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Executives

Sean P. O'Neill - Vice President of Investor Relations & Communications

Daniel W. Rabun - Chairman, Chief Executive Officer and President

James W. Swent - Chief Financial Officer and Executive Vice President

Kevin C. Robert - Senior Vice President of Marketing

John Mark Burns - Chief Operating Officer and Executive Vice President

Analysts

Judson E. Bailey - ISI Group Inc., Research Division

Douglas L. Becker - BofA Merrill Lynch, Research Division

David Wilson - Howard Weil Incorporated, Research Division

David C. Smith - Johnson Rice & Company, L.L.C., Research Division

Nigel Browne - Macquarie Research

Ian Macpherson - Simmons & Company International, Research Division

Collin Gerry - Raymond James & Associates, Inc., Research Division

Rhett Carter - Tudor, Pickering, Holt & Co. Securities, Inc., Research Division

Justin Sander - RBC Capital Markets, LLC, Research Division

Darren Gacicia - Guggenheim Securities, LLC, Research Division

Ensco (ESV) Q3 2012 Earnings Call November 1, 2012 11:00 AM ET

Operator

Good day, everyone, and welcome to Ensco plc's Third Quarter 2012 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. Sean O'Neill, Vice President of Investor Relations, who will moderate the call. Please go ahead, sir.

Sean P. O'Neill

Thank you, operator, and welcome, everyone, to Ensco's third quarter 2012 conference call. With me today are Dan Rabun, CEO; Mark Burns, our Chief Operating Officer; Jay Swent, CFO, as well as other members of our management team. We issued our earnings release, which is available on our website at enscoplc.com.

As usual, we will keep our call to 1 hour. Any comments we make about expectations are forward looking statements and are subject to risks and uncertainties. Many factors could cause actual results to differ materially. Please refer to our earnings release and SEC filings on our website that define forward-looking statements and list risk factors and other events that could impact future results. Also please note that the company undertakes no duty to update forward-looking statements. As a reminder, our most recent Fleet Status Report was issued on October 17.

Now let me turn the call over to Dan Rabun, Chairman and CEO.

Daniel W. Rabun

Thanks, Sean, and good morning, everyone. Before Jay takes us through the financial results, I will discuss third quarter highlights and the state of our markets. In terms of highlights, I want to congratulate our capital projects team in Singapore for successfully delivering our seventh and final ENSCO 8500 Series rig during the quarter. They've done a terrific job managing this multibillion dollar investment project beginning with the first rig back in 2005. Given their commitment to operational excellence and exceeding expectations, Ensco has been recognized for one of the best on-time and on-budget new build records in our industry.

ENSCO 8506, the final rig in the series, is contracted to Anadarko at $530,000 per day for 2.5 years and will commence its term contract in early January. It is the third rig in the 8500 Series that will be working for Anadarko, a tremendous endorsement of the excellent customer service our crews have delivered to Anadarko over the past few years.

During the third quarter, our 8500 Series fleet achieved 99% utilization for rigs working at least 6 months, highlighting the many benefits of standardization. ENSCO 8505, which commenced drilling operations last quarter, has experienced some downtime on its first wells due to some startup issues as reflected in our most recent Fleet Status Report. But we anticipate the rig will quickly improve its uptime in line with the other 8500 Series rigs.

The capital project teams in Singapore and South Korea will continue to be busy as they manage the construction of our ENSCO 120 Series jackups and our ultra-deepwater drillships, which will drive Ensco's revenue and earnings growth well into the future. I'm also pleased to report ENSCO DS-6 has completed its upgrades in Singapore. The rig will commence its 5-year term contract in Angola with BP in January.

New construction is a key element of Ensco's continuous high-grading strategy but so are sales of less capable rigs. As we noted in our recent Fleet Status Report, we sold 2 more assets, a jackup rig and a barge rig. We have sold 9 rigs and now have only 3 cold stacked jackup rigs remaining in the fleet. All of our actively marketed jackups are contracted and marketed utilization was 92% in the third quarter.

As utilization has risen, so has average day rates for the jackup segment. We expect this trend to continue due in large part to contracts already in place. For some time, Ensco has had the largest number of active premium jackup rigs. Now given the recent divestiture by one of our competitors, Ensco is the leading provider of premium jackups worldwide.

Before I turn to a discussion of the markets, I also want to recognize our North and South America business unit for a job well done managing through Hurricane Isaac. We had 18 rigs in the U.S. Gulf of Mexico at the time of the hurricane and our operations and support teams did an excellent job implementing our severe weather plans. No one was injured. There was no significant damage to our rigs and there was no financial impact. These outcomes are the result of effective planning and execution by our employees, as well as close collaboration with our customers.

