Over the past year, analyst after analyst downgraded the older offshore drillers. Everyone believed that older drillers such as Diamond Offshore Drilling (NYSE:DO) and Transocean (NYSE:RIG), would see less business because their customers favored new drilling rigs. 

Due to that negative sentiment, many investors expected bad results for Diamond Offshore's first quarter earnings. So when Diamond Offshore released solid results on April 24, many investors were surprised. Diamond Offshore's first quarter earnings beat expectations handily in all key metrics. Adjusted profit came in at $0.93 per share versus analyst expectations of $0.65 per share. Revenue was $709.4 million versus analyst expectations of $686.3 million. The company declared a special 75 cent dividend on top of the normal 12.5 cent a quarter dividend.  As a consequence of the surprise, Diamond Offshore stock rallied over 6%..

Reasons for the beat
The main reason for the earnings beat was lower costs. Diamond Offshore originally had a drilling cost guidance of between $405 million and $425 million for the quarter. The actual number came in at $370 million, or a positive surprise of 25 cents per share. About half of that surprise was due to longer than expected shipyard times for some rigs, but the other half of the surprise was due to actual cost containment.  

Another reason for the expectations beat was stronger than expected day rates. Normally day rates and utilization rates move in the same direction because they are both just a function of demand. Given the weak utilization rates across the industry, many investors naturally expected lower day rates for the quarter as well.

Diamond Offshore beat those expectations because it had higher day rates for all categories even though utilization rates fell for ultra-deepwater and deepwater. Day rates for ultra-deepwater rigs, for example, increased approximately 11% quarter over quarter to $387,000 while day rates for deepwater rigs increased 4% quarter over quarter to $418,000. 

Even though Diamond Offshore beat expectations, the company still has a relatively sobering outlook for the next couple of years. The company does not expect a strong 2014 or 2015 due to industry oversupply. Total offshore spending is still expected to be tight as oil companies remain hesitant on offshore exploration.

The bottom line
Diamond Offshore earnings and the subsequent stock reaction show that expectations for the sector are too low. Diamond Offshore and Transocean may have older fleets, but if they contain costs enough, they can still mint profits.  

Diamond Offshore's fleet will eventually turn younger as its new builds are finished. The company estimates that the new builds could expand EBIDTA by over 50%. 

The company also has the advantage of having the best balance sheet in the industry. With a strong balance sheet, the company can strategically acquire distressed assets counter-cyclically and benefit from any subsequent appreciation. 

Given the current oversupply problems, the offshore drilling industry will likely muddle through for another couple of years. But in the long term, offshore drillers still have a promising role. 

 

Jay Yao has no position in any stocks mentioned. The Motley Fool owns shares of Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.