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Diamond Offshore Drilling, Inc. (NYSE:DO)

Q2 2008 Earnings Call

July 24, 2008 10:00 am ET

Executives

Les Van Dyke – Director, Investor Relations

Lawrence R. Dickerson - President & Chief Operating Officer

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

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

Analysts

Collin Gerry – Raymond James

Ian Macpherson – Simmons & Company International

Daniel Boyd – Goldman Sachs

Arun Jayaram – Credit Suisse

David Smith – J.P. Morgan

[Robin Shumacher – Citigroup]

Michael Drickamer – Morgan, Keegan & Company, Inc.

[Jeff Hebert – Reading]

Tom Curran – Wachovia Capital Markets, LLC

Brian Lester – The Abernathy Group

Operator

Welcome to the Diamond Offshore Drilling second quarter 2008 results conference call. (Operator Instructions) It is now my pleasure to turn the call over to your host Les Van Dyke.

Les Van Dyke

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 forward-looking statements to reflect any changes in the company's expectations or any changes in events, conditions or circumstances on which any forward-looking statement is based.

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

Lawrence R. Dickerson

Welcome everybody to our second quarter conference call. I’ll make some brief opening remarks, Gary Krenek as is our custom will provide some guidance on the subsequent quarters and then the two of us joined by John Gabriel will be glad to answer your questions.

First of all it’s worthy of comment that the quarter was a record one for the company both in terms of revenue of $954 million, net income of $416 million and earnings per share of $2.99. The quarter was favorable across the board. Our key drivers in our results are day rates, cost and then utilization. On the day rate front we had positive day rate news but that’s primarily impacting future quarters. Some of our jackup rates may have exceeded where we thought they might have been earlier in the year but by and large day rates are not a near term factor in results.

On the cost side I was very pleased with our results. We’ve made a significant effort to ensure that we operate within budget, that’s not easy to do in the face of the cost increases that we’re facing across the board. Primarily we seem to see it in service issues such as a boat or any insulation of equipment which pretty much send out an AFP to buy some equipment. There are rising prices for the equipment but usually when it comes time to install or take a boat we end up seeing that those costs have increased but we’ve made active efforts to try to offset those costs by controlling in other areas and I’m pleased that we’ll be able to that, that we’ve done for the second quarter.

Going into the rest of the year that’s going to continue to be a challenge for us but again this is a top line driven business at least in this particular market and although we’ve got positive in the cost, we’re proud of that. Our biggest single impact on the top line has been the utilization number and that is the number of days that each rig can work. The type of areas where we can see negative utilization are repair time that we spend dealing with issues that may rise on the rig that take us off of the payroll depending upon the contract, survey time, contract preparation and then in some cases any idle time due to inability to have a job for the rig.

Repair time was very, very positive for us in the quarter. We had very few number of days across the fleet, about 51 days I think, where we were off contract due to those issues. So that was a good positive pick up for us. We had a very much reduced number of days for rigs on survey but those surveys are still out there and that’s primarily a timing issue that we will pick up both survey time in Q3 and in Q4 and Gary will give you a better idea of that. We didn’t have really any contract prep going on during the month so that really wasn’t a factor. On our idle time we did have the Ocean Heritage to jackup in the Middle East, it was stacked for the entire quarter, and it was down 91 days. That market just has such a long lead time to get rigs going to work and we got caught in there but we’ve since put the rig back to work, relocated it to the Gulf of Suez and began work shortly into the quarter.

The rigs that did incur down time were the Yorktown was down for the quarter and it was doing some contract prep and also some repair work and some survey work that was going on there. Then we had the Ocean Clipper that came out of its survey in Brazil and then we had some thruster issues which incurred about 64 days of down time for that but the rig is now back to work. So that’s all been very good but again Gary will go through the number rigs we’ll be looking at as we go forward.

To talk briefly about the Letters of Intent that we announced in the press release I think we had some solid fourth generation rates in the Gulf of Mexico. Earlier this year there was moored fifth generation rig that posted a rate from one of our competitors at 535 and so you’ve certainly seen the rate convergence there as we took America and Star and priced those out, even though they’re lesser capable rigs at 520 subsequent to that. Then we had a one year commitment on the Ocean Victory at 540 and then we also noted that the Ambassador which is our lowest spec rig in the fleet has some work here in the US Gulf of Mexico and then is followed by a three year commitment in international markets at 260. That’s a terrific rate for that low end rig and pretty well puts that rig to bed.

I think we still have some renewal opportunities in 2009 that we’re discussing right now that would be the Ocean Valiant and the Ocean Quest. Having put to bed a number of our rigs at improving rates we’re going to be very judicious on these two rigs to ensure that we’re fully reflective of where the market is and the market has continued to move. We’re continuing to see lots of demand for these two rigs from multiple customers so we think the market continues to be very vibrant around the world.

