Now you see ’em; now you don’t.

Land drilling contractors are both adding and eliminating drilling rigs as the U.S. fleet undergoes transformation.

Publicly held land drilling contractors announced 174 newbuild rigs in 2011, capped by the stunning 77 newbuilds in aggregate disclosed during second quarter 2011 earnings calls. In theory, those additions should move 2012 rig count higher by something like 150 units, or about 10%, as new builds exit manufacturing queues for field deployment — assuming the gas market doesn’t collapse.

But what the market giveth, the market also taketh away. Many of the publicly held firms building new rigs are also the same firms announcing rig retirements. The decommissioning process among publicly held drillers brought rig retirements to 201 units in 2011 after both Patterson-UTI Energy and Precision Drilling disclosed they were discarding a combined three-dozen units in the U.S. market at year end.

In all, rig post mortems were conducted in 2011 for 104 units at Nabors Industries, 53 units at Patterson-UTI, 36 units at Precision Drilling (including 6 in the U.S.), 31 rigs at Union Drilling, Inc., and 7 at Helmerich & Payne.

Numbers like those indicate why the domestic fleet is shrinking. The 58th NOV Downhole Rig Census found the U.S. land fleet down for the second year running in 2011 (to 2,808 land rigs) on a net decline of 72 units. NOV’s census, which occurs during the second quarter each year, previously identified 334 rig deletions versus 262 rig additions. Moreover, NOV rig retirements accounted for 315 of those 334 deletions.

The numbers imply a fleet in transition. The census reveals the pace of fleet deletions grew from 95 in 2007 to 334 in 2011 with the vast majority surrounding the removal of rigs from census roles due to extended inactivity or a requirement for substantial capital investment to bring a unit back to service. Units falling within those categories totaled 77 in 2007, grew to 212 in 2010, and hit 315 in 2011.

On the fleet additions side of the ledger, units assembled from parts fell over the last five years from 71 annually in 2007 to just 3 in 2011 even as the number of rigs returned to service declined from 189 in 2007 to 95 in 2011. (Figure 1)

The gap between rigs removed from the annual fleet census and rigs brought back into service suggests the industry is near the end of the line for recycling old equipment.

There is ambiguity in those numbers, however. They can indicate the industry is near the end for reincarnating legacy components into active rigs. Or, they can imply the industry is favoring new builds to address different drilling requirements. Further ambiguity is evident in the fact that the industry added 1,077 new builds over the last five years, including 158 in 2011, according to the NOV census, essentially offsetting deletions of 994 legacy units during the same period.

So think of it this way. Fleet capacity in this new era reflects the land contractor’s version of the First Law of Thermodynamics: drilling capability industry-wide is neither created nor destroyed; it just changes form.

Out With The Old, In With The New?

With numbers like those, the current consensus is that new build rigs are replacing legacy rigs. But the story may be more nuanced. The transformation under way is really about the U.S. oil and gas industry; the domestic rig fleet is simply reflecting changes in how the industry will operate during the next half decade.

This is particularly evident in tight formation oil and gas plays, which became the main focus of U.S. drilling activity after the 2008-09 commodity price collapse. The standard model in tight formation plays goes like this: resource plays evolve through specific phases, beginning with a land grab, followed by an era of delineation to assess acreage. Afterwards, efforts among service providers and operators “optimize” the drilling and completion process, or determine the mechanical and engineering methodologies that work best.

With that knowledge, the industry moves forward on the resource manufacturing stage, or a systematic harvest to convert tight formation oil and gas reserves into production.

But it’s different strokes for different folks. The delineation phase is rig agnostic: any rig will do. As the industry reaches the resource manufacturing stage, operator needs evolve toward specialized equipment—hence the interest in new rigs — often in fit-for-purpose configurations.

Clues that the industry is moving into the resource manufacturing stage are found in the growing trend of pad drilling. More often than not, the resource-manufacturing model incorporates multi-well pads or a combination of multiple horizontal or directional laterals off a single well site as the most economical and efficient way to exploit reserves.

The old model of “one rig, one well” resembled the Texas Ranger approach to law enforcement in 1930s-era boom towns (one riot, one Ranger). The new model is “one well site, multiple laterals”. On a practical level it means a drilling operation evolves from a $5 million one-off event into an industrial program that represents $50 million per multi-well pad and allows an operator to capture economies of scale that can reduce individual well costs by 30%.

This is not to overstate the diffusion of pad drilling throughout the industry. Operators employ a variety of methods to capture efficiencies after the optimization phase. In doing so, savvy operators sometimes bring wells on line up to twice as fast as peers operating in the same area.

To fit this tight oil and gas model, many new builds involve fit-for-purpose rigs configured for pad drilling or multi-well applications. These aren’t really replacement rigs per se; rather, they are specialized configurations constructed on multi-year term contracts to address specific program needs. Thus the large volume of 2011 new builds reflects industry transition in several basins from optimization to the resource-manufacturing phase of tight formation development. This evolution varies in maturity depending on play, but is underway in the Bakken, Haynesville, Marcellus (Appalachia), and Eagle Ford shales—the same zip codes where many of the newly ordered units are headed.

