Analysis: Increase in Capex Leads to a Strong Rise in U.S. Rig Demand

At the end of last year as initial drilling plans were being announced for 2010, we took a sampling of approximately 30 E&P firms to get a gauge of capital spending budgets and their likely impact on rig activity. Original plans of these sampled firms called for exploration and development budgets to increase ten percent in aggregate. Factoring in 2009 service cost declines, drilling efficiency gains, and our belief that commodity prices appeared sustainable; we surmised that U.S. land rig activity in 2010 would rise 20% on average or double the pace of proposed spending increases.

Six months later, recent earnings' reports from E&P firms paint a glowing picture in general for continued capital budget increases. However, service providers have raised prices, especially in the faster growing shale regions; as the availability of both equipment and labor has not been able to keep pace. Additionally, the growth of uncompleted wells is yielding way to an ever increasing backlog for cementation and stimulation service providers. Based on our re-sampling of budgeted capital spending plans following the second quarter; we found that the planned pace of spending now points to 27% budget growth in 2010. Across the 30 firms we tracked year to date, domestic land rig counts are also up 27%. According to Baker Hughes, the overall U.S. land rig count is 1640, up 38% YTD. We anticipate the rising service costs will eat away at a small portion of the growth trajectory for land rigs. Essentially suggesting that most of the rig count growth for 2010 is already behind us.

While the current momentum would suggest a gradual increase in rig demand over the remainder of the year, some discipline has begun to enter the market. This takes the form of delayed natural gas projects, which we believe will provide another slight offset to the pace of rig count improvement. On the whole, consensus remains centered on the view that the number of natural gas wells coming online this year is too high and is thus discouraging for natural gas prices. Proprietary forecasts prepared by our RigOutlook modeling team also project a continued rise in the U.S. land rig count over the remainder of 2010. Specifically, RigOutlook expects that the average annual 2010 rig count will be 1473, surpassing 2009's average of 1033 by 440 rigs or 42.5% year-to-year.

GRAPH: Historical & Projected U.S. Land Rig Count

Where the CAPEX Dollars Are Going

A vocal majority of E&P firms reiterated their intentions to shift more capital budgets to oil and NGL-rich plays. Not surprising to anyone considering that oil prices are trading at 17 times natural gas even though the energy equivalency ratio is more like six times. Furthermore, the conventional view that natural gas markets are oversupplied is another factor shaping some reallocation. Even with some instances of cutbacks to rig deployments on the natural gas side, as we previously mentioned; capex budgets are growing relative to 2009. Looking at our sample of small, mid, and large cap firms we see that the overwhelming majority are spending more this year than last.


After listening to several conference calls (hosted by E&P management teams' discussing their recent quarterly results and their outlooks for the remainder of the year), we compiled a few commentaries regarding the well economics for natural gas plays:

    • Exco Resources - Shut down rigs in four areas as gas prices dropped below $5, have no plans to return these rigs to work at current natural gas prices. They "...believe...that probably 80% of the gas drilling that's going on right now has a low rate of return...there's a lot of guys drilling for other than pure economics right now."
    • SandRidge - Plans to reduce natural gas rig count from eight to five. Company could reduce their natural gas rig count further if prices warrant.
    • Chesapeake - "Unless gas prices increase over $6 per MCF, Chesapeake is committed to continuing to reduce its gas drilling CapEx, increase its liquids drilling CapEx..."
    • Newfield - "Apparently the need to hold acreage by production precedes economics and gas supply remains stubbornly high today."


Over the long run we believe views expressed like those above will actually lead to an improvement in natural gas prices. In our opinion, this growing sentiment (i.e. that the returns on many gas wells are not sufficient) will likely cause a greater number of operators to drop gas rigs and ultimately serve as the correcting mechanism for the current gas oversupply.

Who Is Growing the Most?

In terms of increased capital spending, smaller firms are raising their budgets at four times the rate of the largest firms in the industry. At the root of this growth disparity phenomenon is the fact that drilling programs are inherently capital intensive. A secondary factor that also impacts smaller players to a greater level is that drilling and service cost are on the rise. Without the luxury that economies of scale afford a larger operators, we believe that these rising costs, especially well completions, are causing smaller operators to increase their budgets in order to maintain the original targets.