Other than that my general comments would be that the jackups in the Gulf of Mexico have continued to inch up. That’s not a big part of our fleet but for the few rigs that we have left there we’ve been able to see some short term rate gains so we’re pleased with that. I think that will conclude my opening statements. I’ll now turn it over to Gary for his guidance portion.

Gary T. Krenek

I’d like to expand just a little bit on what Larry has touched on before we move on to the Q&A portion of the call. As always I’d like to spend the bulk of my time talking about expenses both what we experienced in the second quarter and what we expect to on a go forward basis. But first for those who have not yet seen it we filed our bi-weekly status report this morning and would point you to that for the revenue guidance and expected timing of surveys and other rig down time for the remainder of the year rather than me reiterating that here on the call.

Looking at the specifics behind our reported contract drilling expense for the second quarter we gave out some pretty detailed guidance as to what to expect in our last conference call saying that we expected those contract drilling expenses, excluding reimbursable costs, to come in at between $300 million and $310 million. Costs actually came in significantly lower at about $273 million. As Larry said before a portion of that, or approximately $20 million of that favorable amount, is attributable to timing differences as the Ocean Guardian, Drake, Ambassador and General had surveys that shifted from the second quarter into the third quarter. That $20 million has simply been deferred and will be spent in the upcoming quarter. The remaining favorable variance is, as Larry said earlier, due to our continuing efforts at controlling costs to the best of our efforts.

Looking forward with respect to contract drilling expenses in this upcoming quarter we gave out average annual per day costs that we expect to incur by rig class and location at the beginning of the year. At that time we said because these rates were expected to be rising throughout the year, we expected to incur costs at slightly below those rates during the first half of the year and slightly above them the second half in order to reach that average per day, per rig cost that we disclosed. It appears at this point that that was accurate guidance and as such, in order to compute normal daily operating costs for the third quarter, you need to use those annual per day, per rig cost numbers that we previously provided but just escalate them slightly here for the third quarter.

Now in addition to these normal daily operating costs we expect to incur a combined total of approximately $45 million in additional survey and other related costs for the Ambassador, Valiant, General, Drake, Rover, Guardian and Bounty all of which we expect to be down for a combined total of 364 days for surveys in this upcoming quarter. As before we expect the weakness of the US dollar to cost another $4 million to $5 million in additional operating costs and we’ll book an additional $6 million related to the amortization of previously deferred mobilization costs.

All told this totals approximately $335 million to $340 million in contract drilling costs which we expect to incur in the third quarter. Having said that this estimate will change if there is a change in our rig survey timing as happened in this previous quarter and I’d like to take this opportunity to remind everyone that we file that rig status report on our website every two weeks. Changes in survey down times, contract rollover dates, etc. can be found in that report. I’d also like to point out that what I’ve been talking about is the line item in our income statement labeled Contract Drilling Costs only and does not include reimbursable expenses which is a separate line item on our P&L statement. Reimbursable expenses are driven by the amount of consumables we are asked to purchase and provide to our customers and are offset by approximately a similar amount of reimbursable revenues that we collect.

Going back to our second quarter results the only other comment I would like to make on the income statements are in regards to, first other income where we recognized approximately $12 million worth of gains related to foreign currency contracts. We entered into those contracts previously to hedge against our higher operating costs that we are experiencing due to the weakening of the US dollar. Finally interest expense which is up due to us no longer capitalizing interest related to the Ocean Shield jackup which was delivered from the shipyard early on in Q2. We expect interest expense in the third quarter to increase an additional $1 million or so when our other new build jackup, the Ocean Scepter is delivered from Brownsville and we no longer capitalize interest against this project. The delivery of this rig will have a knock on effect of increasing depreciation expense to approximately $74 million or so per quarter for the remainder of the year.

One last item, income statement, our tax rate increased slightly this quarter due to increased earnings in the Gulf of Mexico primarily as Larry said a result of the strengthening of the domestic jackup market. Our prior guidance was an expected tax rate for the year of 28% to 29%. We’re now expecting that rate to be somewhere around 29% to 30% or 1% higher.

Focusing on our current balance sheet for just one second, we have a combined cash and marketable security balance at June 30 of $740 million. Normally we tell everyone to add those two lines together to compute our effective available cash balance. However there was an anomaly that occurred at the end of June resulting from our purchase of US Treasury Bills on 30 June but not settling that purchase until July 3. As a result of that transaction straddling quarter end close our cash balance is grossed up by approximately $200 million with the offset in current liabilities under the line item Payable for Securities Purchase which is also approximately $200 million. Bottom line, if you muddle through all the appropriate GAAP required accounting, you net those three lines, our available cash balance at the end of the quarter is right at $540 million.

