Diamond Offshore Drilling Inc (DO) 2008 Q2 法說會逐字稿

Good morning, my name is Cheryl and I'll be your conference operator today. At this time I would like to welcome everyone to the Diamond Offshore Drilling second quarter 2008 results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. (OPERATOR INSTRUCTIONS) Thank you.

It is now my pleasure to turn the floor over to your host, Les Van Dyke. Sir, you may begin your conference.

Morning, and thank you for joining us. With me on the call today are Larry Dickerson, President and Chief Executive Officer; Gary Krenek, Senior Vice President and Chief Financial Officer; and John Gabriel, Senior Vice President, Contracts and Marketing. Before Larry begins his remarks, I should remind you the statements made during this conference call may constitute forward-looking statements and are inherently subject to a variety of risks and uncertainties that could cause actual results to differ materially from those projected. Forward-looking statements include but are not limited to discussions about future revenues and earnings, capital expenditures, industry conditions and competition, dates the drilling rigs will enter service, as well as management's plans and expectations for the future. A discussion of the risk factors that could impact these areas and the company's business and financial performance can be found in the company's reports filed with the Securities and Exchange Commission. Given these concerns, investors and analysts should not place undue reliance on forward-looking statements. The company expressly disclaims any obligation to release publicly any update to forward-looking statements to reflect any changes in the company's expectations or any changes in events, conditions, or circumstances on which any forward-looking statement is based. With that, I'll turn the meeting over the Larry.

Thank you very much, Les. Welcome, everybody, to our second quarter conference call. I'll make some brief opening remarks. Gary Krenek, as is our custom, will provide some guidance on the subsequent quarters, and then the two of us joined by John Gabriel will be glad to answer your questions.

First of all, it's worthy of comment that the quarter was a record one for the company, both in terms of revenue of $954 million, net income of $416 million, and earnings per share of $2.99. The quarter was favorable across the board. Our key drivers in our results are day rates, cost, and then utilization. On the day rate front, we had positive day rate news, but that's primarily impacting future quarters. I guess some of our jack up rates may have exceeded where we thought they might have been earlier in the year. But by and large, day rates are not a near-term factor in results.

On the cost side, I was very pleased with our results. We made a significant effort to ensure that we operate within budget. That's not easy to do in the face of cost increases that we're facing across the board. Primarily we seem to see it in service issues, such as a boat or any sort of installation of equipment. We can pretty much send out an AFE to buy some equipment. There are rising prices for the equipment but usually when the -- comes time to install or take a boat, we end up seeing that those costs have increased. But we've made active efforts to try to offset those costs by controlling in other areas, and I'm pleased that we'll be able to do that. We've done that here for the second quarter. Going into the rest of the year that's going to continue to be a challenge for us but, again, this is a top line driven business, at least in this particular market. And although we've got positive in the cost and we're proud of that, our biggest single impact on the top line has been the utilization number and that is the number of days that each rig can work. The type of areas where we can see negative utilization are repair time that we spend dealing with issues that may arise on the rig that take us off of the payroll, depending upon the contract, survey time, contract preparation, and then in some cases, any idle time due to inability to have a job for the rig.

Repair time was very, very positive for us in the quarter. We had very few number of days across the fleet, about 51 days, I think, where we were off contract due to those kind of issues. So that was a good, positive pick-up for us. We had a very much reduced number of days for rigs on survey, but those surveys are still out there and that's primarily a timing issue that we will pick up the survey time in Q3 and Q4. And Gary will give you a better idea of that. We didn't have really any contract prep going on during the month, so that really wasn't a factor. On our idle time, we did have the Ocean Heritage jack-up in the Middle East was stacked, for the entire quarter was down 91 days. That market has such a long lead time to get rigs going to work and we got caught in there. But we have since put the rig back to work, relocated it to the Gulf of Suez and began work shortly into the quarter. The rigs that did incur downtime were the Yorktown -- was down for the quarter and it was doing some contract prep and also some repair work and survey work that was going on there. And then we had the Ocean Clipper that came out of its survey in Brazil and then we had some thruster issues which incurred about 64 days of downtime for that, but the rig is now back to work. So that's all been very good. But again, Gary will go through the number of rigs that we'll be looking at as we go forward.

To talk briefly about the letters of intent that we announced in the press release, I think we had some solid fourth generation rates in the Gulf of Mexico. Earlier this year there was a moored fifth generation rig that posted a rate from one of our competitors at 535, so you have certainly seen the rate convergence there as we took America and Star and priced those out, even though they're lesser capable rigs, at 520. Subsequent to that, then we had a one-year commitment on the Ocean Victory at 540. And then we also noted that the Ambassador, which is our lowest spec rig in the fleet, has some work here in the US Gulf of Mexico and is followed by a three-year commitment in international markets at 260. So that's a terrific rate for that low end rig and pretty well puts that rig to bed.

