates, et cetera, can be found in that report.

The guidance we gave on our last conference call with respect to G&A, interest expense and our tax rate still stands. For those that may have missed it, G&A should continue to run at $14 to $16 million per quarter, interest expense net of capitalized interest at about $2 million a quarter, and the tax rate should remain somewhere between 28% and 29%.

And finally, our guidance for capital expenditures for 2008 also remains consistent with our last quarter's conference call. Just to break that down one more time, the Monarch and completion of new-build jackups, we expect to spend $180 million, and the Monarch, of course, is our 10,000 foot upgrade that we're doing in Singapore. We're going to spend about $130 million on required contract upgrades for our Brazil contracts. Capex associated with the 12 rigs that are undergoing their surveys this year is expected to be around $160 million. We'll spend an additional $50 million for additional spare equipment, which is part of our revenue preservation plan. And finally, just general maintenance capital will be about $160 million. All totaled, that comes up, again, to $680 million per year.

And with that, I'll turn it back over to Larry.

Lawrence R. Dickerson

Okay. So let's begin the questions, Les.

Les Van Dyke

Operator, we're ready to begin questions.

Questions-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Ian Macpherson of Simmons & Company.

Ian Macpherson - Simmons & Company International

Hey, good morning. Larry, I guess my first question, starting on the deepwater side, we've seen a lot of very attractive fixtures with the four-generation and up fleet. So I guess, looking at your fleet, I think the Star is the next rig you have rolling off contract. Have you seen the [bidding] environment improve over the past quarter for four-generation rigs or pretty steady state from where you have been? And if you can characterize in any way the work possibilities for that rig in terms of what you envision in terms of renewing the rig in the Gulf of Mexico or putting it somewhere else, and what type of term possibilities are out there for that rig?

Lawrence R. Dickerson

Well, you are correct. The Star is our first higher specification unit in the fourth quarter that will be available for rollover. And I would - we haven't fixed it so there's not a data point that we can look at, but we have bid this in international locations and in the Gulf of Mexico. And we do follow, obviously, the market in establishing our rates. It all depends upon the competition that's in there.

John, do you have anything else to add on that?

John Gabriel

Well, we're looking, obviously, at Gulf of Mexico opportunities, and I think the most recent lease sales bode very well for keeping these rigs gainfully employed here. The interesting part is there are a lot of competing opportunities outside the Gulf of Mexico. There is some unsatisfied demand for that class of rig in Brazil. We're looking at about three different opportunities in West Africa. There's been some conversation about a need for one or two rigs of this caliber in the Australasia area, and there's also at least one opportunity in the Mediterranean. And all of them involve some level of term, anywhere from, I'd say, a year to 18 months on the low end to as long as three years or better on the high end.

In general, there's more term in international markets than in the Gulf of Mexico, but if we renew it in the Gulf of Mexico, we don't have to deal with mobilization issues and the accounting rules are such that during that mobe period, even if you're compensated for that mobe time, you go to a zero rate and you spread that all into the future, so we're cognizant of that as well, although ultimately we do look at cash rather than book income.

Ian Macpherson - Simmons & Company International

Sure. Okay. And then if I could just ask you a quick follow up on the jackup side, if you could talk about the status of the Heritage that's hot stacked in the Middle East. Is there some sloppiness with the windows of supply-demand there, or when do you think that rig gets back to work?

Lawrence R. Dickerson

I don't think it's a function as much of market sloppiness as it is the process, the bidding process, that we've got to deal with in that area. And unfortunately in some late stages of negotiations, while we were still working, we had an LOI withdrawn and that basically threw us out of sequence on the rig.

What we are looking at right now is a couple of promising opportunities that start in the next month or two, and there is obviously significant incremental demand throughout that area in the second half of the year. So we just got caught, in my mind, in a process-driven situation as opposed to a market-driven situation.

Ian Macpherson - Simmons & Company International

Okay. Got it. Thank you.

Operator

Thank you. Your next question comes from Jeff Tillery of Tudor Pickering Holt.

Jeff Tillery - Tudor Pickering & Co. Securities

Hi. Good morning.

Lawrence R. Dickerson

Hi, Jeff.