Finally our guidance for capital expenditures for the year 2008 is $720 million and it’s comprised of, first the Ocean Monarch upgrade and the completion of our two new build jackups at $180 million, required upgrades for our Brazilian contracts that we’ve entered into at $130 million, cap ex that we’re going to spend on our 12 rigs that are undergoing surveys this year at $200 million, acquisition of spare equipment which is part of our revenue preservation plan at $50 million and then finally other general maintenance cap ex at $160 million. If you add all that up it should come to $720 million.

With that, I’ll turn it back over to Larry.

Lawrence R. Dickerson

One other comment I’ll make we have a rig, the Ocean Scepter, which is in its final testing stages in the Brownsville, Texas facility of [Kepelfells] that was close to the path of Hurricane Dolly. Reports that we have this morning, there’s no one on the rig, it’s difficult to get to the shipyard due to flooding but the rig appears at this point to be undamaged. We were on the good side of the hurricane. The hurricane struck a little bit further up the coast and so we’re not expecting any major negative factors to flow from that incident.

With that we’ll go to questions.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from Collin Gerry – Raymond James.

Collin Gerry – Raymond James

Just a quick question on the renewals you all got, the rates were certainly higher than what we were expecting. If I go back last quarter I remember we were speaking of term we were thinking 18 months to 3 years. A couple of these came in a little bit lower than that, on the one year time timeframe. Just give us some color on why the term was a little bit lower. Is that strategic on your part to keep them available in 2010? Was that the operator?

Lawrence R. Dickerson

I’ll let John Gabriel elaborate on that but essentially the Gulf of Mexico does tend towards the shorter term in these fourth generation rigs. When you look at the size of the customers that typically contract for that they don’t always have three years worth of forward commitments.

John T. Gabriel

I think Larry is right in his characterization. Basically it’s what was available to us in terms of duration of commitment but it’s a good point to note that we get to re-price these rigs again in another year to 18 months.

Collin Gerry – Raymond James

It sounds like it was mutual, it wasn’t necessarily strategic on your part but more what the market was giving you and it’s not a problem given where we’re seeing rates going?

John T. Gabriel

I think that’s a fair statement.

Collin Gerry – Raymond James

I’m probably not going to get a definitive answer on this; it couldn’t hurt to try, not to really look at 2009 on the cost line, just ballpark what would you assume a reasonable cost inflation there could come in?

Lawrence R. Dickerson

We haven’t really done our budget and so I hate to give you a number; however, the factors that we’re dealing with right now from all of our suppliers are that prices are going up across the board with steel and all that stuff. In previous years we’d said 10% to 12% and probably we’re looking at 10% to 15% for next year. Labor is a big component of that and labor has certainly not been running at the 15% rate at all. So that helps balance it out a little bit.

Collin Gerry – Raymond James

So consistent with what we’ve seen in the past couple of years? Not accelerating cost escalation but certainly not decelerating either?

Lawrence R. Dickerson

Too early to tell, that’s certainly a possibility.

Collin Gerry – Raymond James

I just noticed on the latest fleet service you’re going through the details that a few of the floaters were added on the down time, the Baroness, the Spur and the Alliance due to equipment change out or equipment repair. Just curious is that the same piece of equipment? Is there something notable there?

Lawrence R. Dickerson

No. I know for instance on the baroness we had a piece of equipment that we had a superior design that was a safer, more robust design and we elected to take I think a little over seven days to take the rig off line and upgrade this particular piece of equipment. So you’ll have those type things on there. The Alliance we had something break. Again those are routine operating results.

Collin Gerry – Raymond James

Just curious what piece of equipment was that?

Lawrence R. Dickerson

We had some issues with our riser tensioner system.

Operator

Your next question comes from Ian Macpherson – Simmons & Company International.

Ian Macpherson – Simmons & Company International

Larry, when you talk about I think you said being a little maybe judicious with regards to the timing of re-pricing you’re the Valiant and the Quest which are a couple more fourth generation risks with re-pricing opportunities, could you elaborate on what the strategy is there? Is this a deliberate wait and see approach with the evolution of day rates or you just thought some of the direction of day rates? Because we did see in the past few days another comparable rig on a short term contract at 650. Do you see term work getting as high as 600 or 600 or higher?

Lawrence R. Dickerson

I think the 650 would have been a fifth generation unit and these are fourths.

Ian Macpherson – Simmons & Company International

That was a fourth gen moored semi in West Africa.

Gary T. Krenek

That commitment I think was for about.

Ian Macpherson – Simmons & Company International

It was short term.

Gary T. Krenek

It was for a 90 day job. Obviously you’ve got availability of the rig, close proximity and a customer that wants to get something done, so those three elements coming together supported that price. With respect to what we’re looking at going forward on available time in 2009, Larry mentioned earlier the Quest and the Valiant, the other floater we’ve got is the Ocean Lexington. We’re in discussions with I would characterize it as several parties on all three of those rigs. At this particular juncture the shortest period of time we’re talking about right now is about two years. What we strategically did having five rigs rolling within about a six month period was go ahead and take commitments on the three that we just announced and are looking at opportunities around the world for the other two.