I think we still have some renewal opportunities in 2009 that we're discussing right now. That would be the Ocean Valiant and the Ocean Quest. Having put to bed a number of our rigs at improving rates we're going to be very judicious on these two rigs to ensure we're fully reflective of where the market is. The market has continued to move. We're continuing to see lots of demand for these two rigs from multiple customers, so we think the market continues to be very vibrant around the world.

Other than that, my general comments would be that jack-ups in the Gulf of Mexico have continued to inch up. That's not a big part of our fleet but for the few rigs that we have left there, we've been able to see some short-term rate gains. So we're pleased with that. And I think that will conclude my opening statements, and I'll now turn it over to Gary for his guidance portion.

Thanks, Larry. I'd like to expand just a little bit on what Larry has touched on before we move on to the Q&A portion of the call. As always, I would like to spend the bulk of my time talking about expenses, both what we experienced in the second quarter and what we expect on a go-forward basis.

First, for those who have not yet seen it, we filed our biweekly status report this morning and would point you to that for the revenue guidance and expected timing of surveys and other rig downtime for the remainder of the year, rather than me reiterating that here on the call. Now, looking at the specifics behind our reported contract drilling expense for the second quarter, we gave out some pretty detailed guidance as to what to expect in our last conference call, saying that we expected those contract drilling expenses excluding reimbursable cost to come in at between $300 million and $310 million. Cost actually came in significantly lower at about $273 million. As Larry said before, a portion of that or approximately $20 million of that favorable amount is attributable to timing differences as the Ocean Guardian, Drake, Ambassador, and General had surveys that shifted from the second quarter into the third quarter. That $20 million has simply been deferred and will be spent in the upcoming quarter. The remaining favorable variance is, as Larry said earlier, due to our continuing efforts of controlling cost to the best of our efforts.

Looking forward with respect to contract drilling expenses in this upcoming quarter, we gave out average annual per day cost that we expect to incur by rig class and location at the beginning of the year. At that time, we said because these rates were expected to be rising throughout the year, we expected to incur costs at slightly below those rates during the first half of the year and slightly above them in the second half, in order to reach that average per day per rig cost that we disclosed. It appears that at this point that that was accurate guidance, and as such, in order to compute normal daily operating costs for the third quarter, you need to use those annual per day per rig cost numbers that we previously provided, but just escalate them slightly here for the third quarter.

Now, in addition to these normal daily operating costs, we expect to incur combined total of approximately $45 million in additional survey and other related costs for the Ambassador, Valiant, General, Drake, Rover, Guardian, and Bounty, all of which we expect to be down for a combined total of 364 days for surveys in this upcoming quarter. As before, we expect the weakness of the US dollar to cost us another $4 million to $5 million in additional operating costs and we'll book an additional $6 million related to the amortization of previously deferred mobilization costs. All told, this totals approximately $335 million to $340 million of contract drilling cost which we expect to incur in the third quarter.

Having said that, this estimate will change if there is a change in our rig survey timing as happened in this previous quarter. I would like to take this opportunity to remind everyone that we file that rig status report on our website every two weeks. Changes in survey downtimes, contract rollover dates, et cetera can be found in that report. I'd also like to point out that what I've been talking about is the line item in our income statement labeled contract drilling cost only and does not include reimbursable expenses which is a separate line item on our P&L statement. Reimbursable expenses are driven by the amount of consumables we are asked to purchase and provide to our customers and are offset by approximately a similar amount of reimbursable revenue that we collect.

Going back to our second quarter results, the only other comment I would like to make on the income statements are in regards to, first, other income where we recognized approximately $12 million worth of gains related to foreign currency contracts. We entered into those contracts previously to hedge against our higher operating costs that we are experiencing due to the weakening of the US dollar. And finally, interest expense, which is up due to us no longer capitalizing interest related to the Ocean Shield jack-up, which was delivered from the shipyard early on in Q2. We expect interest expense in the third quarter to increase an additional $1 million or so when our other new build jack-up, the Ocean Scepter, is delivered from Brownsville and we no longer capitalize interest against this project. The delivery of this rig will have an knock-on effect of increasing depreciation expense to approximately $74 million or so per quarter for the remainder of the year.

And one last item on the income statement, our tax rate increased slightly this quarter due to increased earnings in the Gulf of Mexico -- primarily, as Larry said, a result of the strengthening of the domestic market. Our prior guidance was an expected tax rate for the year of 28% to 29%. We're now expecting that rate to be 29% to 30%, or 1% higher.

