Facing Flood of New Rigs, Drillers Lose Grip on Pricing

HOUSTON Feb.12, 2007 (Dow Jones Newswires)

Drillers have been able to play gas producers off one another the last few years, taking advantage of an historic shortage in manpower and equipment in North America. Now, producers are extracting a little payback.

The change can be seen in the recent performance of the two biggest land drillers: Nabors Industries Ltd. (NBR) and Patterson-UTI Energy Inc. (PTEN). Both companies revised fourth-quarter earnings lower after easily beating Wall Street expectations in the previous three quarters. Both companies' stocks are also off more than 25% from all-time highs hit in the first half of 2006, as investors brood over an expected glut of new drilling rigs projected in 2007.

In a research note last week on Nabors, Banc of Americas Securities said "earnings growth in 2008 will be muted even as the drilling cycle rebounds." The investment bank set Nabors' price target at $33, which is lower than the $36 previously projected, but above Nabors' current valuation of $29.51.

But while the shift in the producer-oil services dynamic has dulled the earnings gloss of some drillers' stocks, analysts continue to be generally positive on the sector. After all, while earnings are coming in weaker, producers are drilling more than at any point in the last 20 years; few expect that dynamic to change anytime soon.

Declining North American reserves are still forcing companies to constantly forage for new supplies just to keep production steady. The difference in 2007 will be that, with 300 new rigs entering an already sated market, the producers can pay services companies far less to do it.

"So far we've seen a 10% to 20%" decrease in prices, said Judson Bailey, an analyst with Jefferies & Co. in Houston. "I think it's fair to say we could see another 10% to 20% going forward."

Gas prices stabilize at $7

Natural gas prices rose from $2 to $15 per thousand cubic feet between 2002 and 2005, fueling an exploration binge the likes of which hadn't been seen since the mid-1980s. Demand far exceeded the available labor and equipment, giving services companies the upper hand in dictating the cost of both drilling and production.

Gas prices stabilized about a year ago around $7/mcf, and have rarely deviated far from that price. The equipment shortage didn't begin to alleviate until late last year, however, so service costs continued to increase in 2006. Some producers found themselves faced in 2007 with paying 25% more to drill for gas that was likely to be sold at the same price as in 2006.

With margins squeezed to the breaking point, and rigs no longer scarce, companies are balking at last year's prices. Apache Corp. (APA) slashed its North American budget by $600 million, threatening further cuts if service fees don't fall in line. EnCana Corp. (ECA) said in December its 2007 upstream budget would shed 9%, or $500 million.

"There's clearly evidence that people are taking a good hard look at how they want to play their capital," said J. Michael Bodell, director of upstream gas strategies at Cambridge Energy Research Associates.

Citing mounting signs of a downturn in North America, analysts have revised Nabors' 2007 earnings estimates down 8% in two months, to $4.33 a share, and 11% for Patterson, to $3.46 a share, according to Thomson First Call. Some believe the damage may extend beyond this year.

Declining Exploration Costs, Returns

Past downturns have been marked by declines in the number of rigs in use, usually starting a few weeks after gas prices start to drop. In the smaller Canadian market, gas rig counts - a barometer for overall demand - fell right on schedule, from 596 in February 2006 to 431 last week, according to Baker Hughes Inc. (BHI), an oil-field services company that conducts a weekly rig census.

But Baker Hughes' U.S. gas rig count hit a 21-year high of 1,466 in January, and has spent 25 of the last 26 weeks above 1,400 rigs. Despite flat gas prices, the count is likely to hover around 1,370 in 2007, according to Ziff Energy Group, a Calgary-based gas consulting firm.

Producers need to operate that many rigs just to maintain current levels of production, said Bill Gwozd, vice president of gas services at Ziff.

"Two wells 10 years ago is equal to 10 wells today," Gwozd said. "They've tapped out all the large reservoirs and now they're getting into much smaller (plays)."

The need to replace depleted reserves has services companies publicly convinced that producers' ability to set prices is fleeting.

In the last two weeks, Schlumberger Ltd. (SLB), Halliburton Co. (HAL), the two largest services firms, as well as Nabors executives have all used variations on the phrase "short-lived and self-correcting" to describe any downturn in North American drilling.

That's not just spin, Bailey said, cautioning that drillers could respond to a surge in demand by bringing retired rigs into service, which would push against any pricing rally.

"If you think about how many rigs we've added in the last two or three years just to get a modest increase in production ... it's like running on a treadmill," he said.

Copyright (c) 2007 Dow Jones & Company, Inc.