Jeff Tillery - Tudor Pickering & Co. Securities

I just wanted to ask a little bit, following up on the previous question on some of your fourth-gen rigs in the Gulf, we've seen terms stretch out longer and longer for the fifth gen and up [inaudible] rigs. What's the longest term you guys are looking at? I know you mentioned some specific opportunities on the Star and 18 months to three years, but what's the longest term you guys are looking at for kind of the 5,500 foot class rig?

Lawrence R. Dickerson

Well, clearly Brazil offers the fairly substantial term seen around the world. John?

John Gabriel

Well, I think that's the right answer, Larry. Outside of Brazil the terms are probably, again, 18 months to three years. We have not seen anything formal in Brazil as yet, but if you based on what we've seen the other rigs being committed to term-wise down there, it could be anywhere from four to six years if we were to pursue that.

Jeff Tillery - Tudor Pickering & Co. Securities

Okay, so maybe five-year top opportunities if something manifests in Brazil. Otherwise it's kind of three years or less is the typical opportunity?

John Gabriel

I think that's fair, yes.

Jeff Tillery - Tudor Pickering & Co. Securities

In terms of an operating preference, would you prefer to operate these class rigs outside of the Gulf where you avoid any sort of hurricane risk or hurricane-related downtime or is there any preference internally?

Lawrence R. Dickerson

I think hurricanes are a factor that we weigh in making those decisions. As John mentioned before, the strength of the lease sale and the fact that there are so few mid-water units left in the Gulf of Mexico also opens up quite a bit of area for these fourth generations to get down and do some of that drilling.

So I think there's great opportunities here and we're not set to abandon the Gulf of Mexico by any means.

Jeff Tillery - Tudor Pickering & Co. Securities

And my last question, on the Shield, the five-month LOI, is that with the same customer?

Lawrence R. Dickerson

No.

Jeff Tillery - Tudor Pickering & Co. Securities

And the rate on that, would you view that as indicative of the market or just the type of rate you could get on a short window?

Lawrence R. Dickerson

I think it's indicative of the market.

Jeff Tillery - Tudor Pickering & Co. Securities

Okay. All right. Well, thank you very much.

Operator

Thank you. Your next question comes from Tom Curran of Wachovia.

Tom Curran - Wachovia Capital Markets, LLC

Moving to the earlier generation and to the mid-water market, in both the Gulf of Mexico and the North Sea, a major driver of this renaissance of demand we've seen has been abandoned prospects or marginal prospects that have become economic because of the [step] change in oil prices, and I was wondering for each of those markets if you could give us a sense of just how large an inventory roughly is remaining of those type of abandoned flash marginal prospects in the Gulf and in the North Sea?

Lawrence R. Dickerson

I think that's really a question for the operator. It's not that I'm hesitant to give you an estimate. It's just that I think we lack the tools to put it in context. It's - clearly, it is a factor. And what we've seen probably in the Gulf of Mexico as the limiting factor is just companies dedicated to that sector. There are some, but there's so many people moving into deeper waters. But there's certainly ripe opportunity there. I think we've seen it'd be a bigger factor in the North Sea because that was really on the standpoint of maybe being abandoned and now you've got lots of companies being active there. And there's actually less mid-water units in the Gulf because we all moved out for hurricanes, for term and for the fact that the Gulf of Mexico was a short-term market.

Tom Curran - Wachovia Capital Markets, LLC

I guess, then, in turning to the North Sea, are you seeing any signs whatsoever yet that inventory of those types of prospects may be starting to shrink at a pace or to a number that would cause you concern relative to the supply of mid-water rigs there?

Lawrence R. Dickerson

Well, I think the only real indicator we have is what our rigs are able to accomplish on a go forward basis from a term and a rate basis. And the extension on the Guardian I think bodes well for that. We are quite a ways away from having conversations about any of the other three rigs there, but every indication we have is that there's nothing on the horizon that would cause us concern about that market and that class of rig.

Tom Curran - Wachovia Capital Markets, LLC

That's helpful. Thank you. Turning to some rig-specific questions, starting with the next two early generation mid-water semis set to come off contract in the Gulf, the Saratoga and Ambassador, John, could you share your current expectations for each of those rigs?

John Gabriel

The Gulf of Mexico market is going to be characterized by a little bit shorter term, either well to well or multiple wells as opposed to term commitments, but we do have significant interest from a lot of different people. And we have, you know, we've been able to string that - basically, we've had that rig working for one customer for a long time, but we have a lot of interest in it and expect to be able to keep it busy, let's say, in the 250 to 300 range just on a short-term commitment basis.