Focusing on our current balance sheet for just one second, we have a combined cash and marketable securities balance at June 30th of $740 million. Normally, we tell everyone to add those two lines together to compute our effective available cash balance. However, there was an anomaly that occurred at the end of June, resulting from our purchase of US Treasury bills on the 30th of June, but not settling that purchase until July 3rd. As a result of that transaction straddling quarter-end close, our cash balance is grossed up by approximately $200 million, with the offset in current liabilities under the line item payable for securities purchased, which is also approximately $200 million. Bottom line, if you muddle through all the appropriate GAAP required accounting and net those three lines, our available cash balance at the end of the quarter is right at $540 million.

And finally, our guidance for capital expenditures for the year 2008 is $720 million and is comprised of, first, the Ocean Monarch upgrade and the completion of our two new build jack-ups at $180 million; required upgrades for our Brazilian contracts that we've entered into at $130 million; CapEx that we're going to spend on our 12 rigs that are undergoing surveys this year, $200 million; acquisition of spare equipment which is part of our revenue preservation plan at $50 million; and finally other general maintenance CapEx at $160 million. If you add all that up, it should come to $720 million. And with that, I'll turn it back over to Larry.

All right. I think we'll be prepared to take questions. One other comment I'll make. We have a rig, the Ocean Scepter, which is in its final testing stages in the Brownsville, Texas facility of Keppel FELS. That was close to the path of Hurricane Dolly. Reports that we have this morning, there's no one on the rig. It's difficult to get to the shipyard due to flooding, but the rig appears at this point to be undamaged. We were on the good side of the hurricane. The hurricane struck a little bit further up the coast, and so we're not expecting any major factors, negative factors to flow from that incident. With that, we'll go to questions.

(OPERATOR INSTRUCTIONS) We'll pause for just a moment to compile the Q&A roster. Your first question is coming from Collin Gerry of Raymond James.

Hey, good morning, guys.

Hey, Collin.

Good morning.

Just a quick question on the renewals you all got. The rates were certainly higher than what we were expecting. If I go back last quarter I remember we were speaking of term. We were kind of thinking 18 months to three years. A couple of these kind of came in a little bit lower than that, on the one year kind of timeframe. Give us some color on why the term was a little bit lower? Is that strategic on your part to keep them available in 2010? Was that the operator? I guess a little bit of color there?

I'll let John Gabriel elaborate on that, but essentially, the Gulf of Mexico does tend towards the shorter term in these fourth generation rigs, when you look at the size of the customers that typically contract for that. They don't always have three years' worth of forward commitments.

I think Larry is right in his characterization. Basically, it's what was available to us in terms of duration of commitment, but it's a good point to note that we get to reprice these rigs again in another year to 18 months.

Okay. So it sounds like it was mutual, wasn't necessarily strategic on your part, more what the market was giving you and it's not a problem given where we're seeing rates going.

Correct.

I think that's a fair statement.

Okay. And I'm probably not going to get a definitive answer on this, couldn't hurt to try. Not too early to look at 2009 on the cost line, just ballpark, what would you assume a reasonable cost inflation there could come in, just a range?

Well, we haven't really done our budget and so I hate to give you a number. However, the factors that we are dealing with right now from all of our suppliers are that prices are going up across the board with steel and all that kind of stuff. In previous years I guess we had said 10% to 12% and probably we're looking at 10% to 15% for next year.

Okay.

That's -- and labor's a big component of that and labor has certainly not been running at the 15% rate at all. So that helps balance it out a little bit.

Okay. Consistent with what we've seen the past couple years. Not accelerating cost escalation, but certainly not decelerating either.

Too early to tell. That's certainly a possibility.

Final question, I just noticed on the latest fleet status, you're going through the details that a few of the floaters were added on the downtime, the Baroness, the [Spartan], the Alliance, due to equipment changeout or equipment repair. Just curious, is that the same piece of equipment? Is there something notable there?

No, I know, for instance, on the Baroness, we had a piece of equipment that we had a superior design, that was a safer, more robust design. And we elected to take I think a little over seven days to take the rig offline and upgrade this particular piece of equipment. So you'll have those type things on there. The Alliance, we had something break. So those are routine operating results.

Right. Right. Just curious, what piece of equipment was that?

We had some issues with our riser tensioner system.

All right. I'll turn it back over. Thanks, guys.

Thank you. Next question is coming from Ian Macpherson of Simmons & Company.

Hi, good morning, thanks for taking my call. Larry, when you talk about -- I think you said being a little maybe judicious with regards to the timing of repricing your -- the Valiant and the Quest which are a couple more [fortunate] rigs with repricing opportunities. Could you elaborate on sort of what the strategy is there? Is this a deliberate wait and see approach with the evolution of day rates? Or just thoughts on the direction of day rates, because we did see I guess in the past few days another comparable rig on a short-term contract at $650,000. Do you see term work getting as high as $600,000 or $600,000 or higher?