Lawrence R. Dickerson

And you understand I don’t want to put a target out there or negotiate with our customers via this mechanism, obviously demand is tight and we’ve got lots of people looking after the rigs as John indicated. The other ones were a little bit shorter, we’ll probably look for a little bit more term on the subsequent commitments but we want to enjoy a market rate.

Ian Macpherson – Simmons & Company International

On the Gulf of Mexico jackups can you offer any color as to how you see the leading edge bidding environment shaping up there from say a few months ago til today?

John T. Gabriel

What we see right now in terms of the mat rigs is numbers in the mic-60s with forward bidding going a little bit higher than that. On the 300 to 350 foot class of rig we’ve got four here and either or current forward commitments are all in excess of $100,000 a day. We don’t see any easing in that market and then if I remember right some of the very large rigs have been committed in excess of $150,000 and approaching $200,000 a day but that’s the absolute high end jackups here in the Gulf. The market’s continuing to show some modest improvement. The one thing that’s a little elusive is any significant term but rates are still moving up.

Operator

Your next question comes from Daniel Boyd – Goldman Sachs.

Daniel Boyd – Goldman Sachs

Gary, your prior cost guidance was looking for an 18% to 20% increase over last year. Given some of the efficiency gains that you’re seeing should we expect this to be in the low end of the range at this point?

Gary T. Krenek

We had a very good quarter this quarter. I would still go with the 18% to 20%, Dan. I’m not sure where we’re going to get at at the end of the year. Remember that 18% to 20% was year-over-year looking at the income statement. So a portion of that, 7% to 8%, is strictly additional rigs that we have working, the Scepter, the Shield, and the Endeavor the full year. That won’t have an impact on that 18% to 20% at all. It’s too early to tell.

Lawrence R. Dickerson

And we had rigs going foreign. The inflation number, the cost increase number is the number that we were saying 10% to 12%.

Gary T. Krenek

10% to 12% was the inflation; the rest of it was additional rigs working.

Daniel Boyd – Goldman Sachs

I want to ask, can you help me understand a little bit more on where you’re seeing the efficiency gains? Is it really just in keeping the rigs up and running a little bit more efficiently, keeping the utilization up?

Lawrence R. Dickerson

I would say we had a good batting average for this particular quarter and we’re working very hard to keep that up, but over time we’re still exposed to routine equipment failures and other issues that might cause us to incur some down time. I wouldn’t necessarily grab this as a trend based upon one quarter.

Daniel Boyd – Goldman Sachs

Looking at the new build and upgrade program winding down here, how long do you think the company can reasonably go without expanding the fleet and what opportunities do you see out there at this point?

Lawrence R. Dickerson

We’ve expanded this fleet tremendously over the years and we are primarily a counter-cyclical expansion company and we’ve used the upgrades tremendously. Certainly the facts of the market right now don’t exactly match those particular scenarios so we don’t have anything on schedule right now and I can’t tell you what we’re going to do, but we’re looking at it all the time. We understand it is a competitive environment and we will add capacity and upgrade and even contemplate new construction if and when we find a scenario that makes financial sense for our shareholders.

Daniel Boyd – Goldman Sachs

If prices for assets remain where they are, the competitive environment remains pretty tight as it is, could you go 12 months to two years without adding to the fleet? Would you be comfortable doing that and just returning cash to shareholders as you’ve done in the past?

Lawrence R. Dickerson

We’ve said that returning cash to shareholders is one of the primary value strategies that we have. The answer is yes because our criteria to add to the fleet are not necessarily based upon the idea that we’ve got to constantly be doing it all the time.

Operator

Your next question comes from Arun Jayaram – Credit Suisse.

Arun Jayaram – Credit Suisse

Larry, it’s odd to me looking at your second and third generation semi-fleet in the Gulf of Mexico, or interesting, and to see that you’ll essentially be left with one rig. I was wondering if you could comment on other parts of the global demand in the mid-water. In addition there’s a lot of new more capable fifth and sixth generation rigs coming, how do you think the mid-water plays out over the next five years?

Lawrence R. Dickerson

I’m gong to let John fill in the color there. Strategically we’re comfortable with this fleet but we think that internationally you have term opportunities and you have much more new areas being opened up that are exciting. Here in the Gulf of Mexico we’re still restricted to just traditional areas and most of the excitement is in the new areas, in the deep water and we’re seeing customer after customer move into deep water. So we’re matching the fleet that here’s really to the residual demand which is actually quite a bit reduced from what it once was.

