Why Diamond Offshore Is Struggling to Keep Its Head Above Water

The near-term outlook for deepwater oil drillers is challenged, to say the least. Despite supportive commodity prices, with crude oil trading near $100 per barrel in the United States, and a sound long-term outlook thanks to rising energy demand across the globe, oil drillers face some significant bumps in the road.

In particular, Diamond Offshore Drilling  (NYSE: DO  ) can't seem to catch a break. Its investors have gotten nothing but bad news over the past month. First, in April the company reported a poor first-quarter earnings report in which several of its key metrics deteriorated.

The latest blow comes from one of its key customers cancelling a significant order. Oil and gas exploration and production giant Statoil (NYSE: STO  ) recently notified Diamond Offshore it would terminate its drilling contract for the mid-water semi-submersible Ocean Vanguard.

Add it all up, and it's clear that Diamond Offshore is in the middle of a rough patch.

Statoil cuts back
Oil and gas companies of all shapes and sizes are cutting back on capital expenditures, which is confusing for a number of reasons. The global economic recovery, while perhaps more sluggish than most would like, is proceeding at a slow and steady pace. In addition, oil prices are still supportive of growth and aren't having a negative impact. Last but not least, demand for energy continues to increase in the emerging markets, as it seems that developing nations across the world can't get enough oil and gas.

Nevertheless, large and extremely mature oil companies are having difficulty generating satisfactory returns from new projects. They struggle to find projects large and attractive enough to move the needle. And, since investors are clamoring for greater cash returns, companies are turning to harsh cost cuts to boost profitability.

Statoil is the latest example of a company trimming capital expenditures to keep its investors happy. According to Bloomberg, Statoil management is seeking to reduce spending to generate $5 billion per year in cost savings. This includes reducing capital expenditures by as much as 25%, and Diamond Offshore seems to be the first victim.

Statoil is terminating a contract that holds a dayrate of $454,000. Analysts estimate the impact of Statoil's decision to be fairly significant to Diamond Offshore's bottom line. Barron's reports the cancellation could shave approximately $0.33 per share off Diamond Offshore's earnings. That will be somewhat mitigated by an early termination payment the oil driller is likely to receive in accordance with the contract, but it's clear that this is a significant event.

Diamond Offshore was already hurting from the downturn in rig ordering activity. Revenue and net income dropped by 2% and 17%, respectively, last quarter. This is on top of a fairly poor performance last year in which the company's operating profit fell by 17%, driven primarily by higher drilling expenses.

Going forward, investors should be concerned about Diamond Offshore's costs. That's because it plans to double its capital expenditures in 2014 to upgrade its fleet. The company expects to spend $2.1 billion on new-builds and other upgrades.

Management under pressure
Diamond Offshore put up a disappointing performance last year, and things didn't get much better in the first quarter. It's seeing less demand for its rigs, and it's about to spend billions to upgrade its fleet. Now, Diamond Offshore will be under even greater stress since Norwegian oil exploration and production company Statoil has cancelled a significant contract.

The long-term economics of offshore drilling are sound, based on the fact that demand is set to rise, especially in the emerging markets. But not all drillers are created equal. Some will sail through better than others, and it appears that for the time being, Diamond Offshore is at a disadvantage.

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