Drilling contractors' long-awaited pickup in U.S. drilling activity is now happening, as most observes predicted months ago. Tight natural gas markets and high gas prices have finally made their mark. As of June 13, the U.S. rig count had risen in 18 of the prior 23 weeks. Nearly all of that occurred on land. At press time, the count stood at 1,071 and 948 of those were drilling on land, up 29.6% year-over-year. Some 910 were drilling for gas, as producers try to replenish gas in storage and offset production declines. Positive outlooks are flourishing. An early June report by Prudential Securities predicted the gas-rig count will go up another 75 to 100 rigs by year-end. UBS Warburg says the total U.S. count could rise11% this year. And at press time, Lehman Brothers and Smith Barney released their midyear capital-spending surveys. Both show U.S. E&P spending going up another 1% to 2% this year. But despite the hopeful signs, dayrates have not budged much-yet. And analysts think still further consolidation in the land-rig market would be welcomed. They hailed the announcement that Patterson-UTI Energy Inc. will acquire long-time Midland, Texas-based TMBR/Sharp Drilling, itself the product of a merger between two West Texas contractors some years ago. The new company will own 358 rigs, second only to Nabors Industries, which has 408 land rigs. "We think we're in a fairly long secular rise here," says John Nikkel, chief executive officer and president of Unit Corp. Last year the Tulsa firm bought 20 rigs, bringing the fleet to 75. Its utilization has gone up, with dayrates just now starting to follow. "The market is reacting as we expected. The difference between now and 2001 is that then, not as many rigs were available, and many needed refurbishment, which was done in 2000 and 2001. Now most of the refurbished rigs are ready to operate. But since there is a bigger pool of rigs available, dayrates will move up more slowly [than they did in the past]." A Stifel, Nicolaus & Co. report says the average operating margin per rig in the fourth quarter was $1,931 a day, which is estimated to rise to average $2,390 in full-year 2003. A mixed bag Many of the contractors have been frustrated, though, and their financial results have been mixed. Some still were reporting mediocre utilization rates, losses and low stock prices for the first quarter of the year. In a few cases, 2002 was the worst year in a long time for some contractors, even though oil and gas prices kept climbing. Pioneer Drilling Co., based in San Antonio, saw revenues for the quarter ended March 31 go up significantly as utilization rose to 84% from 69% in the same period last year. But, since its dayrates were lower than the year prior, the company reported a loss for the quarter. Similarly Grey Wolf lost money in the quarter, even though its rig count rose slightly. Operating margins were slim, and as old contracts expire, the new spot price for a rig can be lower than a year ago. Many contractors are spending money to add quality to their fleets through acquisitions or refurbishing older rigs. "It's a spectrum-pick any particular company and you'll hear 'I can't believe what a good market it is' to "I am not doing that well.' This is a hugely localized market, but people generally are pretty optimistic," says Richard J. Mason, editor and publisher of The Land Rig Newsletter in Lubbock, Texas. "Our activity count is up about 33% since January. We now find 1,100 land rigs working...Our count is always about 20% higher than the widely cited count of Baker Hughes Inc., because they don't count some rigs." (Reed Hycalog and Rigzone.com also provide rig counts. Each surveys the scene a bit differently and thus, comes up with a slightly different count, he adds.) Highly positive gas fundamentals are driving most action now, but observers say a lot of the increase seen in the few weeks before press time can be traced to small, private independents that finally trust high gas prices enough to dare to drill a few more wells. For the count to continue upward, more large independents have to step up their activity. Some are doing so, says Angeline Sedita of Lehman Brothers. "Several of the larger E&P companies are currently at or above the land-rig count they reached at the peak of the last cycle in July 2001," she says. They are Anadarko Petroleum, Burlington Resources, Chesapeake Energy, Devon Energy, Dominion Resources, Occidental Petroleum and XTO Energy. "Given the rapid increase in rig count during the last six months for these companies, we believe the pace of growth will likely slow. However, we project an overall gradual upward trend, driven by attractive gas prices." This offsets companies such as El Paso Production, which earlier in the year laid down almost half of its land rigs as its parent company struggled with finances, the ouster of its chief executive officer and a time-consuming proxy fight. Prudential's Grant Borbridge notes that the fall-off in oil and gas prices from their unsustainable highs before the Iraqi war, means that more E&P companies are comfortable increasing their capex through the end of this year. Dayrates Dayrates have been slower to respond to the jump in the rig count than many had expected, which has been good news for producers and not so for contractors. Generally speaking, rates creep up once fleet-wide utilization passes 60%, with daily operating margins going up shortly after that-unless wages rise. "We keep hearing there are some who are perplexed because they have not seen movement in dayrates concurrent with the increase in activity," Mason says. "There was a brief flurry at the beginning of the second quarter but not since-that will change as the year goes on, as demand for rigs seems to be increasing. "We did a survey in April where contractors expected rates to go up 5% to 10%. I suspect by the latter part of the third quarter that could be valid. And they expect rates to be 25% higher by year-end compared with year-end 2002. I think margins bottomed in the last quarter of 2002 or the first quarter of this year." The stock prices of some contractors have responded to the increased rig count. Mason notes that he sees a more sophisticated investor today. "It used to be they ran when the cycle hit a low, but this time the stocks retained their value [more than in the past]." An overlooked and ironic fact is that operators are always the most profitable when dayrates are highest and least profitable when they hit bottom, Mason says. "That's counterintuitive but that's the reality. When you need a rig, the dayrate is immaterial." The Land Rig Newsletter has a rig-replacement index based at 100 as of April 1998. At press time, it was at 159, versus a peak of 188 in May 2001 and a low soon thereafter, 95 in October 2001. "The U.S. fleet is larger than one would think, and the rig count is higher than standard industry measures indicate," Mason adds. "We see 1,350 rigs ready to work, defined as rigs that have drilled at least one well in the last five months. We saw 1,099 land rigs working as of May 23 versus a Baker Hughes land count of 1,000." "Margins go hand in glove with dayrates and they have to improve dramatically," says Nikkel. "We eventually will have to talk about replacing the U.S. rig fleet and today's margins are only 30% of where they need to be to justify new-builds."