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Why You Should Sell This Oil Stock

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Tim Begany

NEW YORK (StreetAuthority) -- Although energy stocks have been hot as a group -- already jumping nearly 13% so far in 2012 -- individual performance is all over the board, ranging from double-digit gains to double-digit losses. And just because a stock is up a lot doesn't mean it's worth getting excited about.

In fact, there's one energy stock I'd like to warn you about.

This well-known company, an offshore driller with 46 rigs that are contracted out to large oil and gas companies around the world, has seen its stock rise about 25% in 2012.

But I'm not impressed.

If you take a closer look, then you'll see this company hasn't invested adequately for the future -- a short-sighted approach that's about to come home to roost.

The company I'm referring to: Diamond Offshore Drilling (DO)

As I see it, Diamond Offshore has gotten itself into a fix by focusing too much on dividend payments and not enough on equipment upgrades. From 2008 to 2011, for example, the combined dividend payout was nearly $23 a share -- a total of about $3.2 billion. This consisted mainly of "special dividends" or one-time payments over and above the scheduled dividend, which amounted to $2 a share from 2008 to 2011 for a total scheduled payout of $278 million during those four years.

During the same period, the company put about $2.3 billion -- 28% less than it paid in dividends -- toward capital investments such as upgrading existing rigs and buying new ones. This obviously wasn't enough. Diamond Offshore now has one of the oldest fleets in the offshore drilling industry, with an average rig age of nearly 30 years.

The company opted against extensive equipment upgrades and new purchases during the past few years because it believed returns on such investments would be too low in a recessionary economy. But now the economy is picking up, oil prices are rising and deepwater drilling activity is increasing.

Management may be wishing it had put a lot more cash toward capital improvements instead of special dividends. But it didn't, and now it's stuck with one of the least competitive rig fleets in the world. To make things worse, it may be a few years before the company can aggressively invest in upgrades, since many of its rigs are tied up in long-term contracts that don't expire until 2015.

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