Gary T. Krenek

Just to follow up on that the primary driver for the migration of our mid-water fleet out of the Gulf of Mexico is basically term. What we have been able to achieve in moving rigs from here to the Mediterranean, moving rigs to Mexico and obviously moving rigs to Brazil is two to three to upwards of five years worth of term where here in the Gulf of Mexico the market is still characterized by multiple well-to-well to just a couple of wells at a time. To talk about where we see continuing demand in the mid-water floaters, Northwest Europe particularly the UK sector of the North Sea, one or two opportunities in the Mediterranean. We talk to people about West Africa and I think one of the bright spots again is going to be Brazil and that would be for other than Petrobras. We’ve had several inquiries by major companies down there that have some mid-water acreage that are talking about term.

Arun Jayaram – Credit Suisse

Would that be OGX?

Gary T. Krenek

That would be one of them.

Arun Jayaram – Credit Suisse

I may have missed this, John, where are you moving; to what market are you moving the Ambassador?

John T. Gabriel

We have not.

Gary T. Krenek

At the customer’s request we haven’t.

John T. Gabriel

We haven’t announced that at the customer’s request.

Gary T. Krenek

But we really see no easing in level of demand in the near term for this class of rig. Again the departure from the Gulf of Mexico was primarily that we see longer term opportunities outside the Gulf.

Arun Jayaram – Credit Suisse

One question for Larry, the dividend has been relatively flat over the past few quarters while the earnings trajectory has been up pretty sharply. I was just wondering, Larry, if you could update us on where you are philosophically with the dividend and why has the dividend lacked the growth in earnings because we’ve been expecting maybe an increase this quarter.

Lawrence R. Dickerson

Our answer on dividends is that it’s a primary part of our value strategy and that the Board will consider the dividend and we’re now paying it each quarter but included in the lack of disclosure is we never once said that it was going to be linked quarter-by-quarter to the results so I think that’s the only thing I can tell you. But you certainly look at the history going back over three years that we’ve had it in place and it has been an escalating dividend through that point in time and all I can do is guide you to the history.

Arun Jayaram – Credit Suisse

But there’s been on change in what you’ve been thinking about it this quarter and last quarter versus history? Is that fair?

Lawrence R. Dickerson

Yes, there’s no change in our philosophy behind the dividend and our methodology this quarter versus where we were six months ago or a year ago.

Operator

Your next question comes from David Smith – J.P. Morgan.

David Smith – J.P. Morgan

Wondering what turnover on the rig crews looks like and maybe how that’s changed in the past year?

Lawrence R. Dickerson

We’ve been pleasantly surprised that our turnover has been fairly much lighter than we would have expected. I think we’ve got an aggressive retention program and we make sure that our wages are market competitive and then we think that we offer important advantages to our employees to stay here and that is the wide disbursed fleet and the number of promotion advantages that you have here, well established safety systems, well established systems that you’re not dealing with brand new issues and among the people that we’ve lost and we lost a few in the North Sea to another competitor. We’ve gotten most of those guys back, we’ve gotten guys that we’ve lost here in the Gulf of Mexico to other competitors back and those guys are powerful retention factors when they talk to folks and talk about the differences of working at Diamond and another place.

Having said all that we don’t yet really have a full scale delivery especially into the Gulf of Mexico of a lot of these new deep-water units so there will be some competition for some positions there. But I think it’s an issue that we’re managing. I think probably it’s also being driven by the new entrants to the business realize that if they solely compete for the limited pool of existing talent that ultimately all that does is drive up costs for everybody and so they’re doing some of that. I’m not saying we and our competitors are immune, but I think they have their own systems into bringing in people from other parts of the world to man their rigs.

David Smith – J.P. Morgan

You mentioned that you’re getting a lot of people coming back, is there any common theme as to their reason why?

Lawrence R. Dickerson

I would say that people make the move primarily for a perceived advantage in money in the short term because we can’t build the wall high enough that it’s always going to make sure our guys are the highest paid, somebody can always top that wall temporarily. But then they understand that our wages are competitive and I think they’re generally just satisfied, they come back because they’re not really happy with the working conditions, whether it’s the safety conditions on there, whether it’s the, I won’t say lack of systems, but more less developed systems, personnel issues. It’s work conditions.

David Smith – J.P. Morgan

I know that we’re not going to talk about where the Ambassador is going, but can we assume that it’s going to a low tax region?

John T. Gabriel

The tax rate will be between 29% and 30% [inaudible].

Gary T. Krenek

I can’t give you a hint there.

Lawrence R. Dickerson

We will make that announcement as absolutely as soon as we can but we have to respect the customer’s desires.

David Smith – J.P. Morgan

If your expansion philosophy is counter-cyclical what is your thinking of selling assets into a really strong cycle?

Lawrence R. Dickerson

It’s something that we might consider on margin but by and large we’ve retired most of the assets that are marginal and I don’t look for that to occur here in the near term really just based upon valuation of assets and our earning capacity. There’s still fairly low multiples in this industry and I think we can do better. We have more confidence in the future to deploy those assets and earn money with them than to sell them for fairly short term gain.