With respect to the Ambassador, a little bit less water depth capability but we've got the rig busy now and are looking at putting another well hopefully in front of it before it goes into the yard. I guess we've got about 90 days worth of shipyard time planned on that rig, and we are already in conversation with people about the commitment on the rig post its shipyard stay.

Again, it's a short-term market, but it's a healthy market.

Tom Curran - Wachovia Capital Markets, LLC

And the day rate range that you expect for the Ambassador at this point?

John Gabriel

Oh, maybe 10% either side of 250 would be my guess right now just depending on the specific application.

Tom Curran - Wachovia Capital Markets, LLC

That's some helpful color. Thanks, John. And then lastly, the Baroness, that's set to roll off in November of 2009, and I would think you're in a position to command if not something close to current leading edge maybe even push for something higher given the dwindling amount of available with deepwater capacity at this point in late '09. Could you speak to that?

Lawrence R. Dickerson

No. I mean, we'll talk about the general market, but I hate to talk about a specific rig where we have an existing customer who has that and we have yet to enter into negotiations. You understand.

Tom Curran - Wachovia Capital Markets, LLC

Okay. Thanks, guys. I'll turn it back.

Operator

Thank you. Your next question comes from Doug Garber of Fbr.

Doug Garber - Fbr Asset Investment Corp.

Cash billed and on your balance sheet, currently over $620 million and growing, if the special dividend is flat at $1.25 per quarter, I estimate there could be about $800 to $900 million in cash on the balance sheet by the end of the year. Is there another way you guys are thinking about returning the cash to shareholders other than through a special dividend?

Lawrence R. Dickerson

We remain committed to the special dividend as our primary means of returning cash and enhancing - I'd say there are number of ways to enhance shareholder value, but we think that that does it in addition to our earnings capability. And the Board will analyze that at each particular quarter. And although we're not giving future guidance on that, that is our primary method of dealing with that.

And if you look, even if we had acquisition opportunities to come in the future and you look at the fact that we have a low level of debt on the balance sheet, I don't necessarily think that it's an either-or on the use of our cash. Whether or not we can maintain or increase or let the Board determine what size dividend we want to pay or divert it to other opportunities, they're not in all cases an eitheror situation.

Doug Garber - Fbr Asset Investment Corp.

And could you give me a little bit of color into the decision the Board made of - maybe why they didn't increase the dividend this time? I mean, I estimate, you know, another quarter of the special dividend would have cost about $35 million and there's well over $600 million on the balance sheet. Is there any reason to keep, you know, $600 million on the balance sheet versus $500?

Lawrence R. Dickerson

You know, we have declined to give a formula, and so I'm going to stick with that as to. If you look over a several year period, you will see that the amounts that we have paid have grown, but no future color that I could give you as to how that would happen.

Doug Garber - Fbr Asset Investment Corp.

Okay. And one final question: What's the maximum amount of cash you guys would leave on the balance sheet? I mean, would it go up to, you know, $800, $900 million ultimately or is there a cutoff that you want to have there?

Lawrence R. Dickerson

I think that would be getting into a formula. We will look at all the factors involved - including cash needs and cash requirements, which would change over time - in setting our special dividend.

Doug Garber - Fbr Asset Investment Corp.

All right. Great. Thank you. I'll turn it back.

Operator

Thank you. Your next question comes from Wagar Syed of Tristone Capital.

Wagar Syed - Tristone Capital Inc.

Hi. I understand that Transocean is in the process of marketing or selling some of its semisubmersible rigs in the North Sea. Do you guys have any interest in those rigs or otherwise you think that maybe on the cycle it doesn't make sense to buy rigs at this time?

Lawrence R. Dickerson

That's something that you would need to ask Transocean, I would think. They're handling that sale, and I don't want to get into their business.

Wagar Syed - Tristone Capital Inc.

I'm asking you, would you be interested in this part of the cycle to make acquisitions? You know, last time you bought semisubmersibles you paid like $60, $70 million. It's unlikely you can pay that much for a rig now. Would you have any interest in buying at this time?