Now let me discuss the markets. I'll begin with deepwater. In the U.S. Gulf of Mexico, the deepwater fleet industrywide is 100% contracted through 2012 and well into 2013. The demand for deepwater floaters has added 10 rigs to this market from a year ago and we expect the positive trend to continue for at least the next several years. Permitting process has improved significantly and more deepwater permits are being granted.

In Mexico, PEMEX has not announced any current plans to increase their deepwater fleet however, they have publicly announced the need for deepwater drilling to offset declines in production from shallow water and onshore fields. The successful new discoveries, like the recent announcement of a new deepwater natural gas find, we can only surmise sometime in the future, this market will require more deepwater assets.

In Brazil, several short- and long-term programs have outstanding tenders from multiple operators. Petrobras added 8 ultra-deepwater rigs to their fleet this year and 3 more units are expected to finalize acceptance testing before the end of the year. We anticipate that independent operators may become more active in Brazil for the continued exploration success, pursuit of production sharing agreements and, if approved, potential licensing around next year for oil and gas and pre-salt blocks.

The African ultra-deepwater market remains extremely strong, with uncommitted time virtually nonexistent until 2015. The discovery is being announced often in Africa. The future is promising for ultra-deepwater assets. Tightness in the African ultra deepwater segment is possibly affecting the deepwater fleet, adding upward pressure to day rates. There are a number of deepwater rigs that will have availability in 2013, but we expect that demand will keep the market balanced.

In Asian and Australian markets, we believe the demand for deepwater floaters will increase in 2013. There are a few multi-year programs that have yet to be awarded and our customers are also talking about potential ultra-deepwater work commencing in 2014. We currently expect ENSCO 8504, which is available in January of next year, to remain in Asia, and we are in advanced discussions with customers about long-term programs.

Moving to midwater. Ensco's smallest segment with just 6 rigs, the market remains challenging, but there are signs of improvement. There are opportunities in the North Sea with the U.K. semi market, which is effectively booked through 2013 and into 2014. More short-term programs are surfacing in Southeast Asia, Australia, India, Egypt, Libya, West Africa and the Mexico-Latin American market. In Brazil, last week, we extended our existing contract with Petrobras for ENSCO 6000 by 1 year to April 2014 at a rate of $275,000 per day, a $75,000 increase to the current rate. ENSCO 5005, which has been contracted to Petrobras through April of next year, is now mobilizing to Singapore for a planned inspection and shipyard upgrades that will extend into the second quarter of next year.

While certain operators in Brazil have reduced their demand for midwater drilling rigs, we don't believe this is a long-term trend since the midwater geology in Brazil continues to support additional drilling by capable midwater assets.

Turning to the jackup markets. Activity continues to be robust. Almost all regions see higher utilization and competition for assets has pushed day rates higher. In the U.S. Gulf of Mexico, the premium jackup fleet is 100% utilized, and new contract rates for premium jackups are in excess of $100,000 per day. Rigs that roll off contract are quickly awarded new work, often for 6- to 18-month terms. We anticipate the premium jackup market will continue to be strong into 2013.

In Mexico, PEMEX continues to attract rigs from around the world in their effort to increase their jackup fleet to 40-plus units. Currently, they have 25 rigs working with 10 contracts expiring before year-end. We anticipate the majority of these rigs weeks will be awarded further work through direct negotiations.

In the North Sea, where most of Ensco's fleet is fully contracted through the 2013, only a limited supply of standard duty jackups will become available in the third and fourth quarters of next year. In 2013, we anticipate that several newbuild units, including our ENSCO 120 jackup will enter the region. They should be easily absorbed based on the number of new inquiries for work starting in 2013 and 2014 and as operators evaluate jackups to handle overflow projects from the U.K. semi market.

We don't have any jackups in the Mediterranean, which has been a difficult market. With the lack of long-term opportunities and ongoing political instability, we do not anticipate improvement anytime soon.

The African market has tightened in recent months and we expect that the market will be balanced into 2013. There are currently 8 tenders or pre-tenders outstanding for 2012 projects and approximately 7 more for 2013.

In the Middle East, utilization reached 95%, up from 86% a year ago. Incremental demand is expected in Saudi Arabia, Oman and Qatar.

Moving to the Asia Pacific market, activity remains tight with jackup utilization exceeding 96% in the third quarter. There is an upward convergence in day rates for standard and high-spec rigs due to the lack of supply. Jackup demand is forecast to continue increasing in 2013 with a number of incremental long-term projects from several operators.

Australia, Myanmar, the Philippines and Indonesia are actively seeking investment in their country's reserves, which we believe will underpin drilling in the region for years to come and absorb newbuild rigs as they are delivered.