I think the $650,000 would have been a fifth generation unit and these are fourth.

That was a fourth gen [Mord Semion] in West Africa.

That commitment I think was --

It was short-term.

It was for a 90 day job.

Yes.

Obviously, you've got availability of the rig, close proximity, and a customer that wants to get something done, so those three elements coming together supported that price. With respect to what we're looking at going forward on available time in 2009, Larry mentioned earlier the Quest and the Valiant. The only other rig we've got, only other floater we've got is the Ocean Lexington. We're in discussions with -- I would characterize it as several parties on all three of those rigs. At this particular juncture, the shortest period of time we're talking about right now is about two years. So what we strategically did, having five rigs rolling within about a six-month period, is go ahead and take three -- take the commitments on the three that we've just announced and are looking at opportunities around the world for the other two.

Okay.

And you understand, I don't want to put a target out there or negotiate with our customers via this mechanism. Obviously demand is tight and we've got lots of people looking after the rigs, as John indicated. The other ones were a little bit shorter. We'll probably look for a little more term on subsequent commitments. But we want to enjoy market rate.

On the Gulf of Mexico jack-ups, can you offer any color as to how you see the leading edge bidding environment shaping up there from, say, a few months ago until today?

What we see right now in terms of the mat rigs is numbers in the mid-60s with forward bidding going a little bit higher than that. On the 300-foot to 350-foot class of rig, we've got four here and either current or forward commitments are all in excess of $100,000 a day. We don't see any easing in that market. And then if I remember right, some of the very large rigs have been committed in excess of $150,000 and approaching $200,000 a day. But that's the absolute high end jack-ups here in the Gulf. The market is continuing to show some modest improvement. The one thing that's a little elusive is any significant term, but rates are still moving up.

All right. Thanks. I'll turn it over.

Thank you. Our next question is coming from Dan Boyd of Goldman Sachs.

Thanks. Hey, Gary, your prior cost guidance was looking for an 18% to 20% increase over last year. Given some of the efficiency gains that you're seeing, should we expect us to be on the low end of this range at this point?

You had -- we have very good quarter this quarter. I would still go with 18% to 20%, Dan, I'm not sure where we're going to get at at the end of the year. Remember, that 18% to 20% was year-over-year, looking at the income statement and so a large -- or a portion of that, 7% to 8%, is additional rigs that we have working, the Scepter, the Shield, the Endeavor for the full year. That won't have an impact on that 18% to 20% at all. It's too early to tell.

We had rigs going forward.

I think the inflation number, the cost increase number is the number that we were saying 12% to -- 10% to 12%.

10% to 12% would be inflation. The rest of it was additional rigs working.

Can you help me understand a little more on where you're seeing efficiency gains? Is it really just in keeping the rigs up and running a little bit more efficiently, keeping utilization up?

Well, I would say we had a good batting average for this particular quarter and we're working very hard to keep that up. But over time we're still exposed to routine equipment failures and other issues that might cause us to incur some sort of downtime. I wouldn't necessarily grab this as a trend based upon one quarter.

Looking at the new build and upgrade programs winding down here, how long do you think the company can reasonably go without expanding the fleet and what opportunities do you see out there at this point?

Well, we've expanded this fleet tremendously over the years and we are primarily a counter cyclical expansion company. And we've used the upgrades tremendously. And certainly the facts of the market right now don't exactly match those particular scenarios, so we don't have anything on schedule right now. And I can't tell you what we're going to do, but we're looking at it all the time. We understand it is a competitive environment and we will add capacity and upgrade and even contemplate new construction if and when we find a scenario that makes financial sense for our shareholders.

If prices or assets remain where they are, the competitive environment remains pretty tight as it is, could you go 12 months to two years without adding to the fleet? Would you be comfortable with doing that and just paying and returning cash to shareholders as you've done in the past?

We said returning cash to shareholders is one of the primary value strategies that we have. I guess the answer is yes, because our criteria to add to the fleet are not necessarily based upon the idea that we've got to constantly be doing it all the time.

All right. Thanks, I'll turn it over.

Your next question is coming from Arun Jayaram of Credit Suisse.

Good morning, gentlemen, nice results.

Thank you.

Larry, it's odd to me, looking at your second and third generation [semi] fleet in the Gulf of Mexico, or interesting I guess, to see you'll essentially be left with one rig. I was wondering if you could comment on other parts of the global demand -- comment on global demand in the mid-water. In addition, as you know, there's a lot of new builds coming in, more capable fifth and sixth generation rigs come. How do you think the mid-water plays out over the next five years?

