Fresh off the $425-million sale of Sligo Field assets in North Louisiana to Chesapeake Energy Corp. in May 2004, privately held Greystone Oil & Gas LLP created a new venture to develop properties in the ArkLaTex region.

But there was a problem. "When we got ready to drill some of our prospects in the fall of 2005, we were unable to find drilling rigs," explains managing partner Joe Bridges. "We went to contractors who had drilled our wells for years-all of the big ones and a lot of the small ones-and their rigs were booked for years. It was a pretty dismal outlook. We were faced with seeing projects that we had put together so carefully lying fallow for lack of a drilling rig."

Greystone opted to build and operate its own fleet. The Houston company has taken delivery on two 1,000-horsepower, "trailerized" high-performance rigs manufactured by Brady, Texas-based Loadcraft Industries Inc. Greystone will receive four additional units by the end of first-quarter 2007.

"The size of our rig fleet is built around what we think our indigenous needs are likely to be," says Michael Geffert, Greystone's other managing partner. "We're basically oil and gas operators. We don't intend to be in the contract-drilling business as a significant, primary line of business. It is a means to the essential end of our oil and gas efforts."

In the industry's earlier years, it was common for producers to own and operate their rigs. After World War II, the industry evolved into its present structure in which E&P and service companies are separate entities. They are very different businesses, and operators came to prefer to lease rigs on an as-needed basis. Some producers, such as Tulsa-based Unit Corp., continue to make a business in both spaces-drilling fleets and E&P operations.

The current trend towards operator-owned fleets is the result of a convergence of factors. A half decade ago, there was a surplus of rigs as few prospects could pass the commodity-price test of the time-under-$20 oil and under-$2 natural gas. Meanwhile, producers were unraveling the technical puzzle to tight formations. By 2005, rig demand reached the limits of U.S. fleet capacity. Meanwhile, the contract-drilling industry was reluctant to add capacity after suffering a 25-year downturn.

As a result, a number of producers are buying new-build rigs these days and drilling companies outright, or signing long-term contracts for new advanced-technology rigs. Roughly 100 operators now own one or more rigs, or are building rigs, totaling more than 400, or nearly 18% of the marketed U.S. land fleet, according to Fort Worth, Texas-based RigData.

Southwestern Energy Co.'s 15-rig new-build program employs fit-for-purpose, super-single rigs manufactured by Odessa, Texas-based MD Cowan Inc. to develop the company's acreage in the Fayetteville Shale.

Denver-based Delta Petroleum Corp. is developing a drilling fleet, as DHS Drilling Co., to provide flexibility in a constrained market. "Given the size we are, we decided that the only way for us to have the kind of flexibility that has served us well in the last couple years was to own our own rigs," says Delta chairman and chief executive Roger A. Parker, "as opposed to having to stand in line (for rigs) behind the large independents who get preferential scheduling because of their size."

Development of the DHS Drilling subsidiary was enabled by management: Bill Sauer and Harold Hastings. They formerly operated Sauer Drilling Co., which had been a division of Tom Brown Inc. When EnCana Corp. purchased Tom Brown in 2004, it sold the drilling assets to Unit Corp.

Delta partnered with Chesapeake to finance DHS Drilling, which has grown to 16 rigs of which six currently work on Delta projects and the rest, for other E&P companies. "We don't necessarily experience lower individual well costs because of our ownership of rigs, but the rigs themselves generate cash flow, of which we technically own half," Parker explains. "That, in and of itself, minimizes the overall cost of what a well might be for Delta."



Hedging service costs

Similarly, Chesapeake has invested $254 million to date from Texas to Appalachia in construction or acquisition of 42 rigs, and is building another 20. The company's fleet will reach 82 rigs in 2007, including 55 new-builds, representing a total investment of $500 million. The company runs first- or second among most active U.S. drillers in terms of its rig count at any given time (including both its own rigs and rigs it has hired).

"At first it was simply a hedge against rising rig rates," says Tom Price, senior vice president, corporate development. "But as time went on, and as Chesapeake forecasted, rigs came to be in short supply. So it was our way of making sure we would have sufficient rigs available to drill our projects."

Pro forma the acquisition of two contract-drilling firms in 2005, Chesapeake's fleet represents the seventh most-active drilling division in the U.S. based on total footage. Additionally the company's drilling unit reflects current economics in the land-drilling sector with operating margins in the 50% range. The division, including a trucking subsidiary, produced an operating margin at an $80-million annual run rate during the third quarter. The drilling-division margin is allocated into a pool that lowers the company's overall F&D costs.

For Dallas-based CDX Gas LLC, rig ownership was a logical next step. Founder Monty Rial had patented several drilling techniques in the 1990s, including the company's Z-Pinnate horizontal drilling and completion system, which mines gas from coalbed-methane fields through an extensive, underbalanced, multi-lateral system. Subsurface laterals radiate from a single vertical hole and resemble the veins of a leaf-hence the name pinnate. The process extracts up to 90% of the original gas in place.

"Monty Rial was a visionary," says Tom Wingerter, president of Express Drilling Services LLC, the CDX drilling subsidiary. "In 2002, he saw the natural gas market and related services tightening." So the company began buying drilling rigs.