To summarize, customer demand continues to rise and there is a limited near-term supply of new rigs. This has driven up average day rates for both our deepwater and jackup segments. Exploration and appraisal success, new deepwater basins and healthy commodity prices are all positive indications for long-term growth. All of these factors bode well for Ensco and put us in a great position to meet incremental customer demand.

Now I'll turn it over to Jay.

James W. Swent

Thanks, Dan. Today, I'm going to cover highlights of our third quarter results, the outlook for the fourth quarter and our financial position. Now let's start with third quarter results versus prior year. Earnings were $1.48 per share, up from $0.88 a year ago. As noted in our earnings release, certain items influence the comparisons. Third quarter 2012 contract drilling expense included an $8 million loss on the sale of ENSCO I and $4 million of impairment charges. These items reduced earnings by $0.05 per share. We also had a $31 million warranty claims settlement that improved earnings by $0.13 per share. These warranty settlements have benefited the current quarter are related to items that reduced operating income in prior periods.

Finally, in the third quarter of last year, contract drilling expense included an $11 million insurance settlement gain for ENSCO 69.

Total revenue for the quarter was a record $1.1 billion compared to $916 million a year ago. Revenues grew 23% year-over-year. Deepwater revenues increased from $440 million to $629 million, growing 43% from the prior year due to the addition of ENSCO 8505 to the active fleet, a full quarter of operations for ENSCO 8504 and significantly higher utilizations, primarily due to reactivation of ENSCO 7500 late last year, following upgrades that were completed during 2011.

Midwater revenues were $94 million, down from $121 billion in the prior year. The average day rate was $221,000 compared to $239,000 a year ago. Utilization declined to 74% from 89% as a result of downtime from ENSCO 6000 and ENSCO 5003 being warm stacked. Jackup segment revenues increased by approximately 15% due to an increase in both utilization and the average day rate. Utilization for the entire jackup fleet in the third quarter was 83%, up from 77% a year ago. As Dan noted, utilization for our marketed rigs, all of which are contracted, was 92% in the third quarter. The average day rate increased 9% to $109,000 as shown in our earnings release.

Turning now to contract drilling expense. For all segments, the total was $523 million, up from $478 million in the third quarter 2011. This increase was mostly related to significantly improved utilization in the deepwater and jackup segments, reactivation of ENSCO 7500, the addition of ENSCO 8504 and 8505 to the active fleet, an increase in unit labor cost, previously mentioned loss on ENSCO I and impairments totaling $12 million and the $11 million insurance settlement for ENSCO 69 last year.

Third quarter contract drilling expense was lower than expected mostly due to the $31 million of warranty claims that I mentioned earlier and repair and maintenance expense coming in $13 million below our forecast.

General and administrative expense for the quarter was $40 million, down from $41 million last year. Both the last year's number included $7 million in professional fees, severance payments and other acquisition-related costs. Effective tax rate in the third quarter was 11.4%, in line with our guidance for the full year.

Now let's discuss quarterly trends by comparing third quarter 2012 sequentially to second quarter 2012. Third quarter revenue increased 5%, mostly attributable to a 10% increase in deepwater segment revenues, driven by the addition of ENSCO 8505 to the active fleet and a 1% increase in jackup segment revenues from higher average day rates. Midwater segment revenues declined $8 million due to a 5 percentage point decrease in utilization, combined with a $6,000 decline in the average day rate. Total contract drilling expense increased $33 million sequentially from the second quarter. There were several items that influenced the comparisons.

In the third quarter, as noted previously, there were $31 million of warranty claims settlements, partially offset by $12 million from the ENSCO I sale and impairments. In the second quarter, there were $22 million in warranty claims settlements and a $13 million gain on the sale of 2 cold stacked jackups. Adjusted for these items, contract drilling expense increased $17 million or approximately 3%, mostly due to more operating days for ENSCO 8505.

Looking at other expenses, depreciation increased $6 million or 4% compared to the second quarter due to the addition of ENSCO 8505. G&A expense increased $4 million, primarily due to higher compensation expense related to the retirement of our Chief Operating Officer, Bill Chadwick, after 25 years of service to our company.

Now let's discuss the fourth quarter outlook. Based on our current projections, revenues are expected to be approximately equal to the third quarter. The quarter segment revenue utilization and average day rates are projected to remain consistent at third quarter levels. In Midwater, our smallest segment, revenue should decline slightly due to lower utilization as ENSCO 5005 mobilizes to Singapore for a regular inspection and shipyard upgrades, partially offset by ENSCO 6000 that is expected to have more operating days in the fourth quarter. In jackups, the average reported day rate will increase further and utilization is expected to be up slightly in the fourth quarter.