Operator

Your next question comes from Robin Shumacher – Citigroup.

Robin Shumacher – Citigroup

I was wondering if you could talk about what you’re seeing in terms of tender activity for floating rigs from PEMEX and speak to the requirements also of Petrobras as you understand them for the next few years ahead of the delivery of all these new deep-water rigs that they have ordered or supported with new contracts for the 2012 timeframe?

Lawrence R. Dickerson

With respect to PEMEX we have not seen a formal tender for a floater recently. The rumor mills are active and we’ve heard from time to time that they may be looking at additional deeper water capacity say in the fourth generation category but nothing formal on the street yet. With respect to Petrobras I don’t see any additional requirements really in that range between the rigs that they’ve already got on contract and have gone through the extension processes with with us and our competitors down there and I suspect that they’re going to move forward with the fleet that they’ve got until they start taking delivery of the new builds that they’re committed to.

Robin Shumacher – Citigroup

On that side, on the new build commitments, and also in reference to your comments about the winding down of your rig construction program, you’ve clearly got a great deal of skill and capability in terms of supervising reconstruction and here you have all these companies that will be building rigs for Petrobras that are fairly, do you know these companies that have signed contracts with Petrobras, Brazilian contractors and others and is there potentially any role for Diamond hypothetically in terms of building and delivering those rigs?

Lawrence R. Dickerson

I wouldn’t think so. We do know some of those companies and investors and as you’re aware the rates that they took in Petrobras are fairly low on these new construction and I think they’ve got to ensure that they operate and build those rigs as absolutely as cheaply as possible and I think we can bring something to the table but our services are not cheap and so I would expect them to elect other mechanisms.

Gary T. Krenek

I would add to that that most of this new construction is being done pretty much on a turnkey basis. There’s not a lot of design and engineering going into it as much as there is just simple oversight.

Operator

Your next question comes from Michael Drickamer – Morgan, Keegan & Company, Inc.

Michael Drickamer – Morgan, Keegan & Company, Inc.

You just provided a fairly bullish outlook for this mid-water depth floater segment and I look at both your contracted backlog and the rest of the fleet, it provides a pretty bullish outlook here. What is there out there that can go wrong though? Are there any issues that are of concern to you right now?

Lawrence R. Dickerson

Yes, there’s always concerns but the market looks fairly rosy. Obviously I always tell people to follow our product prices because that’s ultimately what’s always undone past up cycles and you’ve got both oil and natural gas declining currently although still well within the range of what it takes to have a robust market. So those would be issues. The whole issue of making sure that all these new rigs can come out and can operate safely and get crewed up even though that’s not necessarily our particular problem, that does impact us from the industry side. So those are the issues that concern us.

This whole business has to work upon the success of our customers. To spend these funds they’ve got to discover commercial quantities of oil and gas and make their returns, so that would be a concern, but to date all of that has played out very, very well. I think the business continues to look, as you put it, very bullish.

Michael Drickamer – Morgan, Keegan & Company, Inc.

Larry, if you look either operationally or let’s say with anything you have going into a shipyard, are there any bottlenecks in the industry right now that could be an issue?

Lawrence R. Dickerson

Bottlenecks on being able to operate, there’s certainly bottlenecks on adding capacity to the business. Equipment delivery is so far out there so that if you need extra riser or you need a replacement top drive or you need a replacement anything we’re talking years sometimes before you can get that. That works to the advantage in that a business as robust as this one actually has per year a very small net addition to the fleet. So that works to that advantage but for operating conditions, making sure that you’ve got everything that you need and that you can get it in the even of something major, a piece of equipment failure, that’s certainly a challenge.

Operator

Your next question comes from Jeff Hebert – Reading.

Jeff Hebert – Reading

Just to come back on the cost issue, what are you seeing in terms of labor inflation? Is it steady? You mentioned that it’s lower than what you’re seeing in materials and supplies are you seeing any acceleration? Do you expect to see any acceleration as the new builds start to be delivered?

Lawrence R. Dickerson

I’m predicting something I can’t really say. We will pay market wages to our employees and we will ensure that they get nice raises regardless because they’re all working very hard and the business is doing well and they need to be rewarded. In the past labor inflation has been 10% or below whether that goes to 15% or 12% or 8% I really can’t tell you, but that’s the range it’s in. I don’t see labor doubling.

Jeff Hebert – Reading

It could move into the 12% to 15% range?

Lawrence R. Dickerson

Absolutely, we’re committed to making sure that we pay market wages. We can’t run these rigs without qualified people.

Jeff Hebert – Reading

I think you mentioned earlier in regards to labor that some of the new entrants have changed their strategy or at least you see it that way, but I wasn’t quite clear what their new strategy was.

