With all the recent buzz about the energy sector, I thought I'd define a common piece of industry jargon: dayrates.

Dayrates convey the amount oil and gas companies are willing to pay drilling contractors for their services at any point in time. Take the full contracted amount, divide it by the number of operating days, and there's your dayrate. When rates are soaring, it's payday on Rig Street. So whether you're looking to invest in an onshore driller like Grey Wolf (AMEX:GW) or an offshore honcho like Transocean (NYSE:RIG), it's critical to understand what moves dayrates.

Not surprisingly, rates rise when the demand for rigs outpaces supply. This partially explains why offshore dayrates are lowest in the Gulf of Mexico, which hosts a relative glut of jackup rigs. Of course, the drillers adjust their geographic deployment of rigs depending on where the going rates are highest.

But it's not simply about shuffling rigs around. When you see an area like offshore Brazil running at 100% utilization, as it is today, you know there's got to be another limiting factor. There are two, actually, but they go hand in hand: the technical limitations of older rigs, and the long lead time in constructing new ones.

A lot of drilling is moving into ultra-deepwater regions, where only the most recently built "floaters" can handle the drilling depth. These units currently set you back a cool half-billion dollars each, so it shouldn't surprise anyone that GlobalSantaFe (NYSE:GSF) and Diamond Offshore (NYSE:DO) don't have extra ones just floating around. Facing high levels of exploration demand, they do order new rigs, but it can take several years to get those new builds delivered. We're sitting smack in that interim period between initial high demand and the supply coming online to satisfy it. Gonzo profits tend to be earned therein.

A driller can follow one of two strategies in times of volatile dayrates -- in other words, just about all the time, since rates can swing faster than a third-grader hopped up on Pixy Stix. Management can either attempt to lock in present rates by attempting to sign long-term contracts, or they can sign short "spot" contracts and hold out for better rates in future years. Generally, long-term lock-ins are the prudent thing to do in a period of elevated rates, which is why you can expect to see contracts lengthen in periods of strong pricing.

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Speaking of drills, Fool contributor Toby Shute is overdue for a dental checkup. He doesn't own shares in any company mentioned. The Motley Fool has a disclosure policy.

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