Adjusted for the $31 million warranty claim settlement that benefited the third quarter, we expect no increase to contract drilling expense in the fourth quarter. Depreciation expense is expected to be unchanged. General and administrative expense is expected to decline $8 million to $32 million in the fourth quarter. Their expense is anticipated to be approximately $22 million, $29 million from interest expense, partially offset by $7 million of interest income and other items.

Finally, we feel very good about our total synergy target of $100 million for the year, which is included in our outlook. Capital spending is forecast to be about $1.8 billion for the full year. The anticipated breakdown is $1.3 billion for newbuild rigs, $330 million for rig enhancement projects and $210 million for sustaining projects. We've already invested $1.6 billion through September 30, so remaining capital expenditures are estimated to be about $240 million for the balance of this year. Looking ahead, contractual commitments for our newbuild rigs under construction are approximately $1.9 billion, which will be spent through the end of 2014.

In terms of our financial position, we ended the third quarter with a 29% leverage ratio and $9 billion of revenue backlog. Overall, we feel very good about the progress we've made this year. Our new rigs have been delivered on time and on budget and our 6 rigs under construction are all on track for their delivery dates. Growth of our fleet has produced record revenues and earnings. We have divested several rigs and reinvested the proceeds back into our fleet as part of our continuous high grading strategy. The integration of our operations following the acquisition last year has gone extraordinary well and we are achieving our targeted synergies. We've improved our leverage ratio to below 30%, even as we have increased our dividend payout 7% earlier this year and invested another $1.6 billion year-to-date in our fleet. Importantly, 75% of this capital investment has been dedicated to the growth of our rig fleet, which will drive future earnings and cash flows.

Finally, Ensco was reinstated into the S&P 500 Index in the third quarter shortly after we converted our NYSE listing back to ordinary shares.

With that, I will now turn the call back over to Sean.

Sean P. O'Neill

Thanks, Jay. Before we open it up for questions, we know that many of you listening in on our call today were severely impacted by Hurricane Sandy, and we hope that's you and your families are safe. We know how challenging it can be to manage through such a damaging storm and our thoughts and prayers remain with you as you work through the aftermath of the hurricane.

Operator, you may now open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Jud Bailey with ISI Group.

Judson E. Bailey - ISI Group Inc., Research Division

I guess, first, I'll go ahead and get the MLP question out of the way. So Jay, I'll get your thoughts, if you guys look at the structure at all or do you have any just high-level thoughts on the MLP talk within the industry?

James W. Swent

Thanks for the question, Jud. Everybody's talking about it, so obviously, we've looked at it. I think our view at the moment is we have better or more efficient ways to raise capital than through that structure, so it's not something we're looking at very hard at the moment as something we'd pursue but we'll keep an eye on how things go with other people that have used the structure. But I wouldn't anticipate it's anything you're going to see us do in the near term.

Judson E. Bailey - ISI Group Inc., Research Division

Okay. And then, I guess, actual business question. On Brazil, there's a lot of moving parts down there. It seems like for 2013, you could get some midwater rigs released, you do have a lease sale coming up. Can you help us think about maybe thinking about utilization for some of your rigs that are rolling off contract next year. Do you have immediate work potentially lined up or should we start to factor in a little bit of downtime if those have to leave the region and then come back maybe?

Kevin C. Robert

Jud, this is Kevin Robert. First of all, I think Petrobas is being very practical to make sure that the rigs they have are efficiently utilized. So in their rebalancing of their portfolio, what we see them doing is shifting more resources to pre-salt, which is a lot higher value game for them. So what that has done is de-emphasize some of their efforts in the midwater region. We've got the ENSCO 5000 that will roll off contract in the middle of next year. There's a number of opportunities for that rig that we're chasing down. We also see the independent operators in that market growing in terms of their presence in the midwater. We see OGX staying consistent with what they're doing. And I think all in all, it does bode well that the geology there is strong and we don't expect this to be a long-term problem in Brazil.

Judson E. Bailey - ISI Group Inc., Research Division

Okay, great. And just a quick follow-up to that, Kevin. So for instance on the 5000, are the leads, I guess, are they warm enough that you think you can have fairly continuous utilization in the back half of the year? Or would you anticipate it having to have some downtime in the back half of the year?

Kevin C. Robert

Right now, there's a lot of activity. Of course, you've got to bid for everything and most of the opportunities we're looking at are outside of the country. We have had a few short-term in the country, so it's hard to predict right now where we'll end up.

Operator

Our next question is from Doug Becker with Bank of America Merrill Lynch.