Lawrence R. Dickerson

I’m not saying their new strategy but the fears of everybody was that they would have to hire wholesale from existing contractors to be able to staff up their fleets and I don’t think that we’ve seen that. We’ve seen some turnover, we’ve lost people to some of the new entrants but we haven’t had a wholesale loss. So clearly that says to me that they are training on their own, that they’re recruiting from other areas then what we and our competitors primarily recruit from.

Jeff Hebert – Reading

On the Valiant and the Quest, you referenced being strategic in regards to that available capacity looking for term. Are you saying that you wouldn’t take an opportunity to put those rigs to work for $650,000 a day for 90 days?

Lawrence R. Dickerson

Try me.

Jeff Hebert – Reading

So you’re being opportunistic but your real idea is to try to put those rigs to work for two plus years?

Lawrence R. Dickerson

We’ll respond and whatever but if you look at the fleet as John indicated Victory, America, Star longest commitment is 18 months, the other two are one year, it seems to us that within that category that we ought to take another one and try to go longer term in a market that will, and I think that $650,000 was probably a one off type situation. I would be surprised if that is the normal posted rate but it certainly indicates that rates have moved up.

Jeff Hebert – Reading

I may have missed it, what was your cap ex in the second quarter?

John T. Gabriel

In the second quarter right at $200 million.

Jeff Hebert – Reading

And that puts you where for the half year?

John T. Gabriel

Right around $350 million I believe. We’ll release those exact numbers when we release the Q.

Jeff Hebert – Reading

At this point what would you expect 09 to be?

Lawrence R. Dickerson

We haven’t done the budget but we will not have the new construction program, that should be done so the cap ex will be driven by number of rigs in the shipyard which will be down from what it is in 08 and then whatever we believe maintenance cap ex should be and this is an area where we are seeing quite a bit of inflation and we are making an effort to identify critical pieces of equipment that we believe that we need to have spares because it could deprive us of revenue and/or the delivery is just so long out there that we need an extra piece of equipment just to cycle through for normal maintenance. Until we do all that I can’t tell you where it would be but I would look what we spent in past years plus or minus some reasonable inflation rate. We’ve been spending $350 million in the past years.

Operator

Your next question comes from Ian Macpherson – Simmons & Company International.

Ian Macpherson – Simmons & Company International

Just got a quick follow up, I wanted to see where we are today with cost escalation provisions in the contracts, if we’re looking at probably double digit cost inflation at least for the next year if not beyond 09? Are you getting those for instance on these recent contracts that you fixed for the fourth gen rigs? If not, what types of contract terms qualify and what don’t for that provision for your customers?

Lawrence R. Dickerson

In general we will have cost escalation provisions in contracts I would just say of a duration of a year or longer. We do have cost escalation provisions in the commitments that we’ve announced for the deep-water rigs. Again some of these are at the LOI stage so we’re not completely finished with formalizing the document but the intent is to have cost escalations in all of these new contracts. Other than PEMEX and some of the older Petrobras contracts, because our new contracts and our renewals, do address cost escalation. That’s about the only things I can think of that don’t have it off the top of my head or maybe some shorter term commitments where it just doesn’t make sense. We’re pricing basically knowing what our costs are at the time for a short period of time so cost escalations don’t come into play.

Ian Macpherson – Simmons & Company International

Have you had an opportunity to back check some of those contracts that have them and see how much of the overall daily op ex inflation is captured with those escalator offsets? Is it closer to 50% or closer to 100%?

Lawrence R. Dickerson

I would say the general rule of thumb is probably about 50% of our escalations are adequately protected and that comes from certain contracts that aren’t covered. Labor is generally covered very well and other items on our cap ex are probably not covered at all and some of the rig maintenance expenditures are covered to varying degrees. If you take our jackup fleet which is offshore term there’s almost no cost escalations in those items.

Operator

Your next question comes from Tom Curran – Wachovia Capital Markets, LLC.

Tom Curran – Wachovia Capital Markets, LLC

Following up on your earlier line of questioning with regards to the special dividend, should we expect that as long as you continue to plan to pay it out that on an annualized basis it should at least remain flat?

Lawrence R. Dickerson

I’m sorry, we’ve gone against giving even that level of guidance and just saying that the Board will analyze it and compare it to all other available opportunities but I point everybody to the history of the company which is the most solid thing that we can give you guidance on.

Tom Curran – Wachovia Capital Markets, LLC

And that’s what I was referring to is that you have recently been highlighting that on an annualized basis looking backwards, historically it has been rising. Turning to the South of the border on the jackup side what is the best read your marketing guys currently have on PEMEX’s plans for its remaining mat supported backups?

