Musings: Rig Count Downturn Moves into Uncharted Territory
As Mark Twain said, "History seldom repeats, but it often rhymes." That philosophy has led investors and analysts to track the progression of the current rig downturn against prior ones in an attempt to gauge just how far the rig count still might have to fall before hitting bottom. Many analysts suggested that the current decline would more likely mirror the rig downturns of 2001-2002 or 1998-1999. Those industry downturns are within the business memories of many of the Wall Street analysts and some company executives, but we have been suggesting that the correction might more closely resemble the debacle that followed the industry boom of the 1970s. Even that model, however, may not prove an accurate guide for forecasting the bottom, or definitely how quickly we get there, this time.
The primary difference between past industry downturns and the current one is the existence of a global credit crisis in conjunction with a worldwide recession. There were credit market problems in 1997-1999, but they were primarily regional and associated with foreign currency problems that impacted certain countries in Southeast Asia. The collapse of the value of a handful of Asian currencies as their economies imploded due to the bursting of speculative property bubbles disrupted global trade and curtailed consumption. This economic contraction happened just after a decision by OPEC to boost its production to satisfy the growing oil thirst of these boom economies. The resulting supply glut depressed oil prices until global oil-supplying nations joined together and agreed to curtail production to bring supply and demand back into balance.
The 2001-2002 correction, on the other hand, was driven initially by the collapse of the technology company-driven stock market of the late 1990s. The September 11th attacks on the United States by al- Qaeda further contributed to the downturn. The economic recession was driven by the destruction of consumer and corporate wealth due to the stock market collapse and an increased fear that political stability worldwide was at risk of imploding.
The different causes for these recessions were matched by oil industry experiences during the 1997-1999 and 2001-2002 downturns. The 2001-2002 correction was considerably shorter lasting only 38 weeks and less severe as the industry dropped 455 working rigs, or 35% of the beginning working rig fleet. In contrast, the 1997-1999 rig market decline needed 84 weeks to eventually reach bottom with the industry shedding 544 working rigs, or nearly 53% of its starting working rig fleet. So far, this rig market correction has lasted 26 weeks, but is continuing and we have lost 905 rigs, or 45% of the peak working rig fleet. At the moment, this rig downturn in terms of the number of working rigs lost is worse than either of the other two rig market corrections, and it has accomplished its damage in considerably less time than the earlier periods. This current rig downturn reminds us of the collapse of energy stocks last fall.
How does this current downturn compare with the 1980s correction? That earlier downturn actually was an extended market correction with intermittent periods of market improvement until the ultimate bottom was reached following the collapse in global crude oil prices in late 1986. The initial rig market correction of 1981-1983 was associated with the recession engineered by the Reagan administration through a tightening of monetary policy to break the inflation that had been raging within the U.S. economy during the latter half of the 1970s. Following that recession, the economy began to expand and U.S. government policy regarding leasing of acreage in the Gulf of Mexico was changed. Those conditions contributed to a brief recovery in drilling activity, which was eventually undercut by the growing glut of oil and the battle between Saudi Arabia and other OPEC member states over OPEC's share of the global oil market.
When the industry first turned down in 1981, global oil prices were in the $39 a barrel range as a result of inflationary forces and the fallout from the Iranian revolution and the removal of Iran's oil from the global market. By the time the domestic rig count peaked at the end of 1981 at 4,530 working rigs, U.S. refiner acquisition cost of imported oil averaged about $36, down from $39 at the start of the year. By the time the initial rig count decline bottomed out at 1,807 rigs in spring of 1983, oil prices had only fallen to about $28 a barrel. Oil prices then started to rise, eventually getting back to about $29 a barrel as a recovering economy tightened the global oil supply/demand balance. In late spring of 1983, the U.S. government altered its policy for leasing acreage in the Gulf of Mexico from requiring that all blocks to be auctioned needed to be nominated beforehand by at least two companies to area-wide leasing where oil companies could lease any block without any prenomination. This shift generated one of the largest Gulf of Mexico lease sales ever, and definitely the largest up until that time, as oil companies seized the opportunity to acquire prospective drilling acreage, which resulted in more offshore drilling rigs eventually returning to work.
However, the damage to oil market fundamentals from high oil prices earlier in the 1970s began to surface as global oil demand peaked in 1979 and then fell for four consecutive years through 1983. The cumulative decline was about 6.5 million barrels a day, or about 7.5% of 1979's oil demand. At the same time, non-OPEC oil supplies were growing as Alaska, the North Sea and Mexican production surged. Along with Brazil, these new, growing oil supply basins added roughly 4 million barrels a day to global supply. In 1984, oil prices averaged $28-$29 a barrel, followed by about a twodollar a barrel decline in 1985 and then a collapse in 1986. Saudi Arabia, the dominant source of oil in OPEC in the early 1980s, acted through unilateral production cuts to defend OPEC's $33 a barrel target price, but then was forced by some cheating cartel members to try to hold the organization's benchmark price at $27 a barrel.
By January 1986, the U.S. refiner acquisition price for imported oil averaged only $25 a barrel, which subsequently fell to $18 a barrel in February, $14 in March and averaged $13 for April and May. June saw oil prices slipping to the $12 a barrel level and then to $11 in July, which marked the bottom in the oil price decline. However, the financial damage done to the highly-levered domestic oil and oilfield service industries was acute. The U.S. petroleum industry landscape was littered with bankrupt companies, both producers and service companies, along with failed financial institutions and legions of unemployed workers. Residential neighborhoods throughout Oklahoma, Texas and Louisiana became ghost towns as these unemployed oil industry employees gave up on their homes and moved on in search of work elsewhere. Within roughly five years, the energy world had gone from one of the greatest industry booms of all time to one of its largest busts.
