Though Largely Unnoticed, Land Drilling Boom Is Underway

Abstract: With little fanfare, the land drilling industry is experiencing the largest percentage gain in rig activity in any of the last three cycles. Trends in rig employment suggest the industry is within 90 days of reaching peak 2001 levels.

Analysis: It is boom time in the land drilling sector.

U.S. land-based drilling activity is up more than 35 percent since the first of the year. In fact, the U.S. land sector has witnessed the largest percentage mobilization yet in the three previous upcycles, including 1997, 2001, and the present unfolding event.

In prior cycles, gains of 35 percent typically took place over a period of 10 months. The industry has achieved such a gain this time in roughly six months. High natural gas prices and the headlong rush to fill storage for next winter are creating conditions that favor expansion in the land drilling business.

Indeed, the main issue at the moment centers on how much additional rig capacity is in reserve.

For perspective, consider that the land drilling industry is adding between 1.5 and 1.7 additional rigs to the working fleet every day. If this pace continues, land-based drilling activity will reach peak 2001 activity levels by the end of the third quarter.

Operators were waiting six months or longer for land drilling rigs when the cycle peaked in July 2001. While there are reports of some waits on rigs currently, it appears that capacity and manpower will be available to meet higher demand as the current cycle unfolds.

For one, the largest land drilling contractors still have reserve capacity. Adding current rig counts for Nabors, Patterson-UTI, and Grey Wolf and comparing the aggregate number to the previous cycle suggests there are approximately 160 rigs that have yet to return to the market.

And those numbers are potentially higher because acquisitions over the last two years have expanded fleet capacity further for those three companies. Furthermore, each of those contractors still had rigs in inventory when the cycle peaked in 2001.

But extra capacity is not limited to the three largest land drilling companies alone. Helmerich & Payne IDC has another 35 rigs available for work domestically in this cycle versus the last, thanks to a strong newbuild program and the relocation of rigs back to the U.S. from overseas.

Similarly, other contractors have refurbished equipment, assembled units from components, or expanded their own fleets through purchases. While such expansions are typically at the one-, two-, or three-unit level for individual companies, it amounts to dozens of additional rigs in the aggregate for this cycle.

While labor is a perennial issue in oil and gas, it has not been as great a challenge at this point in the cycle as it was during the 2001 run. The land drilling industry is adding jobs at the rate of about 30 positions a day. Since the first of the year, the land drilling industry has created between 5,500 and 6,000 rig employment positions, which makes it one of the brightest spots in the U.S. economy.

Labor shortages were a major stimulant to day rates in the last cycle as contractors created incentive packages to attract hands for work in the oilpatch. But more than a million-and-a-half jobs have disappeared from the U.S. economy in the two years since the last drilling cycle peaked. In theory, higher unemployment levels from the current economic malaise provide a potential pool of workers who may not have been available without high wage incentives the last time.

The combination of greater fleet capacity and fewer labor constraints is a major reason that day rates have yet to reflect increased drilling levels. In 2001, day rates experienced a major revolution, briefly reaching replacement cost economics for the first time since the early 1980s. While rates have moved up since the first of the year, they have not expanded at the same pace that occurred in 2001.

But rates will eventually move higher as demand for drilling services collides with tighter capacity later this year. At some point in every drilling cycle, operators develop angst over rig availability and begin bidding rates ever higher. The rule of thumb in oil and gas is that operators bid rates up when the cycle expands, while contractors bid rates lower when the cycle contracts.

The rising tide in rig activity is evenly distributed among land contractors of all sizes. Nabors and Patterson-UTI, the two largest drilling companies, witnessed a persistent rise in rig activity levels through April, though the pace has since slowed. Ostensibly, these companies benefited as the largest independent E&P firms ramped up activity levels after the first of the year.

In contrast, drilling companies that have between 10 and 99 rigs active did not experience a significant change in rig employment until the second quarter. Between April and May, this segment saw rig counts literally balloon upwards. Those levels are still expanding.

For the smallest fleet contractors, or those companies with nine or fewer rigs active, rig employment levels actually fell early in the first quarter, but have since rebounded and continue to rise. The inference is that smaller E&P firms, often privately held, have developed enough cash reserve from high commodity prices to return to field activity. These E&P firms operate below the radar screens of typical industry indices. Often they are employing just one or two rigs each. For example, the industry spending surveys seldom include this subsector in their sample, yet the group may account for more than 40 percent of drilling volume in the U.S. land sector.

Think of these smaller E&P firms as the swing producers. When commodity prices and cash flow are right, these individual firms can draw on a robust list of prospects and quickly alter the dynamics of the drilling market.

It is this group that will absorb remaining rig capacity for the smallest- and mid-sized contractors. When incremental rig capacity resides in the fleets of the industry's largest drilling contractors, one can expect day rates to respond accordingly.

How high will land rig counts go? The first marker is whether the trend indicated by six consecutive quarters of declining gas production--typically referred to as sequential decline--will continue. If additional drilling expands gas production, it will take some pressure off pricing in the current market and eventually slow demand for drilling services, though the final number will be higher than present activity levels and possibly greater than 2001 levels.

So far, a cool summer has helped the natural gas industry whittle away at its storage deficit by preventing gas on gas competition. Gas is being directed to storage at phenomenal rates and the deficit versus the five-year average continues to shrink. Meanwhile, high natural gas prices are driving demand out of the market.

It is still a horse race to fill winter storage. That race is taking place primarily in the land drilling sector. But it is also too early to begin joining the terms "energy" and "crisis."