Douglas L. Becker - BofA Merrill Lynch, Research Division

Maybe just following on the Brazil questions. Do you think Ensco has the appropriate exposure to Brazil? I mean, the commentary has been pretty favorable. The flip side, margins seem to be a little bit lower, maybe the risk profile is a little bit higher than we originally thought. If we look out 1, 2 years, do you think Ensco have more or less rigs in the region?

Daniel W. Rabun

I think, Doug, first thing I would say is we like the region. There's been certain amount of discussion about it being a challenging region to work in. Everywhere we work is challenging. We feel like we have a great position there. We've got an outstanding organization on the ground there that allows us to really do a good job for our customers. And I think it's possible over the next couple of years, we may go plus or minus a rig there but we're committed to something in the 10 kind of number. I think our view is that it probably will always be a market that has slightly lower returns in some other markets that we have, and the offsetting benefit is that it has more term and more predictable cash flow and the rigs stay in the same region. So on balance, we like the exposure. I don't think we're looking to massively increase it or decrease it .

Douglas L. Becker - BofA Merrill Lynch, Research Division

Okay, makes sense. And I guess, one of the common questions is just about a dividend going forward and maybe one way to approach it is back in 2010, Ensco did bump the dividend from about $0.025 to $0.30 a quarter, just maybe a little contrast from what we see today versus that point in time. You had over $1 billion on the balance sheet, just no debt. On the flipside, today, as we have over $9 billion of backlog, just how would you compare today's outlook versus back when you did that large dividend bump a few years ago?

Daniel W. Rabun

As you say, obviously, we had a lot of cash on the balance sheet at that time and we didn't have the same level of CapEx commitments that we have at the moment. So we clearly are ramping up on cash flow generation. And we still have a lot of newbuild construction to fund. So it's, obviously, going to be a balancing act going forward as to what we do on dividends, but I think our answer on capital allocation is as it's always been. I think we feel like we're really fortunate to be in a position that we can pay a meaningful dividend, we can continue to probably grow that dividend in the future and not really impair our ability to also grow the business. So as I always like to say, in the investment community, we're a great growth story and a great current income story.

Douglas L. Becker - BofA Merrill Lynch, Research Division

Is there a minimum cash balance you're comfortable running the company at?

Daniel W. Rabun

We've been working on that a lot, and I mean, you can see that our cash balances dropped dramatically over the last couple of years, and we're not using any CP facility at the moment to fund the business. So we figured out, I think, how to run the business in a $150 million kind of range pretty comfortably through a lot of the outstanding work with our treasury group.

Operator

Our next question comes from Dave Wilson with Howard Weil.

David Wilson - Howard Weil Incorporated, Research Division

You guys have a high concentration of 8500s in the Gulf of Mexico. Was that by coincidence or design? And is there anything to infer from this concentration as far as the suitability of these rigs? I know the 8504 is over in Brunei, but I was wondering is there any rhyme or reason to the Gulf of Mexico concentration?

Daniel W. Rabun

Yes, there's a real good reason for it. The rigs have performed excellent for our customers and they keep wanting to contract them in the U.S. Gulf of Mexico. So we have 3 of those rigs with Anadarko, as a repeat customer that will enjoy the 8501 and Cobalt loves 8503. So it's really a comment on what our customers think. Also from an efficiency standpoint, having a concentration of rigs in one geographic market makes for an extremely efficient operation. And as you saw in the prepared comments, we had 99% uptime on the 8500 Series rigs and a lot of that has to do with the standardization and operating in one geography. So it's very effective from our perspective. The rigs could operate elsewhere in the world, it's just where they came first.

David Wilson - Howard Weil Incorporated, Research Division

Great. And then just as a follow-up, any new developments to the possibility of the 130 jackup series?

Daniel W. Rabun

No, we continue to market -- actively market that rig. And there has been no new developments since the last earnings call. There's an awful a lot of interest in these high-spec jackups in the North Sea, but the 120 series seems to be addressing most of those market needs right at the moment.

David Wilson - Howard Weil Incorporated, Research Division

Okay, great. And then just one quick final one. As far as the North Sea, any possibility of moving a rig or 2 from Brazil into the North Sea market? And if so, how much capital and time will that take?

James W. Swent

Yes, we're evaluating that, but I don't view that as a likely scenario.

Operator

Our next question is from David Smith with Johnson Rice.

David C. Smith - Johnson Rice & Company, L.L.C., Research Division

Nice contract disclosure on the 6000. I want to make sure I had correctly that the 5005 is now mobilizing to Singapore for upgrades? Is the 5005 expected to return to Brazil to finalize the contract with Petrobras?