I'm going to let John fill in the color there. I guess strategically we're comfortable with this fleet, but we think that internationally you have term opportunities and you have much more new areas being opened up that are exciting. Here in the Gulf of Mexico, we're still restricted to just traditional areas and most of the excitement is in the new areas in the deepwater and we're seeing customer after customer move into the deepwater. So we're matching the fleet that's here really to sort of the residual demand which is actually -- is quite a bit reduced from what it once was.

Just to follow up on that, the primary driver for the migration of our mid-water fleet out of the Gulf of Mexico is basically term. What we have been able to achieve in moving rigs from here to the Mediterranean, moving rigs to Mexico and obviously moving rigs to Brazil is two to three to upwards of five years worth of term, where here in the Gulf of Mexico the market is still characterized by multiple well, well to well, to just a couple of wells at a time. To talk about where we see continuing demand in the mid-water floaters, Northwest Europe, particularly the UK sector of the North Sea, one or two opportunities in the Mediterranean. We talk to people about West Africa and I think one of the bright spots, again, is going to be Brazil and that would be for other than Petrobras. We've had several inquiries by major companies down there that have some mid-water acreage that are talking about term and --

Would that be OGX?

That would be one of them.

I may have missed this, John. Where are you moving -- to what market are you moving the Ambassador?

We have not announced --

At the customer's request.

We've really seen no easing in the level of demand in the near term for this class of rig. Again, the departure from the Gulf of Mexico was primarily that we see longer term opportunities outside the Gulf.

One kind of question for Larry, the dividend has been relatively flat over the past few quarters, while the earnings trajectory has been up pretty sharply. Just wondering, Larry, if you could update us on where you are philosophically with the dividend and why has the dividend lagged the growth in earnings? Because we had been expecting maybe an increase this quarter.

Well, I mean, our answer on dividends is that it's a primary part of our value strategy and that the Board will consider the dividend and we're now paying it each quarter. But included in the lack of disclosure is we never once said that it was going to be linked quarter by quarter to the results. So I think that's the only thing I can tell you. But you certainly look at the history going back over three years that we've had it in place and it has been an escalating dividend through that point in time. All I can do is guide you to the history.

But there's been no change in that -- what you've been thinking about it this quarter, last quarter, versus history; is that fair?

Yes, there's no change in our philosophy behind the dividend and our methodology this quarter versus where we were six months ago or a year ago.

Okay. That's fair. Thanks a lot, guys.

Thank you. Next question is coming from David Smith of JPMorgan.

Hi, good morning.

Good morning.

Wondering what turnover on the rig crews looks like and maybe how that's changed in the past year?

We've been pleasantly surprised that our turnover has been fairly -- much lighter than we would have expected. I think we've got an aggressive retention program and we make sure that our wages are market competitive. And then we think that we offer important advantages to our employees to stay here. And that is the wide dispersed fleet and the number of promotion advantages that you have here, well-established safety systems, well-established systems that you're not dealing with brand-new issues. And we've -- among the people that we've lost, and we lost a few in the North Sea to another competitor, we've gotten most of those guys back. We've gotten guys that we lost here in the Gulf of Mexico to other competitors back. And those guys are powerful retention factors when they talk to folks and talk about the differences at working at Diamond and another place. Having said all that, we don't yet really have a full scale delivery, especially into the Gulf of Mexico, of a lot of these new deepwater units. So there will be some competition for some positions there. But I think it's an issue that we're managing. I think probably it's also being driven by the new entrants to the business, realize that if they solely compete for the limited pool of existing talent, that ultimately all that does is drive up cost for everybody. And so they're doing some of that. I'm not saying we and our competitors are immune. But I think they are -- they have own systems and they're bringing in people from other parts of the world to man their rigs.

Okay. You mentioned that you're getting a lot of people coming back. Is there any common theme as to the reason why?

Well, I would say people make the move primarily for perceived advantage in money in the short-term. And -- because we can't build the wall high enough that it's always going to make sure our guys are going to be the highest paid. Someone can always top that wall temporarily. But then they understand our wages are competitive. I think they're generally dissatisfied. They come back because they're not generally happy with the working conditions, whether it's the safety conditions on there, whether it's the -- I won't say lack of systems, but more less-developed systems, personnel issues. It's work conditions.

Okay. I know that we're not going to talk about where the Ambassador is going, but can we assume that it's going to a low tax region?

Tax rate will be between 29% and 30% for the year.

Okay.

I can't give you a hint there.

And also --

We will make that announcement as absolutely soon as we can. We have to respect the customer's desires.