Speaking to service cost inflation, we have provided a summarized commentary of E&P management teams' discussing what is transpiring. The comments below were also taken from second quarter conference calls:

    • Cabot Oil & Gas - Speaking to the Haynesville/Bossier region, "we've seen cementing costs up 30%-35% and frac services costs up 50%-60% plus."
    • El Paso - Pressure pumping and stimulation services are tight. Now expect drilling costs to be 5%-7% higher than originally anticipated.
    • Exco Resources - Speaking about the Haynesville the company said that dayrates are averaging slightly above $20,000 and that frac-stimulation service costs are on the rise.
    • PetroHawk - "Keep in mind that every year, there's a certain inventory of wells that have been drilled, but not yet completed at year end. This year, that inventory is a little larger because of the scarcity of these frac fleets and frac crews."


U.S. Land Rig Count Trends

The most recent average monthly U.S. land rig count increased sequentially to 1558 rigs in July (+3%). Since bottoming out during early June 2009, a steady upward trend has ensued with sequential growth averaging 5% from month to month. But over the past four months, while still growing, the pace of the U.S. land rig count has slowed to less than the average.

GRAPH: US Land Rigs - Sequential Monthly Growth

Dynamics of the U.S. Oil Rigs

Stratified by the type of drilling; the majority of the solidly upward growth trend in the U.S. land rig count has come as a direct result of more activity in oil-rich regions. In fact, although oil prices are off 43% from the high of 2008, oil directed activities as measured by rig count are up 38% from the last peak in November 2008. Historically, the last time rigs drilling for oil in the U.S. mirrored current levels was 1998. On a month-to-month basis, the oil rig count is averaging a growth rate of 9% while the number of rigs drilling for natural gas is growing at a sequential rate of 5%.

GRAPH: US Oil Rigs - Sequential Monthly Growth

We have previously expressed the opinion that sustainable crude oil prices at +$60/bbl yields an environment that promotes domestic drilling activities for oil. Although lagging commodity prices by a few months, we note that a comparison between U.S. oil rig count and WTI spot prices provides some credence for this opinion. WTI spot prices have averaged over $75/bbl year-to-date and the U.S. oil rig count has risen steadily over this timeframe. Currently the U.S. oil rig count stands at 611.

GRAPH: US Oil Rig Count & Prices

Looking back to when oil hit its peak (nearly $150 in early July 2008), the U.S. oil rig count continued to climb until November reaching a peak of 442 rigs. In the subsequent months the U.S. oil rig count declined by 60%, hitting its trough during the summer of 2009. Although oil prices have only appreciated 18% since the oil rig count troughed, we believe the current perception that prices are sustainable going forward is providing investors with the necessary enticements for activity levels to continue upward.

Dynamics of the U.S. Natural Gas Rigs

The average monthly natural gas rig count recently established a 17-month high at 971 rigs in July. This is still below 39% below the peak count set back in September 2008. Since bottoming out in July 2009, the natural gas rig count has averaged sequential monthly improvements of 3%. From a growth stand-point the best months occurred at the beginning of the year. While July's growth of 2% is encouraging considering it stalled in May and proceeded to drop slightly in June, this surge may be more related to reallocating assets due to the drilling ban in the GOM in order to hold productions levels than a signal of increased activity over the remainder of 2010.

GRAPH: US Natural Gas Rigs - Sequential Monthly Growth

The front month natural gas futures have declined 12% in the month of August alone (as of August 13th close). In addition to unfavorable near-term commodity price trends, the overall sentiment for natural gas remains weak with the combination of strong production and high storage levels seen as the primary factor discouraging pricing on the horizon.

GRAPH: US Natural Gas Rig Count & Prices

To find the silver lining in this dark cloud, we note that some operators are voting with their checkbooks. These operators have been showing less appetite for hedging future production and in some cases are closing out existing positions. We note that most recently Sandridge's management indicated that they had closed their 2010 natural gas hedges. While likely driven more by cash flow management strategy, we doubt that management would have closed out their positions if they thought futures would drop significantly. Their decision to sell suggests that the bottom for natural gas prices is near.

Although we expect both U.S. oil and natural gas rig counts to climb over the remainder of the year, the trajectory of growth is clearly starting to flatten out. Based on fundamentals, we would anticipate that an industry-wide decision to lay down rigs will first occur in the natural gas industry and that the risks to this occurrence are rising daily. For oil rig counts to drop we would need to see a resounding drop in crude prices like what occurred in 2008. So far futures prices are signaling continued stability in oil prices over the next twelve months.

While 2009 was challenging period for the global jackup market to say the least, the last several months of the year have set a more positive tone going into the new year. In our next installment in this series, we will preview what 2010 has in store for the global jackup fleet and provide forecasts for activity and dayrate levels in the new year.


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