Lawrence R. Dickerson

I can agree that we're not going to see in the foreseeable future those kind of rig prices, but beyond that, if things are up for sale or not up for sale, you'll hear a comment from us. And I don't mean to be less than clear, but I think anybody that's in the business as we have been in buying rig purchases cannot make comments as to - that we're interested in this one or that one or any particular opportunities that may be out there.

Wagar Syed - Tristone Capital Inc.

Okay, great. And then, Gary, you gave some guidance for 2008 costs last quarter. Could you repeat that again for us, please?

Gary T. Krenek

For what, for the year?

Wagar Syed - Tristone Capital Inc.

For the year, yes.

Gary T. Krenek

We're still looking - we'd said 18% to 20% over last year, and we're still expecting somewhere around that. With the weakening of the U.S. dollar as I talked about, probably toward the upper part of that 20% but not substantially outside that range.

Wagar Syed - Tristone Capital Inc.

Okay, great. Thank you very much.

Operator

Thank you. Your next question comes from David Smith of J.P. Morgan.

David Smith - J.P. Morgan

Wondering if you can talk about the labor situation, what you're seeing on turnover and maybe where wage inflation is running now and if that's changed over the last 12 to 18 months?

Lawrence R. Dickerson

I would think we've continued to see demand for people, but I would say our wage escalation is not running away from us. I haven't seen that to be the case. Certainly we're pleased to be able to return and make sure that our employees enjoy this up cycle as well, and so we've been making steady increases. But they're not beyond what I think is reasonable given the business environment.

David Smith - J.P. Morgan

Is there maybe a numeric range around that, inflation-wise?

Lawrence R. Dickerson

I guess we've said that overall if you strip out of our costs the fact of new rigs and rigs going overseas, both of which drive up costs on a year-to-year basis, that we've been looking in the 10% range, 10% to 12% range, for overall inflation. And wages are a component of that.

David Smith - J.P. Morgan

About half probably?

Lawrence R. Dickerson

Half might be a reasonable guess as to broadly defined what are all the components but there's also components on prices we pay for goods as well, and those two things split back and forth. But those are in the ranges of what we're looking at.

David Smith - J.P. Morgan

Is that 10% to 12% across all of the op ex fairly evenly distributed so we would be looking at a similar range for labor?

Lawrence R. Dickerson

No, I said if our costs go up 10% to 12%, half our costs are labor, then our labor's not necessarily driving up at that rate.

David Smith - J.P. Morgan

Okay. And any thoughts on turnover, how that's been tracking?

Lawrence R. Dickerson

We are pleased with our turnover. We have retention programs in place. We offer lots of promotional opportunities in addition to that, and we are comfortable that for the foreseeable future we're able to maintain adequately trained crews and we're committed to continuing to do that.

David Smith - J.P. Morgan

Okay. Well, thank you.

Operator

Thank you. Your next question comes from Arun Jayaram of Credit Suisse.

Arun Jayaram - Credit Suisse

Good morning, guys.

Lawrence R. Dickerson

Good morning.

Arun Jayaram - Credit Suisse

Gary or Larry, I was wondering if you could comment a little bit. You have a lot of rigs that you've done survey work over the last couple of years. I'm just wondering if you could comment on some of the challenges of getting these surveys done in a timely manner, and is it getting easier as your experience grows or does the tightness make it more challenging?

Lawrence R. Dickerson

It's a constant challenge, I think, for us and or everybody that's in the industry to get anything done on a timely basis because there's huge demand in shipyards. Many shipyards are involved in new construction projects, and so being able to get space to perform your surveys is an issue, getting labor and welders, because when you go in you're doing any kind of upgrades that you've got. Being able to take equipment off service and get it returned by the time you're ready to set sail is a huge challenge.

I would guess on looking at this year versus last year, most of our surveys last year were domestic and this year most of our surveys are international. The international ones are always more challenging because they're further away and each individual market is unique.

So far I'm pleased with our ability to manage. We've had some rigs go over; we've had some rigs go under, and so I'm pleased with that. But you'll have things like weather that are really not related to this market that can be a huge variability.

Arun Jayaram - Credit Suisse

Okay. And during these SPSs, particularly on the floating rig fleet, are there common things that you're seeing in terms of things that are addressed during the SPS and any surprises you're seeing, given the age of the fleet?