Of course. If your expansion philosophy is counter cyclical, what is your thinking of selling assets into a really strong cycle?

It's something that we might consider on margin, but by and large, we retired most of the assets that are marginal and I don't look for that to occur here in the near term really, just based upon valuation of assets and earning capacity. There's still fairly low multiples in this industry and I think we can do better. We have more confidence in the future to deploy those assets and earn money with them than to sell them for fairly short-term gain.

I appreciate it. Thank you.

Thank you. Next question is coming from Robin Shoemaker of Citigroup.

Good morning. Was wondering if you could talk about what you're seeing in terms of tender activity for floating rigs from PEMEX and speak to the requirements also of Petrobras as you understand them for the next few years, ahead of the delivery of all of these new deepwater rigs that they've ordered or supported with new contracts for sort of the 2012 timeframe.

With respect to PEMEX, we have not seen a formal tender for a floater recently. The rumor mills are active and we heard from time to time that they may be looking at additional deeper water capacity, say, in the fourth generation category. But nothing formal on the Street yet with respect to Petrobras. I don't see any additional -- any additional requirements really in that range between the rigs that they've already got on contract and have gone through the extension processes with with us and our competitors down there. And I suspect that they're going to move forward with the fleet that they've got until they start taking delivery of the new builds that they're committed to.

Just on that side, on the new build commitments, and also in reference to your previous comments about the winding down of your rig construction program, you've clearly got great deal of skill and capability in terms of supervising rig construction. And here you have all these companies that will be building rigs for Petrobras that are fairly new. Do you know these companies that have signed contracts with Petrobras, I guess Brazilian contractors and others, and is there potentially any role for Diamond, hypothetically, in terms of building and delivering those rigs?

I wouldn't think so, and we do know some of those companies and investors and as you're aware, the rates that they took in Petrobras are fairly low on these new construction and I think they've got to ensure that they operate and build those rigs as absolutely cheaply as possible and I think we could bring something to the table. But we're not -- our services are not cheap and so I would expect them to elect other mechanisms.

I would add to that, that most of the -- most of this new construction is being done pretty much on a turnkey basis. So there's not a lot of design and engineering going into it as much as there is just simple oversight.

Yes.

Okay. All right. Good enough. Thank you.

Thank you. Next question is coming from Mike Drickamer of Morgan Keegan.

Hey, good morning, guys. You guys just provided a fairly bullish outlook for this mid-water depth floater segment. When I look at both your contracted backlog and the rest of the fleet, it provides a pretty bullish outlook here. What is there out there that can go wrong though? Are there any issues that are concerning to you right now?

Yes, I mean, there's always concerns, but it's -- market looks fairly rosy. Obviously I always tell people to follow product prices because that's ultimately what's always undone past upcycles. And you've got both oil and natural gas declining currently, although still well within the range of what it takes to have a robust market. So those would be issues. The whole issue of making sure that all these new rigs can come out and can operate safely and get crewed up -- even though that's not necessarily our particular problem, it does impact us from the industry side. So those are the issues that concern us. The whole -- this whole business has to work upon success of our customers to spend these funds, they've got to discover commercial quantities of oil and gas and make their returns. So that would be a concern. But to date, all of that has played out very, very well. So I think the business continues to look as you put it very bullish.

Okay. Then Larry, if you look either operationally or let's say with everything you have going into the shipyard, are there any bottlenecks in the industry right now that could be an issue?

There's certainly bottlenecks on adding capacity to the business. Equipment delivery is so far out there, so that if you need extra riser or you need a replacement top driver, you need a replacement anything, I mean, you're talking years sometimes before you can get that. That works to the advantage in that it -- a business that is as robust as this one actually has per year a very small net addition to the fleet and so that works as an advantage. But for operating conditions, making sure that you've got everything that you need and that you can get it in the event of something major, piece of equipment failure, that's certainly a challenge.

Great. Thank you, guys. That's my questions.

Thank you. Next question is coming from Jeff Hebert of [Reeding].

Just to come back on the cost issue, what are you seeing in terms of labor inflation? Is it steady? You mentioned that it's lower than what you're seeing in materials and supplies, but are you seeing any acceleration? Do you expect to see any acceleration as the new builds start to be delivered?

I'm predicting something I can't really say. We will pay market wages to our employees and we will ensure that they get nice raises, regardless, because they're all working very hard and the business is doing well and they need to be rewarded. But whether in the past labor inflation has been 10% or below, whether that goes to 15% or 12% or 8%, I really can't tell you. But that's sort of the range it's in. I don't see labor doubling.

But it could move up into the 12% to 15% range? That wouldn't be -- ?

Absolutely. We're committed to making sure we pay market wages. We can't run these rigs without qualified people.