Kevin C. Robert

This is Kevin. No. I think, David, we will market the rig out there. The end of the Petrobras contract was so close to the end of the shipyard that I think it's going to make more sense just to leave it in that region where there's actually quite a few number of opportunities for that rig.

David C. Smith - Johnson Rice & Company, L.L.C., Research Division

Okay. And is it fair to suppose that the day rate increase on the 6000 includes partial compensation for the early release of the 5005?

Kevin C. Robert

No, actually, we've been in long discussions with Petrobras on that rig and they have a high need for workover and that rig is highly valued. So that length of contract made sense, the work program for that rig.

David Wilson - Howard Weil Incorporated, Research Division

Okay. And just a quick follow-up on the 5005. Any commentary on scope of the upgrades, if that's being done? An expectation of a program are just more general in nature?

Daniel W. Rabun

I think it's a planned SPS. We do have some contingency for the age of the rig in case have replace from some steel. But nothing out of the ordinary.

David C. Smith - Johnson Rice & Company, L.L.C., Research Division

No major CapEx in that, okay.

Operator

And our next question is from Nigel Browne with Macquarie.

Nigel Browne - Macquarie Research

Just wanted to piggyback on that question regarding the 8500 Series and how prolific it is in the Gulf of Mexico. Given that it's a semi, usually smaller deck load, is the popularity there a function also of the fact that it's just a much more logistically friendly region or are there any differentiating features that you think may get ideal for the U.S. Gulf?

John Mark Burns

Nigel, this is Mark Burns. Regarding the 8500 Series units, we are extremely pleased as is our customers with the performance of those units. As Dan mentioned, having a number of these units in the same geographical area, it gives us economies of scale in terms of our logistics resupply, spare parts, sharing. All of these things just make good sense for these units. They performed well. We've had repeat customers. We are looking at other areas around the world where we can utilize these if the term and economics makes sense. But we're very, very pleased, as is our customers, with the performance of these rigs.

Kevin C. Robert

Yes, Nigel, this is Kevin. I might add that we've actually got today more opportunities for these rigs in the Gulf of Mexico than we have rigs. So even though we've had opportunities outside the Gulf of Mexico, it hasn't made sense given the alternative of keeping right them where they are continuing to take advantage of the synergy of having that concentration.

John Mark Burns

Yes. And I think I'd be remiss if I didn't mention ENSCO 8504, which is the one rig in the series that's operating in the Far East. It's had less than 2% downtime in its operations. So it's been an extraordinarily well-performing rig as well.

Nigel Browne - Macquarie Research

And I guess, just following up on that question. I'm trying to gauge, it seems like the industry is sort of skewed towards drillship assets. Just wanted to sort of get your impression on whether that will sort of evolve, in time, move in time over to the semis versus drillships?

Kevin C. Robert

Nigel, drillships versus semi is a continual discussion that we've had for decades in this business. And sometimes, the preference depends on the construction cost. But in the Gulf of Mexico, you've got distinct trends of geology and the 8500 Series rigs can really access a wide range of those prospects. So as you look at the clients and look at the nature of the programs, that's really more of the driver. These semis are large, they're efficient, they're easy to use. You look at the geologic expansion of the clients using these rigs and these rigs are very, very efficient for them accessing their reserves. So that's really, in short, it's the best economic choice for those clients and it's the best economic choice for us in that region.

Nigel Browne - Macquarie Research

All right. And just 2 quick follow-up questions. One, are you able to give us any color on your fleet mix of exploration versus development? And second, any sort of update or color on what you're seeing in terms of cost and, in particular, labor inflation?

James W. Swent

On the exploration versus development, the industry is in a fairly significant exploration mode right now. We've had a large increase in exploration drilling versus a few years ago as an industry, which is real positive for the long term. A lot of our rigs are tied up on development programs because of the high commodity prices are also a very strong incentive for clients to get every drop of oil and every cubic foot of gas out of the ground. So I don't have the exact split but we're at least 50% development, maybe more. But it's significant in the industry and with our fleet.

Daniel W. Rabun

And, Nigel, I think on the second part of your question relative to cost inflation, what we've said for the fourth quarter is it's basically flat on contract drilling expense. So I think that would tell you what we think about the near term. But we haven't made any long-term commentary yet. We'll do that on the next call relative to next year. But obviously, you mentioned labor, that there's going to continue to be a huge demand for labor with all the rigs that need to be crewed up in the next couple of years. And so there's going to continue to be pressure there, but we'll give you a little more color on our views on that on the next call.

Operator

Our next question is from Ian Macpherson with Simmons.

Ian Macpherson - Simmons & Company International, Research Division

Jay, I'd clarify your fourth quarter cost guidance was flat, excluding the warranties, correct?

