Oil service companies generated more cash over the last few quarters than anyone predicted, as crude prices spiked and demand for drilling equipment and services reached near-record levels.

Investors are wondering what they will do with the money. It looks increasingly likely that at least some of it will come back to shareholders in the form of dividends.

An example was set last week by

Diamond Offshore

(DO) - Get Report

, which doubled its quarterly payout to investors and said its board would consider a special dividend in the first quarter of 2006.

Diamond Offshore said the boost reflects its success in securing contracts at favorable rates. And indeed, most drillers have enjoyed near-record dayrate increases as demand for drilling rigs has surged. Rates in the U.S. Gulf of Mexico, for example, increased by 55% in the second quarter of 2005 to $56,000 a day, from $36,000 a year ago, according to a Zephirin Group report.

"It's been a dream market for the drillers," said Lenny Zephirin, who owns the independent sell-side oil service research company. "We could start seeing some of the free cash flow they generate going back to investors through more share buybacks, dividends and special dividends." (Zephirin doesn't own shares of any of the companies he covers, nor does he have investment banking relationships with them.)

Zephirin estimates that

Transocean

(RIG) - Get Report

, the offshore driller, might reinstate its dividend plan, which last paid $9.5 million to inventors in the second quarter of 2002, within two or three quarters. Zephirin noted that that the company has managed to use cash flow from operations to cut its debt from $4.7 billion in 2002 to $2.2 billion at the end of the first quarter of 2005.

Ensco

(ESV)

, another offshore driller, recently sold a barge unit for $56.5 million, money that could be used for paying a special dividend on top of the current 10-cent annual rate, Zephirin said.

Rowan Cos.

(RDC)

gave investors a one-time special dividend of 25 cents in January, using the proceeds from a noncore aviation business, said Victor Marchon, analyst at RBC Capital. RBC Capital seeks investment banking relationships with companies it covers.

For companies without a lot of debt that have funded their capital budgets, special dividends make sense, particularly when a new rig can cost up to $4.5 billion to build.

Noble

(NE) - Get Report

has added 20 rigs to its fleet over the past five years and is upgrading one unit for deep water. The company said in its second-quarter earnings call that its board plans to discuss the option of raising its dividend (currently 8 cents annually), and perhaps add a variable dividend that changes according to company's performance.

"The oil service group wasn't known historically as a good source for yields," said RBC's Marchon. "But as opportunities for growth are more difficult, we will probably see more share-repurchases and dividends going forward."

Bear Stearns analyst Robin Shoemaker published a report last week presenting hypothetical dividend scenarios for drillers. Shoemaker's research suggests that the drilling companies' 2006 cash flow could support an average dividend yield of 7.8%, well above the current mean. He mentioned

Pride International

( PDE) and

GlobalSantaFe

(GSF)

as companies that could afford bigger dividends.

"Our analysis of projected free cash flows in 2006 shows that the offshore drilling companies could afford to pay hefty dividends," Shoemaker said. "The prospects of paying such dividends are real because they are fully supported by strong and improving cash flows."

As drillers' earnings reports approach, analysts and investors will be expecting not only good results, but some indication on how the success will be redirected to the hands of shareholders.

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