I think you mentioned earlier in regards to labor that some of the new entrants have sort of changed their strategy or at least you see it that way. I wasn't quite clear what their new strategy was.

I'm not saying their new strategy, but I mean the fears of everybody was that they would have to hire wholesale from existing contractors to be able to staff up their fleets. And I don't think that we've seen that. We've seen some turnover. We've lost people to some of the new entrants, but we haven't had a wholesale loss. So clearly, that says to me that they are training on their own, that they're recruiting from other areas than what we and our competitors primarily recruit from.

On the Valiant and the Quest, you referenced kind of being strategic in regards to that available capacity, looking for term. Are you saying that you wouldn't take an opportunity to put those rigs to work for $650,000 a day for 90 days?

Try me.

Okay. So you'll be opportunistic, but your real idea is to try to put those rigs to work for two plus years.

We'll respond and whatever. But if you look at the fleet as John indicated, Victory, America, Star -- longest commitment is 18 months, the other two are one year. It seems to us that within that category, that we ought to take another one and try to go longer term.

Got you. Okay. That makes --

In a market that will -- and I think that $650,000 was probably a one-off type situation. I won't say one-off, but I would be surprised if that is the normal posted rate. But it certainly indicates that rates have moved up.

And I may have missed it. What was your CapEx in the second quarter?

In the second quarter, right at $200 million.

And that puts you where for the half year?

Right around -- let's see -- $350 million, I believe. We'll release those exact numbers when we release the Q.

And at this point, what would you expect '09 to be?

Well, we haven't done the budget but we will not have the new construction program. That should be done. So the CapEx will be driven by number of rigs in the shipyard, which will be down from what it is in '08. And then our -- whatever we believe maintenance CapEx should be, and this is an area where we are seeing quite a bit of inflation. And we are making an effort to identify critical pieces of equipment that we believe that we need to have spares, because it could deprive us of revenue and/or the delivery is so long out there that we need an extra piece of equipment just to cycle through for normal maintenance. Until we do all that, I can't tell you where it would be, but I would look to what we spent in past years, plus or minus some reasonable inflation rate. And we've been spending $350 million in the past years.

Okay. Great. Thank you.

Thank you. Your next question is coming from Ian Macpherson of Simmons & Company.

Hey, thanks, just had a quick follow-up. Wanted to see where we are today with cost escalation provisions in the contracts, if we're looking at probably double-digit cost inflation, at least for the next year, if not beyond '09. Are you getting those, for instance, on these recent contracts that you fixed for the fourth gen rigs? If not, what types of contract terms qualify and what don't for that provision from your customers?

In general, we will have cost escalation provisions in contracts. I would just say of a duration of a year or longer. We do have cost escalation provisions in the commitments that we've announced for the deepwater rigs. Again, these -- some of these are at the LOI stage, so we're not completely finished with formalizing the document, but the intent is to have cost escalations in all of these new contracts. Other than PEMEX and some of the older Petrobras contracts, because new contracts and renewals do address cost escalation, that's about the only things I can think of that don't have it off the top of my head. Or maybe some shorter term commitments where it just doesn't make sense to -- we're pricing it basically knowing what our costs are at the time for a short period of time. So cost escalations don't come into play.

Okay. Have you had had an opportunity to sort of back check some of those contracts that have them and see how much of the overall daily OpEx inflation is captured with those escalator offsets? Is it closer to 50% or closer to 100% or -- ?

I would say the general rule of thumb is probably about 50% of our cost escalations are adequately protected, and that comes from certain contracts that aren't covered. Labor is generally covered very well and other items on our CapEx are probably not covered at all and some of the rig maintenance expenditures are covered to varying degrees.

That's really helpful.

If you take our jack-up fleet which is all short term, there's almost no cost escalations in those items.

Okay. Thanks a lot.

Next question is coming from Tom Curran of Wachovia.

Good morning, guys.

Good morning.

Following up on the earlier line of questioning with regards to the special dividend, should we expect that as long as you continue to plan to pay it out, that on an annualized basis it should at least remain flat?

I'm sorry, we're just -- we're not -- we've gone against giving that, even that level of guidance, and just saying that the Board will analyze it, compare it to all other available opportunities. But I would point everybody to the history of the company, which is the most solid thing that we can give you guidance on.

Right. And that's what I was referring to, is that you have recently been highlighting that on an annualized basis, looking backwards, historically it has been rising. Turning to the south of the border on the jack-up side, what is the best read your marketing guys currently have on PEMEX's plans for its remaining mat supported jack-ups?