In the first leg of that drilling industry downturn, the rig count fell by 2,723 rigs, or about 60% of the industry peak count of 4,530 working rigs at the very end of 1981. This rig decline lasted for 65 weeks from peak to trough. Some analysts might say that because the rig count bounced up in the last few weeks of 1982, that this decline was over and we should be measuring a new rig drop period. We believe that the industry conditions in late 1982 were not materially improved from the earlier months of that year, nor the following year, and that is why the rig count decline quickly resumed.
Much like a stock trading between support and resistance price points, the rig count over the next several years essentially traded within a range bounded by that late 1982 recovery peak and the bottom of the decline in spring 1983. Then in 1986, the bottom fell out of the rig count along with crude oil prices. By that point the financial health of the global petroleum industry had been eviscerated and the drilling industry was essentially entirely bankrupt.
We have taken the pattern of this extended 1980s rig downturn and applied it to the current rig decline to see where we might wind up if that earlier cycle were to be followed. It suggests that while we have already surpassed the bottom of the first phase of the 1980s' cycle downturn, from the 1,126 working rigs at March 13th we could see the industry needing to shut down another 211 rigs. Added to the current 905 rig decline, the domestic rig count would fall by 1,116 rigs or a 55% decline from the September peak of 2,031 working rigs.
The complete 1980s rig cycle spanned 246 weeks from peak to trough. At the average rate the rig count is dropping, we would reach the comparable 1980s correction low in another eight weeks, or by May 1st. If achieved, the low would have been reached in 40% of the time of the 1997-1999 cycle, five weeks short of the entire 2001-2002 cycle and in 13% of the time of the 1980s cycle. The speed of this cycle's decent, assuming that was the bottom, is astounding. It suggests that other factors are at work in the oil and gas business than merely commodity prices and the recessionary impact on oil and gas demand. We would suggest that the industry variable analysts and corporate executives have underestimated is the workings of the global credit crisis on business spending and confidence. While these concerns have been most visible in their impact on the U.S. drilling rig count, we thought it also would be interesting to examine the history of the international rig count for guidance about its movements in light of economic recessions and the credit crisis.
The international drilling market has tended to demonstrate much less volatility over time compared to the U.S. rig count as the work is primarily driven by large oil companies - both independent companies and national oil companies - and involves larger fields than those found in the United States. These characteristics have meant that the international drilling market has been slower on the uptake during commodity price rises and likewise slower to fall during price contractions. This pattern is clearly demonstrated when one compares the international (non-U.S. and Canada) rig count over time and the world oil price.
The greater stability of the international rig count compared to the U.S. rig count is demonstrated by plotting the two measures over time. The volatility difference can be noted by examining the pattern of rig count movements during two corrections - 1981-1983 and 1997-1999. In the first case, the U.S. count peaked at the end of 1981 and bottomed in the spring of 1983 with a 60% drop. The international rig count did not peak until November 1982 and then bottomed in July 1984. These peaks and troughs were approximately one year later than for the U.S. rig count. Over its cycle, the international rig count only fell by 20%.
The pattern of the 1997-1999 rig market downturn was somewhat different than that of the 1980s, as the peak in drilling for both regions came at about the exact same time - September 1997 for the U.S. count and July for the international rig count. The bottoms for the two rig counts were within months of each other with the U.S. rig count touching bottom in April 1999 as the international count continued falling until reaching bottom in August 1999. The magnitude of the declines was measurably different - the U.S. count fell by 53% as the international count was only off 33%. Surprisingly, at the bottom of the 1999 rig market correction there were more rigs working internationally than in the United States - 556 rigs versus 488 - although at their respective peaks the U.S. had 206 more rigs working - 1,032 versus 826.
The current rig market downturn has shown some similarities to the 1997 correction as both the U.S. and international rig counts peaked in the same month - September. However, the magnitude of the U.S. rig count fall has been dramatic. It fell by 788 active rigs, or 61%, from the peak to the end of February. In contrast, the international rig count has only dropped by 88 rigs, or 8%. One has to believe that there is risk of a further decline in the international rig count over the coming months if oil prices remain depressed - at least compared to their levels of the past two years - and show few signs of rising while the credit crisis continues to adversely impact capital availability for all segments of the global petroleum industry and thus their willingness and ability to fund drilling programs.
How much further the international rig count might fall is no less easy to project than forecasting the bottom for the U.S. rig count. If, as some forecasts are suggesting, the U.S. rig count falls to 850 rigs, then we would be returning to activity levels last experienced in the 2002-early 2003 period. If we assume the international rig count mirrors the U.S. count and retreats to that activity level, there is room for an additional approximately 275 rig drop from February's 1,020 working rig count. While we cannot rule out a decline of this magnitude, our intuition suggests that it is too severe a correction.
We remain optimistic that the economic stimulus efforts of governments around the world, coupled with the long-term business strategies of large oil and gas companies will support petroleum industry capital spending at levels that will keep most of the current international rig fleet active. There is a significant difference between the health of the U.S. natural gas market, which is the focus for roughly 78% of the active drilling rigs, and that of the global oil market. Both markets suffer from oversupply and weak demand conditions, but in our view, the global oil market could return to a semblance of balance faster than the U.S. gas market. That difference is critical to our view that the damage to the U.S. oilfield market has been, and will continue to be, much greater than for the international oilfield market. We must always remember, though, that while the global oilfield market is composed of many smaller, regional markets, there is a certain spillover effect from one market into another. A global oil industry malaise is the greatest risk for oilfield company executives.
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Managing Director, PPHB LP