A Shocking Blow for Diamond Offshore Drilling

Norwegian giant Statoil (NYSE: STO  ) has just delivered a very unpleasant surprise for Diamond Offshore Drilling (NYSE: DO  ) . Statoil unexpectedly terminated its drilling contract for the mid-water semisubmersible Ocean Vanguard, a contract that started in July 2013 and was ending in late February 2015. Statoil stated that the termination was due to technical aspects of the rig and refrained from further comments. Is it just another sign of continuing drilling market weakness?

Bad news for revenue
In response to Statoil's notice of contract termination, Diamond Offshore Drilling stated that it was going to defend its rights under the drilling contract. Ocean Vanguard, which was built in 1982, is a part of Diamond Offshore Drilling's older fleet. The rig was operating at a $454,000 dayrate, and had yet to bring around $120 million of revenue.

This is not good news for Diamond Offshore Drilling, as its revenue has recently been in a downtrend. First quarter revenue declined from $730 million in 2013 to $709 million in 2014, while earnings fell from $176 million to $146 million. This might not seem like a big difference, but the trend is worrisome.

More puzzling is the current state of the market for older rigs, which constitute a majority of Diamond Offshore Drilling's portfolio. Lately, Seadrill (NYSE: SDRL  ) scored a five-year contract for its newbuild ultra-deepwater drillship West Jupiter with dayrate of around $600,000. At the same time, Seadrill failed to find work fast for its West Tellus rig. West Tellus was built in 2013, so it is a new rig as well. Seadrill's difficulties with marketing West Tellus highlight the fact that it could be challenging to find the job for the latest generation of rigs. For older ones, it could be even more difficult.

Diamond Offshore Drilling CEO defends older rigs
Diamond Offshore Drilling has a semisubmersible called Ocean Lexington, which was built back in 1976. This rig is operating in Trinidad until early June 2014. After this, the rig is destined to go to Mexico to do a job for Pemex. The latest rig status report from Diamond Offshore Drilling states that while the contract has not yet been awarded, the low bid for the 1,189-day term has already been defined with a $160,000 dayrate.

Given that a significant number of new rigs are going to enter market in 2015, one can expect further pressure on older rigs' dayrates. Surely, Diamond Offshore Drilling recognizes this trend. It currently has five rigs under construction – three drillships and two semisubmersibles. Importantly, three of these rigs have already found their first customers.

During its first quarter earnings call, the company was directly asked about the age of its rig fleet and whether some of older rigs are close to the end of their life cycle. The company's stance on this question is that maintenance plays a big role in supporting the value of the older rigs and that market commentators exaggerate the problem of having an older fleet. There are still jobs for which older rigs are a perfect match. However, the growth in dayrate difference between old fleets and the new ones still looks like the most probable outcome.

Bottom line
The termination of contract with Statoil is bad news for Diamond Offshore Drilling. Given the current state of the drilling market, the pressure on Diamond Offshore Drilling's shares is likely to continue.

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