Land-Based Rig Counts on Track for Peak in First Half of '04

Deconstructing the U.S. land-based rig count indicates the larger independents are front-loading 2004 capital expenditures. Everyone else plans greater activity this year than last. Look for rig count to exceed the 2003 peak during the first half of this year.

The secret is in the rig count.

Or rather, the secret lies behind the rig count. If you want to understand what is happening in the current land drilling market, it pays to drill down into the numbers.

That process suggests big independent operators are front-loading 2004 capital spending. The numbers also suggest that smaller operators have stepped back from the market, which accounts for the slight deflation in drilling activity since the industry rig count peaked in mid-fourth quarter 2003.

The exercise is useful in getting a handle on how U.S. field work will unfold this year.

There are some contradictory signals out there. On the one hand you have the financial industry spending surveys that indicate 2004 capital expenditures will be little changed from 2003. Yet you have a number of industry polls that indicate contractors are going to increase field work.

Reconciling the two divergent views requires a greater understanding of exactly what is transpiring at the field level--hence the usefulness of any exercise that breaks rig count down into manageable segments.

There are two separate markets out there, as shown by rig count trends. One market--those E&P firms employing 10 or more rigs--has added more than 70 units since October. Indeed, the U.S. land count earlier this month registered 90 more rigs in this category than for the third quarter 2003.

Meanwhile, the other market--those companies employing three rigs or less (one assumes these are the moms and pops or smaller publicly held independents)--has lost 30 rigs during the same period. Furthermore, the number of individual companies employing one or more land rigs has fallen from a high of 509 in October to 478 in February. It is safe to assume that the decline is 100 percent relegated to the smaller E&P portion of the drilling marketplace.

The big news revolves around what is happening at the upper end of the market, or those programs employing the most rigs. This group is gaining market share. While land-based rig counts in mid-February were down just 16 units from the fourth quarter peak, market share changed appreciably. Those companies employing 10 or more rigs rose from 34 percent of the market in November to 40 percent in February. At the same time those companies employing three or fewer rigs fell from 45 percent of the market at the end of November to just 42 percent of the market recently.

Here is how that comes into play for 2004 forecasting. If one follows the financial industry's spending surveys, overall expenditures will rise only slightly for the large publicly held independents, a segment that includes the Anadarkos, El Pasos, and Burlingtons of the industry. The fact that this group has increased rig count significantly at the moment within a spending environment that will not be materially different from 2003 suggests that the companies are front-loading expenditures for the year.

There is precedent for this. It is what happened in 2003. Matter of fact, this segment increased rig count dramatically in the first half of 2003, then pulled back after mid-summer. Specifically, large operators added more than 120 rigs during the first half of the year. As the summer matured, this group began to lay rigs down. Eventually the group--as a group--employed 35 fewer rigs in the fourth quarter than it had in mid-third quarter when this group's rig count peaked.

The other side of the question involves what is going to happen with the smaller firms in 2004. The answer is contained in their fourth quarter earnings announcements. Those announcements are characterized by at least two of three common items. First, production is going up for this class of companies, often at double digit percentages. Pick a company--any company. Look up its earnings announcements on the web. These range from 14 percent production growth year over year for Penn Virginia to 64 percent growth for Ultra Petroleum. Suffice to say that the story is pretty much the same for other smaller firms. In fact it is difficult to find smaller E&P firms who did not increase production last year.

Secondly, high commodity prices have helped cash flow for these companies. While the adjective "record" is only used on occasion, it is safe to say that many smaller E&P firms were generating earnings at near record levels as 2003 came to an end.

Unlike their bigger competitors, these firms are not redirecting free cash flow to other corporate purposes. They plan to spend free cash flow on development, having overcome the liquidity squeeze that characterized the sector one year ago.

The third item reflected in many companies' press announcements involves a sleeper issue. Several companies, such as Carrizo Oil and Gas, and Gasco Energy to name just two, have raised outside capital through issuing equity or private placements. Proceeds from this capital will be directed towards developing proved reserves.

The first item should give the industry pause later this year. If production continues to expand--and the U.S. Department of Energy speculates natural gas production rose two percent in 2003--then the industry should hope there is an expanding market for the swelling production tide. The alternative is lower commodity prices.

The remaining two items in those fourth quarter earnings releases indicate that smaller E&P firms plan to expand field programs in 2004 even further, which jibes with industry trade surveys showing a propensity to increase rig count among smaller E&P firms.

The implications are that U.S. land rig counts will be higher during the first half of 2004 than they were in the last half of 2003.