Lawrence R. Dickerson

Well, sometimes we'll see a rig that will have some deterioration over and above what we might have expected, but we try to do a lot of pre-survey where we can before we get in there. And adequate planning is the best tool that anybody has to be able to manage these type of projects.

So by and large I think we're seeing what we expect, and then occasionally we'll see a rig that's in much better shape than our fears or our initial survey may have indicated they would be.

So all those balancing out, we're comfortable that they're staying more or less as we expect.

Arun Jayaram - Credit Suisse

Okay. And last question, in the fleet status you did update and it looks like there's no changes to the 2009 survey schedule. Do you have a read on 2010? Is it going to be similar to '09 or could it be a heavier load in 2010?

Lawrence R. Dickerson

2010 will be less just from the number of rigs that we've got scheduled for survey. We have our 45 or so rigs that we've got are scheduled primarily to be in every five years, and they have a two-year cluster which is occurring in 2008 and 2007. So when we get to 2010, I don't know the number but it's probably four or five rigs.

Gary T. Krenek

Just to clarify, it'll be definitely less than this year, probably similar to 2009.

Lawrence R. Dickerson

That's on the scheduled shipyards. But we also, if we have a job and we have elected to take rigs offline to do upgrades for jobs - for instance, going into Brazil can take some period of time to do that which we'll characterize that as shipyard, and then acceptance testing on the other end that we'll face in Brazil, Mexico and some of the other locale - so those are almost voluntary. We look at the cash flow impacts of it before we make those overall decisions, so those kind of things could be variable.

But we are expecting as we clear through 2008 that we will see declines in 2009 and 2010.

Arun Jayaram - Credit Suisse

All right. That's very helpful, gentlemen. Thanks a lot.

Operator

Thank you. Your next question comes from Dan Boyd of Goldman Sachs.

Daniel Boyd - Goldman Sachs

Hey, you mentioned earlier that the market rate on the Shield was 175 for the five months. Is it safe to assume that on a two or even a one-year contract that the market rate would be lower than that?

John Gabriel

It depends on the area. I think what we're seeing with respect to the new build commitments in particular that have come out and been contracted recently have run in a range anywhere from somewhere in the low 160s to 190, maybe a little bit better.

There are certainly exceptions to that rule or exceptions to that characterization, if you will. Northwest Europe, the North Sea, and Norway are substantially higher based on higher cost of entry and limited supply. On the low side you'll see some things in the mid one teens, like the Gulf of Suez. And for some short-term and either very difficult or opportunistic commitments, we're still seeing a commitment now and then above $200,000 a day. But generally I think those rigs are going to be at this stage somewhere in the 165, 170 to 190 range.

Daniel Boyd - Goldman Sachs

Okay. I know you don't want to comment specifically on the Scepter, but that is pretty much the same rig as the Shield, and if the Scepter received 175 for five months, it's likely that if the Scepter was on a longer-term contract it would be lower, though. Is that a correct way to read that?

Lawrence R. Dickerson

No.

John Gabriel

No.

Lawrence R. Dickerson

I don't think so.

John Gabriel

Part of it is area specific in Malaysia.

Daniel Boyd - Goldman Sachs

Okay.

John Gabriel

And that is part of it.

Daniel Boyd - Goldman Sachs

Okay. And then, Larry, if you can comment more - you mentioned acquisitions - can you talk about what you're seeing out there in terms of opportunities, if you would be willing to acquire a new build as part of your acquisition strategy?

And then also you mentioned the clean balance sheet and the balance sheet optionality that you have. What levels of debt would you be comfortable with?

Lawrence R. Dickerson

We are committed to enhancing shareholder value and so we look at opportunities all the time. And I think it's going to be really dependent upon pricing that's out there. And I think in general new build pricing is still at a premium, and we would look for that rare situation - and we're no different than anybody else, so I understand that there's not going to be great steals out there because everybody would be dancing around that same thing - so we would look at that. We always look at used equipment across a wide variety of areas because we think that there can be some really good values there at a point in time when other costs are escalating.

So far as debt on the balance sheet, I can't really tell you, but when you start with our low level and with the market cap of the overall company, obviously, when you look at what rigs or a couple rigs would cost, there's clearly room to take on - to contemplate debt in that range without being over levered.

