Horizontal Boon Continues
Dayrates for land rigs in the lower 48 states are averaging well above prices charged back in 2008 when WTI crude was approaching its historic high. The rationale for why dayrates are trending higher is easily explained by the mix shift in both what E&P firms are targeting and how they are getting there.
Several months back we mentioned that, on an energy-equivalent unit basis, the spread between drilling for oil versus natural gas was approximately $11 per barrel (favoring oil). With this disparity in mind, we noted that E&P firms would favor projects that would bear oil or condensates where available. Furthermore we identified commentary made by Chesapeake's CEO supporting this view. It is this mindset echoed across the industry that has been very supportive of a greater emphasis on drilling for oil in the United States.
The numbers tell the story of how the US rig count has shifted over the past three years. According to Baker Hughes, there were 1470 rigs drilling for natural gas and 371 rigs drilling for oil back in June 2008. The overall count versus three years ago is only 37 rigs fewer as of May 27, 2011. However, the mix now has shifted to 864 natural gas rigs and 940 oil rigs. Clearly, the industry has adapted to an environment that favors drilling for oil.
In tandem with the mix from natural gas drilling back to greater emphasis on oilier reservoirs, the significance of non-conventional drilling has also grown. According to Baker Hughes, non-conventional drilling (both horizontal and directional) is climbing at twice the pace of the vertical count in 2011. At the end of May 2011 there were 232 directional and 1054 horizontal rigs drilling in the United States, improvements of 20 and 107 rigs, respectively, year-to-date. These 1,286 rigs account for an increase of 11% versus the vertical count that has grown 5% to 561 rigs year-to-date. The longer-term trends are similar. The significance of this shift is that rigs capable of drilling long laterals typically are higher performance pieces of equipment compared to rigs used for vertical wells. The amount charged via dayrates tends to follow the performance level of the rig with higher horsepower rigs commanding higher dayrates.
At present, the unconventional rig count has grown 25% since the last peak in the overall U.S. rig count, recorded in September 2008. The growth over the past three years is a vast contrast when compared against the nearly 44% decline the vertical rig count has experienced during the same timeframe. Of the two components of non-conventional drilling (horizontal and directional), the horizontal rig count has climbed at a much faster pace. Over the past eighteen months the horizontal count has grown by 483 rigs while the directional count has increased by 32 rigs.
Contract land drillers have seen their operating margins improve over the past year along side this industry-wide infatuation with unconventional drilling. The successful exploits via horizontal drilling and hydraulic fracturing continue to push the demand for rigs characterized by their efficiencies and greater horsepower (needed in order to drill longer laterals). Our observations of four firms with a sizable stake in U.S. land drilling (Nabors Industries, Helmerich & Payne, Patterson-UTI, and Unit) demonstrate the leverage effect that greater activity in shale plays is having on their financial results. In our opinion these four serve as a good proxy for the overall land drilling market.
Both the growing rig count, in general, and the mix shift gravitating towards rigs that command higher dayrates are quite beneficial to contract land drillers' operating margins. But while dayrates have surpassed 2008 levels, operating margins for land drillers still have ample room for improvement.
Operating margins are improving for a number of reasons. First, the more units drilling in the fields translate into a spreading fixed costs across a greater number of rigs (i.e. lower fixed costs per unit). Second, higher demand levels ultimately lead to improved pricing (i.e. higher dayrates). Finally, even though the requirements typically call for more advanced equipment, a coat-tail effect pulls more of the lower-end equipment back into the market. In combination, these forces make for a considerable leverage effect. Furthermore, the greater service intensity of horizontal drilling suggests that peak margins when reached in the current cycle could actually surpass levels achieved in 2008.
Stable oil prices should continue to drive activity levels higher on land, if for nothing else, to compensate for losses to production experienced offshore in the Gulf of Mexico. During 2011 the domestic oil supply is anticipated to gain 120,000 barrels/day, based on OPEC's assessments, to average 8.72 million barrels per day. Considering that the EIA has pegged the loss (due to delays) from the Gulf of Mexico at 125,000 barrels/day during 1Q11, then combining these two estimates implies that the supply from land drilling (assuming no change in Artic/Alaskan production) in the lower 48 will increase by 245,000 barrels per day during 2011. We along with most other industry observers would attribute this ramp-up in onshore production to unconventional drilling in shale formations including the Bakken (North Dakota) and Eagle Ford Shale (Texas).
Commentary from Unit's CEO, Larry Pinkston, in the company's 1Q11 financial results release provides how his firm is handling the changes the land drilling industry is currently undergoing in the United States:
"Our fleet went through a transition in 2010 to accommodate the growing industry focus on drilling horizontal or directional wells. We refurbished and upgraded 30 drilling rigs in 2010 in order that they could undertake this type of drilling. Approximately 80% of our drilling rigs working today are drilling for oil or natural gas liquids and approximately 99% are drilling horizontal or directional wells. We had previously announced that during 2011 we will add five new drilling rigs to our fleet, all of which are 1,500 horsepower, diesel-electric drilling rigs under two-year term contracts."
Most recently, Marathon Oil purchased 141,000 net acres from Hilcorp Resources in order to double their efforts/acreage in an oil-rich section of the Eagle Ford Shale. Marathon has expansion plans that will take its new holding from current production of 7,000 bbl/day up to 80,000 by 2016. Obviously, this will require stepped-up drilling efforts in order to achieve this objective. Importantly, this is a region that is dependent on non-conventional equipment to access the reservoirs.
Going back to Unit's commentary we direct your attention to the following map provided by the EIA. The map of drilling efforts along the Louisiana and Texas border illustrates the disparity in well counts favoring horizontal wells in the Haynesville Shale.
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