About two weeks ago I wrote about the flurry of orders for deepwater drilling rigs that kicked off late last year. The pace has not subsided, with Daewoo Shipbuilding & Marine Engineering since pulling in three more drillship orders: two from Aker Drilling -- a Norwegian drilling contractor prepping for an IPO on the Oslo Stock Exchange -- and one from Atwood Oceanics (NYSE: ATW ) .
We've seen the ticket price for a new drillship pull back from its peak, but contractors aren't exactly getting deep value at $600 million per rig. Many of them are also willing to commit to newbuild orders without a drilling contract in hand -- something that Transocean (NYSE: RIG ) has typically refused to do.
Are these outfits simply that bullish on the long-term demand outlook for deepwater drilling, or is there something else driving this herd-like behavior?
The folks at JPMorgan think there's something else at work. That something is a company named Seadrill (NYSE: SDRL ) . This hard-charging company has taken the drilling market by storm, amassing a world-class drilling fleet in a shockingly short period of time. JPMorgan's analysts basically see Seadrill forcing other companies' hands, in that the more top-shelf rigs Seadrill brings into its stable, the less competitive operators like Diamond Offshore (NYSE: DO ) become.
Diamond, a cornerstone of the Tisch family's Loews (NYSE: L ) empire, has historically shown a knack for opportunistic purchases and a preference for upgrades over newbuilds. Even this company is joining in the newbuild rush, which is pretty telling. Whether it's Seadrill that's pushed it into a corner, or simply the broader market trends toward ever-deeper drilling targets and higher-capacity rigs, Diamond Offshore seems to find itself in a bit of a bind.
The firm is popular with value and income-oriented investors, but I question whether Diamond's high returns on capital and outsized special dividends are sustainable. Looking at the age and capabilities of this contractor's fleet, I foresee significant future capital expenditure requirements in order to stay competitive with the more modern fleets of firms like Seadrill and Ensco (NYSE: ESV ) . That implies a drag on future free cash flow, and perhaps a lower valuation than the market is awarding this company today.