Daniel Boyd - Goldman Sachs

Given that new builds are likely to be priced at a significant premium, I guess it's safe to assume, then, that you're unlikely to do a new build or, better said, more likely to purchase used equipment or an existing rig on the market?

Lawrence R. Dickerson

I wouldn't rule that out because it all depends on the specifics of the rig and the contract opportunities, so you'll have to - as you indicated, you may believe and our history has been more towards used equipment, but I think we surprised the market when we ordered two new jackups.

Daniel Boyd - Goldman Sachs

All right, thanks.

Lawrence R. Dickerson

Which worked out - has worked out very well for us.

Operator

Thank you. Your next question comes from Bill Sanchez of Howard Weil.

William Sanchez - Howard Weil Inc.

Good morning. Just one question, following up on the Scepter, I guess on previous conference calls there was some thought that that rig might actually start off in the Gulf of Mexico and, given the comments this morning, is it just likely we go straight from the shipyard internationally or could this thing still go to the Gulf of Mexico for a brief period of time before starting a term contract internationally?

Lawrence R. Dickerson

We have said - I said it at the beginning - that we are in advanced stages on an international contract, so unless the wheels fall off that for some unforeseen reason, that would be our initial job.

William Sanchez - Howard Weil Inc.

That's it for me. Thank you.

Lawrence R. Dickerson

Thanks. Let's take a couple more questions.

Operator

Thank you. Your next question comes from Geoff Kieburtz of Citi.

Les Van Dyke

Geoff?

Geoff Kieburtz - Citigroup

Can you hear me?

Les Van Dyke

Now I can, Geoff. How you doing?

Geoff Kieburtz - Citigroup

Okay, how are you doing? Made it back okay.

Les Van Dyke

Made it back from Mexico?

Geoff Kieburtz - Citigroup

Yeah. A short-term question. Looking at the high spec, the mid-water and the jackup categories, all three categories had increased utilization, but the high spec and jackup operating expenses went down whereas the midwater operating expenses went up on a sequential basis. What is going on there?

Lawrence R. Dickerson

I'll let Gary comment on that because we don't have a - I'm sure it's related to survey costs and things that we're spending on the rigs in total.

Gary T. Krenek

Well, for the jackups, you're right. That went down, and that was due - in the fourth quarter we had survey costs on the Crusader and the Tower which we incurred. Also in the fourth quarter we had some 210 days of warm stack time, and when you are warm stacked without a job, you have additional costs such as fuel and helicopter and travel, et cetera. And we worked the vast bulk of the time in the first quarter. We put those rigs back to work.

So we had no surveys and no stacking-type costs, so that's what drove those costs down in Q1.

Geoff Kieburtz - Citigroup

Gary, just to clarify, though, your costs when you're warm stacked are higher than when you're operating?

Gary T. Krenek

Yes.

Geoff Kieburtz - Citigroup

Okay.

Gary T. Krenek

Yes, because while we're operating, except fuel getting the crews back and forth to the rig, that is -

Lawrence R. Dickerson

There are certain costs that the operator will pay for.

Geoff Kieburtz - Citigroup

Got you. Okay.

Lawrence R. Dickerson

And they then switch to us. And then in addition, in this market, if we're down for a short period of time then we will do catch-up maintenance and so you'll actually see more money go out the door during those times. We would only cut back on our operating expenses if we thought there was a long-term stacking thing in front of us.

But I think, as Gary indicated, any of the swings that you've seen in the individual components from Q4 to Q1 are situational specific and there's not indication of long-term trends that jackup costs are out of whack or that the age of the mid-water fleet is catching up and therefore it costs, you know, any of those types of conclusions I don't think are valid. I think the rigs are pretty much operating within budget as we had designed it.

Gary T. Krenek

Yeah, for - the mid-water fleet or the other semisubmersible are easily answered by the Patriot.

Geoff Kieburtz - Citigroup

Right.

Gary T. Krenek

That was in for survey in the first quarter of this year. And as we had indicated, that was one of our higher-cost surveys that we anticipated, and those costs still went a little bit over than what we actually anticipated.

Geoff Kieburtz - Citigroup

Just to come back on the questions that have already been asked on the Shield, just so I make sure I understand this, you have a prior commitment at 265 but you would say that the current market is 175 for that rig?