Lawrence R. Dickerson

Again, PEMEX has indicated that they will be reducing the number of mat jackups in their fleet but indicating that they would replace them with independent leg cantilever rigs. There is nothing again formal right now but they are rumored to be looking at picking up quite a few additional independent leg cantilever jackups. The question at the end of the day is how many will replace mats and how many will ultimately be incremental and how much of the rumor ultimately materializes? If it’s a significant number of rigs in the 250 to 300 foot category they’re going to have to come from somewhere other than the Gulf of Mexico because if you take a look at the Gulf of Mexico I think that there are was it 23 independent leg cantilevers here left in the 250 foot and greater range. Again we haven’t seen anything yet, we’re just talking about rumors and that’s probably not a real good thing to try and hang your hat on. But there is again an indicated intent on their part to continue to replace some of their mats anyway.

Tom Curran – Wachovia Capital Markets, LLC

Would you expect the next round of mat supported jackups that’ll be rolling over in Q3 to ultimately end up heading back North?

Lawrence R. Dickerson

We don’t have any mats down there so it’s difficult for us to comment on there but that has been the historical pattern.

Gary T. Krenek

I think also if you take a look at mat rigs on a global basis 90% of them are either in Mexico or in the US Gulf of Mexico. There are only seven outside of that geographic area.

Tom Curran – Wachovia Capital Markets, LLC

Previously when you mentioned that your best estimate right now is to where costs might go in 09 with 10% to 50% were you referring to on a per rate day basis or on the P&L total operating costs?

Gary T. Krenek

That would be a per rate basis. It will go up more than that simply because of a full year’s operating with the two jackups in Monarch coming out in the first quarter of next year.

Tom Curran – Wachovia Capital Markets, LLC

And then lastly, when you think about what you might end up doing on the growth front should you be looking at another two years passing without having invested in any growth? Do you think at that point you might be willing to at least consider another Victory class upgrade if not buying or building?

Lawrence R. Dickerson

I think the problem with Victory class upgrades is that the lost opportunity cost is to great right now because the rigs, the two that we have left that are unmodified have forward day rates in excess of $300,000 a day and that pretty much kills it. So I don’t think you’re going to be looking at that until we have a really lousy market and we think that’s far into the future.

Tom Curran – Wachovia Capital Markets, LLC

The reason why I was thinking the upgrade option might become increasingly more attractive than building or buying is if you start to see that the deep-water market in terms of your meeting the longer term outlook be expected to meaningfully pull away from the mid-water market and therefore while the.

Lawrence R. Dickerson

No, I think the cost of the upgrade itself is escalating just as much as the new builds because you still have the equipment in there and you had the lost opportunity you’re starting to approach you’d be better off building new.

We’ll take one more question so that we can wrap this up within an hour or less.

Operator

Your final question comes from Brian Lester – The Abernathy Group.

Brian Lester – The Abernathy Group

Large macro question, the first is to potentially understand the Board’s position on guidance for management regarding eventually the dividend but could we gain any perspective by understanding ideal cash levels on the balance sheet or your advice to the Board on needs there so that we could understand when dividend payouts might be more flexible?

Lawrence R. Dickerson

I’m sorry, I can’t help you there. All I can just repeat is that, and I understand that you desire to have this, but that the Board will look at all our cash uses and possible cash expenditures, cash uses, places where we put the cash including the dividend and that we believe that returning cash to the shareholders via this mechanism is a primary means of enhancing shareholder value.

Brian Lester – The Abernathy Group

Is there a target level of cash that you feel like you need to have on the balance sheet?

Lawrence R. Dickerson

No, but there is a level that we need to operate and that varies but can be $400 million, $500 million just to cover what we need to do.

Brian Lester – The Abernathy Group

So something significantly in excess of that might be then there would be some considerations then if you drop below that then you’d have to consider building that back. Let me move on so that we can get the call over guys. We saw something take place in transition not too long ago but how strategic is personnel today in acquiring successful terms for equipment in your opinions?

Lawrence R. Dickerson

How important is it to have quality people?

Brian Lester – The Abernathy Group

Yes, is equipment is actually turning upside down a little bit so that personnel is really becoming a driver versus the absolute profile of the equipment or is it not to that extent yet?

Lawrence R. Dickerson

We think people are the most important part of the business and that’s not just routine blather. However, equipment is very important as well. You’re seeing all new people that have no people committing to equipment purchases but I think the key difference is we don’t see our customers committing, they tend to prefer an established contractor when they make their commitments, somebody with some operating expertise until there’s just absolutely no other alternative.

Brian Lester – The Abernathy Group

What can you do to increase that talent pool? Was there anything? One weird extreme would be to build a school or something? I don’t know. Are there any ideas out there other than to just trying to poach from others?

Lawrence R. Dickerson

We have training programs for critical positions. We have overstaffed in critical positions so that we’ve got everybody that we need to do, to be able to carry forward on that. There’s no magic. Ultimately a lot of it just comes from you have to gain experience and it’s hard to shortcut that.

I appreciate your interest and everybody’s attention to the call and we’ll see you in 90 days.

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Source: Diamond Offshore Drilling Q2 2008 Earnings Call Transcript
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