Well, again, PEMEX has indicated that they will be reducing the number of mat jack-ups in their fleet but indicating that they will replace them with independent leg cantilever rigs. There is nothing, again, formal right now, but they are rumored to be looking at picking up quite a few additional independent leg cantilever jack-ups. The question at the end of the day it how many will replace mats and how many will ultimately be incremental and how much of the rumor ultimately materializes. If it's a significant number of rigs in the 250-foot to 300-foot category, they're going to have to come from somewhere other than the Gulf of Mexico, because if you take a look at the Gulf of Mexico, I think that there are, what was it, 23 independent leg cantilevers here left in the 250-foot and greater range. So, again, we haven't seen anything yet. We're just talking about rumors and that's probably not a real good thing to try and hang your hat on. But there is, again, an indicated intent on their part to continue to replace some of their mats, anyway.

I understand. Would you expect the next round of mat supported jack-ups that will be rolling over in Q3 to ultimately end up heading back north?

We don't have any mats down there. So it's difficult for us to comment on there. But that has been the historical pattern.

I think also, if you take a look at mat rigs on a global basis, 90% of them are either in Mexico or are in the US Gulf of Mexico. There are only seven outside of that geographic area.

Okay. That's helpful. Previously when you mentioned that your best estimate right now is as to where costs might go in '09 is 10% to 15%, were you referring to on a per rig day basis or on the P&L total operating costs?

That would be on a per rig basis. It will go up more than that simply because of the full year operating with the two jack-ups and the Monarch coming out in the first quarter of next year.

Then lastly, when you think about what you might end up doing on the growth front, should you be looking at another two years passing without having invested in any kind of growth, do you think at that point you might be willing to at least consider another victory class upgrade? If not buying or building.

I think the problem with victory class upgrades is that the lost opportunity cost is too great right now, because the rigs -- the two that we have left that are unmodified have day rates, forward day rates in excess of $300,000 a day. And that pretty much kills it. So I don't think you're going to be looking at that until we have a really lousy market, and we think that's far into the future.

The reason why I was thinking the upgrade option might become increasingly more attractive than building or buying is if you start to see the deepwater market in terms of the -- your medium to longer term outlook, be expected to meaningfully pull away from the mid-water market and therefore while the -- ?

I think the cost of the upgrade itself is escalating just as much as the new builds because you've got -- you still have the equipment in there and you add the lost opportunity, you're starting to approach building new and you'd be better off building new.

Right. Makes sense. Thanks a lot, guys. I'll turn it back.

We'll take one more question so we can wrap this up within an hour or less.

Your final question is from Brian Lester of the Abernathy Group.

Large macro question. The first is to potentially understand the Board's position on guidance for management regarding eventually the dividend, but could we gain the perspective by understanding ideal cash levels on the balance sheet or your advice to the Board on needs there, so that we could understand when dividend payouts might be more flexible?

I'm sorry, I can't help you there. All I can just repeat is that -- and I understand that you desire to have this, but that the Board will look at all our cash uses and possible cash expenditures, I mean, cash use -- places where we put the cash, including the dividend, and that we believe that returning cash to the shareholders via this mechanism is a primary means of enhancing shareholder value.

Is there a target level of cash that you feel like you need to have on the balance sheet?

No, but there is a level that we need to operate and that varies but can be $400 million to $500 million, just to cover what we need to do.

So something significantly in excess of that might be -- there would be considerations, and if you drop below that then you would have to consider building that back. Okay. Fair. Let me move on so we can get the call over, guys. How strategic -- we saw something take place in Transocean not too long ago. How strategic is personnel today in acquiring successful terms for equipment in your opinions?

I'm sorry, I didn't -- I mean, how important is it to have quality people?

Yes, I mean, is equipment actually being -- is it turning upside down a little bit so that -- I mean, personnel is really becoming a driver versus the absolute profile of the equipment, or is it not to that extent yet?

Well, we think people are the most important part of the business and that's not just routine blather. However, equipment is very important as well. I mean, you're seeing all kind of new people that have no people committing to equipment purchases. But I think the key difference is we don't see our customers committing. They tend to prefer an established contractor when they make their commitments, somebody with some operating expenditures, expertise, until there's just absolutely no other alternative.

Okay. So what can you guys do to increase that talent pool? Is there anything? I mean, one weird extreme would be to build a school or something. I don't know. Are there any ideas out there, other than just trying to poach from others and -- ?

We have training programs for critical positions. We have overstaffed in critical positions, so that we've got everybody that we need to do to be able to carry forward on that. There's no magic. Ultimately a lot of it comes from you have to gain experience, and it's sort of hard to shortcut that. I appreciate your interest and everybody's attention to the call, and we'll see you in 90 days.

Thank you. This concludes today's Diamond Offshore Drilling second quarter 2008 results conference call. You may now disconnect.