James W. Swent

That's correct, that's correct.

Daniel W. Rabun

Let me say it as simply as I can. Add $31 million to our third quarter number and that gets you to the fourth. We don't want any confusion on that.

Ian Macpherson - Simmons & Company International, Research Division

I think your last fixture for 8500s was the 06 about 9 months ago with Anadarko. I think we've seen some -- but it's hard to tell exactly, how much general ultra-deepwater day rate inflation in the past 9 months. Can you talk about how much you think rates, how much more dynamism there is in ultra-deepwater rates, particularly for your rigs that have a prompt availability advantage next year?

Daniel W. Rabun

I think it really depends by market around the world and I think there's going to be -- that's only difference is depending on the geography that you're in. So I don't think they've been -- they benched up some but I think it really depends of the markets you're talking about.

Ian Macpherson - Simmons & Company International, Research Division

Okay. Just quickly, back to the warranty issue, that's been as pleasant surprise. I think we've heard some of your peers talk about similar problems with equipment issues and having warranty coverage for their service and replacement but not necessarily to the extent that we seem to see with your recoveries for cost and revenue losses. Are your contract term typical do you think in terms of your relationship with the vendors? Or that you think that you have sort of an advantage there? And also, are there more warranty claims outstanding that we might see in the future?

Daniel W. Rabun

I think in terms of the last part of your question, we have a few things we're talking to people about. I don't think you should anticipate the level that you've seen in the last couple of quarters, if anything, going forward. I think we probably have pretty good contracts. I can't comment vis-à-vis other people. The one thing I'd say, Ian, is that I think it's just another confirmation that putting 2 companies together really provides you a lot of capabilities. I mean, we have had the technical capability to be able to talk to vendors about these issues and we've had the procurement clout to kind of make our point with them. And we're viewed as, obviously, a very important client going forward for all of our suppliers. But it's one of these sort of unintended synergies of the acquisition that we were in a position to be able to do that.

Operator

Our next question is from Collin Gerry with Raymond James.

Collin Gerry - Raymond James & Associates, Inc., Research Division

Just wanted to follow up on a quick guidance note. I believe you said depreciation is guided to be flat next quarter. Does that mean we should start depreciating the 8506 and the drillship in the first quarter?

Daniel W. Rabun

That's correct.

Collin Gerry - Raymond James & Associates, Inc., Research Division

Okay. Just making sure on that one. The other question I had going back to the 8500 Series, quite a few have been in service for a while. There's some rollovers coming over in the Gulf of Mexico. I just wonder if we should preemptively assume some shipyard-related downtime in 2013? I know it's early in the planning stages, but do you think that's a prudent assumption?

John Mark Burns

Yes, that will be very -- this is John. It will be very minor downtime associated with 8500 Series next year.

Collin Gerry - Raymond James & Associates, Inc., Research Division

Okay. And then last one for me, just kind of strategically. Obviously, Ensco has strong roots in the jackup market in the Gulf of Mexico. I guess, going forward, is that viewed as a strategically core market in the Ensco fleet, the shallow water Gulf of Mexico market?

Daniel W. Rabun

Absolutely. It's provided a foundation for our company. A lot of our deepwater employees have come from our jackups in the Gulf of Mexico and they're core to our company.

Operator

Your next question is from Rhett Carter with Tudor, Pickering, Holt.

Rhett Carter - Tudor, Pickering, Holt & Co. Securities, Inc., Research Division

With another follow up on 8500 Series, just with those coming available in 2013, should we still expect the options to be exercised that are there? And if an option is unpriced, is that -- should we think about that being market rate?

James W. Swent

I would -- the answer is yes, you should think about it if it's unpriced that it's going to be market rate because we're not going to sign a contract anything but markets. So yes, the answer to your question is yes. Now to exercise the options, we should know soon, but I don't think we're concerned that we're going to have any downtime on those rigs.

Rhett Carter - Tudor, Pickering, Holt & Co. Securities, Inc., Research Division

Right, okay. And then just following on with the Gulf of Mexico jackup market, you have the 2 stacked jackups there. Just given how that tight that market is getting, any change on your position of potentially destacking either of those?

Daniel W. Rabun

No.

Operator

Our next question is from Justin Sander with RBC.

Justin Sander - RBC Capital Markets, LLC, Research Division

I just had one follow-up question for you, Jay, on -- your comments around the R&N costs in the quarter. Coming in $13 million below expectations and then it sounds like that the outlook x the warranty claim is for R&N cost to remain low in the fourth quarter as well. Just wanted to understand if that's a timing issue? Or is that something that you're seeing that's kind of structural and how that portion of your expenses are developing?

