The Argument for an Active 2004 Drilling Market

Abstract:
The first capital expenditure surveys for 2004 indicate little change in North American oilfield spending versus last year. A look at changes in the 2003 land drilling market suggests that the market is going to be more active than those spending surveys indicate.

Analysis:
Notice any change in the land drilling market this year?

The most obvious answer is to cite the rapid rise in land drilling activity during the first half of 2003, followed by an extended period when rig count remained largely static. Land rig counts then staged a brief rally in the fourth quarter, but apparently have peaked for the year.

However, that activity trajectory fails to tell the real story of what was transpiring in the U.S. land drilling market in 2003. In fact, this year's land drilling market consisted of two halves. The first, which occurred during the first two quarters of 2003, involved the rise of the large independent oil and gas operator as a stimulus for rig employment.

The second, during the second half of the year, was characterized by the rise of the small, privately held operator as the main employer of drilling rigs. It is this latter event that holds clues regarding how the industry will evolve in 2004.

While there is temptation to view rig counts as a monolithic number, the reality is that the U.S. land sector demonstrates remarkable dynamism behind those tallies. There are multiple niches in the fragmented land drilling market, each of which has its own dynamics. The interplay between these dynamics can make for a tight rig market, or a market that operates efficiently without undue constraint on labor, equipment, or rig availability.

The primary illustration for this principle involves market share in rig employment. During the first half of 2003, market share was weighted in favor of larger independent E&P firms who employed approximately 55 percent of all rigs. By August, those numbers had re-polarized and the smallest oil and gas operators, usually privately held firms, came to dominate rig employment with a similar share.

The change in customer base played out in the rig employment profiles of U.S. land contractors. In recent months small fleet contractors have been the main beneficiaries of this market change and are now working at levels higher than they were in the third quarter 2001 when the industry last peaked. Most small contract drilling companies are virtually 100 percent utilized, with additional work stretching well into the first quarter 2004.

Meanwhile, mid-fleet contractors, or those companies with 10 to 99 rigs active, witnessed gradual erosion in market share after peaking in May. By August, this group was down more than 40 units from its top, 90 days earlier. In the second quarter, these companies benefited from demand among large independent E&P firms, who increased rig employment nearly 90 rigs in less than 60 days. When many of those E&P firms reduced drilling levels during the summer, the mid-fleet portion of the contract drilling industry experienced a decline in rig employment.

Concurrently, smaller E&P firms were adding rigs at about the same rate as larger independent E&P firms were letting them go during the course of the summer. Overall rig count remained virtually unchanged even though the market's character was changing in a significant way.

When the final tallies are done for 2003, the story of the smaller E&P firm will be the primary event for the year. From February to August, small oil and gas operators added nearly 200 rigs to their activity level, or about twice the volume of larger independent E&P firms. Smaller firms lagged their larger competitors in getting started, but their momentum grew during the summer. Today this sector dominates the land drilling market when it comes to market share.

Why the change in market character? After all, the assumption is that everyone benefits from a high-price commodity environment. There are two theories afoot. The first is that independents seem to have run through budgeted monies quickly in the first half of 2003, spurred early by attractive commodity prices. The record pace of storage refill this summer created doubt among those in management about the sustainability of the run.

The second is a nuanced concept. It suggests a new evolution in oilpatch spending in which publicly held E&P firms are exhibiting remarkable spending discipline. Typically, high commodity price events are characterized by companies reinvesting the major part of their cash flow plus adding debt to expand field work. In other words, plowback rates can exceed 100 percent of cash flow during high commodity price events. This pattern is underway right now in Canada.

But U.S. operators took a different path this cycle. Plowback rates vary for individual firms, but financial industry studies earlier this year indicated many independents were reinvesting only about 70 percent of cash flow in field work. The remainder was directed to corporate balance sheet issues, monetary reserves in expectation that strong cash positions would provide opportunities for mergers and acquisitions, or other corporate financial goals.

This phenomenon was not confined solely to the publicly held independent oil and gas operator. According to a John S. Herold, Inc. summary, the supermajors (BP, ExxonMobil, ChevronTexaco, and Shell) were returning only 40 to 50 percent of their 2003 estimated cash flow to U.S. upstream activity.

What does this say about 2004? For one, look for the larger independents to return and play a vital role in supporting rig counts during the first part of 2004. New budget monies will be available, commodity prices remain attractive, and field costs are relatively stable. For all practical purposes, free cash flow should continue rising, which will be ultimately favorable for field work.

As usual the determining factor in how tight the 2004 rig market will become stems from the collective actions of hundreds of small operators who may employ one or two rigs at most as they work through a backlog of prospects that have been waiting for the right combination of available capital, commodity prices, and general opportunity. That time is now.

These businesses are quaintly referred to as the moms and pops of the E&P industry, or checkbook operators. When cash flow is right, they pick up the phone and go to work. Similarly, when commodity prices drop and cash flow tightens, these firms are quick to forego fieldwork. In other words, "quick in" when the price is right; "quick out" when it isn't.

What makes this sector fascinating is that these companies fail to appear in most industry indices. For example, spending surveys are weighted towards publicly held companies with a significant portion of those expenditures earmarked for the higher dollar projects offshore. About the only way these firms show up is through drilling permits--and then just 60 days or so before they are moving into the drilling phase.

While the initial spending surveys suggest capital expenditures will be little changed in 2004, high commodity prices suggest smaller E&P firms are going to be active.

As they go, so goes the market.

Events  SUBSCRIBE TO OUR NEWSLETTER

Our Privacy Pledge
SUBSCRIBE


Most Popular Articles
Related Articles


Brent Crude Oil : $54.46/BBL 0.96%
Light Crude Oil : $51.68/BBL 1.21%
Natural Gas : $3.44/MMBtu 1.99%
Updated in last 24 hours