And that is the main reason to monitor the pace of new build rig announcements going forward. Future new builds will indicate how quickly the transition to resource manufacturing is unfolding in the domestic market. Another way of looking at it is that 2011 new build announcements were about the 2012 market; the 2013 story will unfold in the pace of 2012 new build announcements.

Swiss Army Rigs Or Fit-For-Purpose Units

A half decade ago, a contractor who owned a 750 horsepower (HP) conventional mechanical rig could drill more than 60% of wells in the U.S. That sweet spot in rig size is now 1,000 HP, or higher, and entails electric rigs in either DE-SCR or AC-VFD power configurations as operators employ extended reach laterals. Newer units feature higher hoist capacity, often sport top drives, and entail higher hydraulic horsepower. Separately, contractors have developed modular, highly mobile units to reduce rig move cycle time. Regardless of configuration, new build units have proved popular with customers who are willing to pay higher day rates for higher performance.

Non-vertical drilling created demand for higher spec rigs over the last three years as the industry eschewed conventional wells in favor of unconventional targets. That shows up as rising market share for higher spec electric rigs.

Since market share remains virtually unchanged over the last three years for traditional DE-SCR electric rigs, some argue that newbuild AC-VFD rigs gained share at the expense of conventional mechanical rigs. (Figure 2)

But the correlation is not precise.

“It’s not as simple as saying all mechanical rigs will be replaced in these plays as various capital improvements can enhance performance and crew quality/loyalty impact results in the field,” according to a December 2011 land market analysis by Tudor Pickering Holt & Co. “However, mechanical rigs are generally targets for replacement, as are many older SCR rigs that will be pushed out by AC or newer SCR rigs.”

The decline in share for mechanical rigs and subsequent rise in share for AC-VFD units over the last three years occurred as the industry underwent a transformation in the types of wells drilled. At peak in 2008, horizontal and/or directional drilling represented 46% of rig count. That share grew to 73% of active rigs at the end of 2011.

Similarly, conventional mechanical units represented 58% of active rigs at the 2008 peak but fell to a 47% share in 2011 as low natural gas prices rendered conventional vertical gas uneconomic and capital flowed toward tight formation plays with mechanically challenging conditions.

The transformation also coincides with a shift from private operators drilling conventional wells to public operators drilling unconventional wells. Ultimately, public companies have greater financial resources to commit to multi-year contracts on new build equipment in unconventional plays. Consequently, private operators who represented 41% of rig count in 2008 have seen share drop to 31% currently. Simultaneously, the number of rigs employed by private operators fell 40% to just under 500 units between 2008 and 2011.

The nuanced argument is that new build rigs are not replacing legacy rigs; rather they are drilling different kinds of wells for different customers.

Two other items complicate the theory of displacement in the U.S. rig fleet. In the Fayetteville, the Marcellus, and the Permian Basin, conventional mechanical rigs are drilling the vertical well bore before an electric rig is brought in to drill the lateral.

Similarly, high oil prices are stimulating demand for conventional targets in the Permian Basin and re-opening shallow oil plays in the Midcontinent’s Cleveland Sands or Mississippi Lime. The conventional mechanical fleet, which is half the active market, isn’t going away. It is mostly being re-purposed.

Can We Get 250 More Newbuilds?

After a review of fleet capacity, Tudor, Pickering and Holt estimated in December that the industry may build another 250 units beyond the 160 units in the fabrication queue. Ultimately oil and gas operators will answer the question on how many rigs are necessary over the next three years. One theoretical permutation in the transition to resource manufacturing is that the industry may need fewer—but better — rigs for production volume growth. Whatever the ultimate new build number, the industry is currently delivering new rigs (most of which are fabricated by drilling contractors) at the rate of three per week.

And that gets back to the contractor’s First Law of Thermodynamics. The current new build cycle illustrates the transition to resource manufacturing in oil and gas even as publicly held land drillers close the books on a handful of legacy rigs acquired a decade or more ago. (Figure 3)

The emphasis on unconventional targets after 2009 is reflected in rising rig count for new build units and expanding mark share for the Helmerich & Payne fleet versus an average of rig count for Nabors Drilling USA and Patterson-UTI Energy. HP is a proxy for the new build effort; NBR and PTEN represent traditional fleets that grew previously by acquiring legacy rigs.

Indeed, it looks like a new era has begun in the land rig fleet. But long-term investors have always fought a gnawing fear about land rigs. Reincarnated drilling units have an unsettling habit of showing up whenever commodity prices rise, private operators jump back in, and day rates skyrocket. Conventional drilling is not dead, it’s just not needed at current commodity prices.

And that is why the long-term investor awakes, Deliverance-like, at 3 a.m. following a haunting dream about an apocalyptic Terminator-style world. In that dream, Mel Gibson or John Connor have come face-to-face with a contractor marketing a Mad Max conventional mechanical rig.