James W. Swent

I think it's really probably more timing and by the way, there's a lot of moving pieces, although it's flat quarter-to-quarter, there are a number of moving pieces and we could spend a half hour probably going through line-by-line on the differences between the 2 quarters, so I wouldn't read anything structural into that at all.

Operator

[Operator Instructions] Our next question is Darren Gacicia with Guggenheim.

Darren Gacicia - Guggenheim Securities, LLC, Research Division

During your Investor Day, you guys talked about having kind of a supply demand model set up for rigs. You used basically as a capital budgeting tool. I'm thinking about how you're going to deploy capital...

Daniel W. Rabun

Darren, just so you know, we have lost you.

[Technical Difficulty]

James W. Swent

Operator, while you're trying to get Darren back, I think we understand the gist of the question in terms of what we laid out at Investor Day. So, Kevin, if you want just maybe kind of explain our outlook in terms of supply and demand going forward?

Darren Gacicia - Guggenheim Securities, LLC, Research Division

I think you were about to address, but basically what I was going for is if the market now seems to be kind of be in a scramble for rigs in '14, as you kind of employ your model and your logic, are you seeing the market continually short rigs beyond? And what does that mean for kind of how you guys are thinking about deploying capital?

Kevin C. Robert

Darren, this is Kevin Robert. I can address the supply and demand part but someone else will have to address the capital part. As we look forward at both the jackup and the floater markets, and look of the level of activity, 2012 is turning out the way we track it to be, the fourth busiest year for contracting rigs in the last 10 years. If that pace has certainly already put pressure on 2013 availability for both jackups and floaters, and I think that's why you see the rates going up and the terms getting longer. Now on the floater side, a lot of clients have expanded their tenders to look for rigs to the end of '14 because of the strength in the market and we see that continuing because of the activity level. So if you try to project that out and make some assumptions, at this moment, if we continue at this pace, I think we're going to see 2014 available -- availability disappearing as quickly as we saw 2013. And that's kind of an overview. And that's the market that we see deploying our fleet into over the next couple of years.

Darren Gacicia - Guggenheim Securities, LLC, Research Division

Does that mean -- does that translate the market being short rigs come '14 and '15? Or you think it's more of a balanced market or is it too early to tell?

Kevin C. Robert

Well, there's a growing fleet in both jackups and floaters from the newbuilds. There's also a growing fleet of aged rigs, which are becoming less efficient. So as you look at client preference to utilize dependable contractors because that's the first thing, is our customer service and the utilization and the efficiency of our fleet benefits our clients. So that's first. Second, as the fleet size has grown, demand has also grown due to exploration success and strong commodity prices. So we're seeing the growth in the fleet more than balanced out by the increases in demand.

Darren Gacicia - Guggenheim Securities, LLC, Research Division

Got you. So that tells me there's a deficit. So if you're in a deficit and that means rates will stay higher, probably for even contacts signed into '15, probably expanding the question out, does that mean there's a propensity to continue to build rigs in here? Or kind of where are your thoughts incrementally, especially since I think you only have what, 3 more drillships to be contracted in your own queue for newbuilds?

Kevin C. Robert

Well, I think, Darren, as I said earlier, we are fortunate to be in a position to be able be an income story and a growth story. I think we're pretty strongly committed to growth as long as we can do it at a good return on investment for our shareholders. So at any point in time, we've got to look at where are day rates, where are construction cost, what's the supply-demand situation look like. But at the end of the day, we are committed to being a growth story, as well as an income story. As long as there's good opportunities, we'll look at them.

Darren Gacicia - Guggenheim Securities, LLC, Research Division

If I can add one more. So is kind of thinking about that and coming to closer decision a function of contracting your existing fleet? Or is it a longer-term thought process?

Daniel W. Rabun

It's really -- everything goes under the thought process. It's all of the above.

Darren Gacicia - Guggenheim Securities, LLC, Research Division

And is there an optimal kind of net debt-to-capital ratio that you see kind of going forward as you start to build cash? Or is there a way to kind of think about how capital gets deployed over time in function to that?

Daniel W. Rabun

I mean, we committed as part of the acquisition to delever somewhat over time and we're still on that path. And I think we feel real good that we've done even more delevering than we probably originally planned up to this point. So we're in a slightly below 30% debt-to-cap territory right now. We're real comfortable with that. I think we've always said if there was some really exciting strategic transaction, we might lever up a little bit. But for the most part, I think we're real comfortable with where we are. We're not interested in trying to drive it down dramatically below where we are, but I don't think we have a specific target in mind.

Sean P. O'Neill

Okay, everyone. Thank you very much for participating on our conference call today and we'll see you on our next earnings call. Thanks very much.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.

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