John Gabriel

Well, they're different areas. Australia's going to be a much higher-cost area. And it's a timing issue. There were very few competing jackups at the time that we entered into that original commitment, and now the market's gotten a little more competitive. And in Malaysia, that is probably a pretty good number for Malaysia. We've seen commitments in that area for new rigs as low as the low 150s.

Geoff Kieburtz - Citigroup

Right. Okay. I guess I don't know if this is an answerable question, but at the time you signed the contract for the rig in Australia, what would you say the rates would have been in Malaysia?

John Gabriel

Originally, I believe there were - or early on I believe there were some commitments in Malaysia in the low 200s.

Geoff Kieburtz - Citigroup

Okay. So we have seen a, you know, in your mind, a decline in the day rate environment in Malaysia on the order of maybe $50,000 or $60,000?

John Gabriel

Yeah. I mean, this is a single data point, and you can't totally draw on that. It's also - it is reflective of the markets that there's new delivered rigs that took short-term jobs and there's more bidding activities and that Malaysia has  the approval process of contracts can be drawn out, and we wanted to fill it in on a short-term basis. A number of factors all brought it to bear, but we don't feel like we underpriced it in the market, and I don’t necessarily - the market certainly has come down from an earlier point in time internationally broadly speaking. When you go out for bid for new rigs, many of the bids now will be certainly under 200 and they were above 200 at one point in time.

Geoff Kieburtz - Citigroup

Okay.

John Gabriel

And I don't think that's a surprise or that you had to wait necessarily for this posting to be able to see that.

Geoff Kieburtz - Citigroup

Sure. And my last question is somewhat strategic in nature. Has the recent sort of dialogue or lack of dialogue, I'm not sure, going on between SeaDrill and Pride prompted any renewed strategic dialogue or discussions within Diamond? I mean, is this a factor or is this really not very important to you?

Lawrence R. Dickerson

Well, we monitor everything that goes on around the world, but we're comfortable with where we are. We believe that we can continue to compete with anybody, that we're sufficient size, and we're comfortable with that. Certainly we've seen merger activity up to this point in time and we'll see some more, but it's not causing us to change our goal.

Geoff Kieburtz - Citigroup

Thank you.

Les Van Dyke

Okay, so we'll take one last question.

Operator

Thank you. Your final question comes from [Ola Silor] of Morgan Stanley.

Ola Silor - Morgan Stanley

Thank you very much. Just back to what you said on new building, I can understand acquisition of secondhand units opportunistically, that makes sense, but this entire [file] new building floaters as there was another announcement today of a company that bought two of these resales for $800 million. I mean, what's your view in terms of recommending something like that to your Board at that type of a level? What type of return do you think you can get on that relative to investing in your own asset base?

Lawrence R. Dickerson

Well, I mean, I think we've deployed a lot of cash into our own asset base, and that's why we've elected to return cash via the dividend mechanism. Certainly when - there's been some movement in rates, on fifth-generation rates, but I'm not sure that they're enough to compensate for the $800 million plus of valuations of new builds. The math is no great secret there. If you just run that - existing day rates that you have today - on out 20 years that you'll be in the 12%, 13% pre-tax rate of return on $800 million plus drill ships. And that's okay, but it's [break in audio] the high rates of return that I think you would want to put that much money - that we would want to put that much money out there.

Ola Silor - Morgan Stanley

So how likely do you think it will be that you would recommend to your Board to make an investment into a new rig, a new construction project at this point?

Lawrence R. Dickerson

You know, I think we've given you enough guidance as to the kind of rates of return that we've done. You can look at it historically, what we've done. But I wouldn't want to specifically say that we would not do a new build because there might be a situation with some special factors where we could make that pay. But certainly your plain vanilla commit for $800 million and take a day rate below 500 - and we've seen some of those - that's not attractive to us.

Ola Silor - Morgan Stanley

So in order to do that would you need a contract locked up beforehand that could guarantee you - would that be a hurdle that you would require?

Lawrence R. Dickerson

Contracts are good, but again, I think rates are - the rate of the contract is very important.

Ola Silor - Morgan Stanley

Of course. Thank you very much.

Lawrence R. Dickerson

Thank you. I appreciate everybody joining us today, and we will talk to you in approximately 90 days.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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Source: Diamond Offshore Drilling, Inc. Q1 2008 Earnings Call Transcript
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