Contract drilling is a tough business. Few other industries feature competitors so willing to slit each other's throats (and their own throat in the process) with overcapacity and pricing. But by the same token, when there are periods of under-capacity, few industries can turn so profitable so quickly.

As the major player in offshore drilling, Transocean (NYSE:RIG) is living in the confluence of some major present-day trends. High energy prices are leading to more drilling, depleting onshore resources are leading more companies to drill offshore, and day rates (the negotiated usage price per day) for drilling platforms are climbing on a fundamental imbalance between supply and demand.

A variety of accounting movements (gains, losses, and the deconsolidation of TODCO) makes year-over-year comparisons a little tricky. Sticking to reported GAAP results, revenue declined slightly, while reported operating income climbed 48%. Looking at a non-GAAP analysis of the Transocean drilling segment, operating revenue grew 9%, while field operating income dipped slightly.

On a sequential basis, the picture is brighter. Not only did the company achieve a 6% reduction in operating expenses but also average day rates increased 3% and utilization climbed 6% to 75%.

Day rates and utilization are the real story here. With rig supply remaining very much constrained, industrywide day rates in major production regions such as the Gulf of Mexico and North Sea have in some select cases doubled or tripled from year-ago levels.

Even Transocean management acknowledges that predicting day rates is more voodoo than science, but it appears that the market should stay robust for a few years' time. Contract durations are lengthening as producers try to ensure future access to drilling platforms. Transocean has nearly two-thirds of its high-specification floaters and more than one-third of jack-up rigs already committed for 2006.

While management seems concerned that the jack-up business could begin to soften in a couple years from added supply, the much higher-value high-spec business looks good through 2008. With shipyards reporting a three- to four-year timeline for new high-spec rig constructions (and hardly anyone put in significant new orders a few years ago), it's clear that new supply won't be hitting the market in force for at least a few years.

What happens if oil prices drop? Clearly, oil prices play a direct role in determining demand for drilling; as oil prices climb, more potential projects become viable. Nevertheless, demand for drilling rigs should stay profitably firm so long as oil stays at $30 a barrel or higher. What's more, Transocean already has a number of attractively priced contracts in place for 2005 and 2006; clients such as major energy producers BP (NYSE:BP), ChevronTexaco (NYSE:CVX), and Petrobras (NYSE:PBR) aren't likely to renege or weasel out of those deals.

Transocean has already had a great run, climbing about 75% in the past year. But with day rates still on the rise and a positive two- to three-year outlook, the story might not be over just yet. If this were a baseball game, I might say that we're in the fourth inning -- the move is clearly already under way, but the game is likely far from over.

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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).