CDX Gas drills a million feet of laterals annually and has five rigs in West Virginia, one in Alabama and two each in the Arkoma Basin, Barnett Shale and southern Colorado. The company will take delivery on three additional rigs during first-quarter 2007 and refurbish two more company-owned rigs in 2007, bringing the fleet to 17 units.

"The majority of our rigs were purchased and refurbished to support CDX Gas and its coalbed and unconventional shale properties. We plan rig refurbishments for unconventional multi-lateral horizontal drilling. We have top drives and integrated power swivels on every rig, and we provide air packages and pull-down systems," Wingerter says.

Two drilling rigs were included with Inland Resources' oil and gas properties Newfield Exploration Co. purchased in August 2004. The Inland holdings included the Monument Butte Field in southern Utah that produces oil at shallow depths. (For more on this, see "Monument Butte," Oil and Gas Investor, November 2006.)

"We systematically move our way through the field, drilling at a reasonable economic pace so we can convert wells to injection," explains Newfield's Rocky Mountain operations manager Michael Guinn. Inland built the first rig in the low-oil-price environment of 2001 in an attempt to reduce drilling costs. That rig paid out in nine months, leading to construction of a second rig.

Newfield is currently building a third rig, but also employs a Patterson-UTI rig in its Monument Butte development program. One drills 6,200-foot directional offset wells from existing pads on 20-acre spacing. Of note, the three working rigs in the Monument Butte Field ranked among the Top 20 individual drilling units in total footage nationwide in 2005. Brad Mecham, Newfield's Monument Butte operations superintendent, adds, "We have to drill just as good as or better than third-party drillers or we can't really justify having the rigs."

The company also owns workover rigs and trucking, water hauling and other well-site service operations. "A lot of third-party services have doubled their rates over the last two or three years," says Guinn. "One advantage we have over some of the other operating companies in this area is that we have softened that inflationary effect by owning internal services.

"Drilling rigs are a crucial part of that and are probably one of our top returns on investment. Over the last two years, we've seen expenses 29% lower than through third-party services."

Other companies that have acquired drilling divisions include Forest Oil Corp., which operates a fleet of seven rigs through its Lantern Drilling Co. division.



New mindsets

More than 330 new-build rigs have been announced since March 2005, with an equal number of refurbished or reactivated units flowing into the market.

More than half of the new-builds are the result of producer-contractor partnerships. Many involve advanced-technology rigs, which feature AC power, top drives, digital controls and automated pipe-handling equipment.

By signing multi-year contracts with drilling companies, producers provide financial support to warrant construction of new rigs. The most active new-rig builders include Nabors Industries Ltd. and Helmerich & Payne Inc., with more than 150 advanced-technology units under construction or currently in the market.

What motivates operators to finance a rig for which they will never take ownership? "Many new H&P FlexRigs are replacing older rigs that had demonstrated best-in-class performance but were simply restricted by technical limitations," says Juan Pablo Tardio, Helmerich & Payne vice president of investor relations. Although many operator-financed new-builds are described as fit-for-purpose, 18 of 73 new-builds H&P has announced since March 2005 involve FlexRig3s, which are highly adaptive rigs that have been used in a variety of regions, well depths and well types.

"Performance has become a question of productivity, reliability and reduced cycle time, which creates synergies that generate significant savings-even at much higher rig rates," Tardio says.

What's new in the current cycle is the development of some of the largest producer-owned fleets since the 1980s. Fleet sizes-present or projected-include Unit Corp. with 116 rigs; Chesapeake, 82; and privately held SandRidge Energy Inc., 42 rigs.

Fort Worth-based Sundance Resources Inc. and Oklahoma City-based SandRidge will be among the largest importers of Chinese-manufactured drilling rigs in the current new-build cycle.

Still, E&P executives caution their peers about trying this at home. The service industry is materially different from oil and gas operations-drilling divisions are both people- and equipment-intensive.

"It is important to recognize the mindset differences and skill levels between an exploration and development company and a service company," Express Drilling Services' Wingerter says. "If you can get the right folks in each skillset, you can be very successful in doing both. If you try to run one like the other, it will never work."

Furthermore, upfront capital requirements are high. In early 2005, Delta Petroleum reported the cost of refurbishing a rig to like-new condition at $5 million; Greystone reports a new rig costs $10 million, fully equipped today. Building rigs also means adding an inventory of spare maintenance components like engines, mud pumps and drillstring.

Greystone's Geffert says, "Once you start ordering equipment and paying out money, you have no return on investment until the rig is fully assembled and working."

While rigs can be assembled in three or four months, lead time on items like drillpipe stretch well over a year, while costs for components continue to escalate. Most new-build programs locked in prices and orders early in the cycle.

Finding seasoned drilling management is critical for success, which may be why many producer-owned rig divisions report drilling performance at levels higher than industry averages. Delta's Parker says, "Realistically, the most important factor is to make sure you have very good, experienced personnel to align yourself with before you get started. If you don't, the learning curve in the drilling business is a tough one.

"The second part is, if you don't own your own rigs, how much would your own drilling programs really be hindered? If the answer is 'not that much,' then you may decide it is not worth the extra effort to own a drilling company."



Richard J. Mason is editor and publisher of The Land Rig Newsletter in Lubbock, Texas. It is owned by RigData.