With sell-side downgrades coming faster than a summertime Houston heat wave, it appears the land drilling sector has developed a little Saturday Night Fever of its own.

The land drillers were fashionably late to this cycle’s services downgrade discotheque. Previously land drillers were always the first on the rig rate decline dance floor whenever the cycle turned. This cycle, pressure pumpers began the pre-announcement boogie early, upstaging the land drillers.

In fact, there were skeptics who thought the land drillers might not shake their money maker this go-round thanks to multi-year contracts and newbuild technology rigs. But once NGLs joined falling oil prices in the DJ booth, the beat picked up and the land drillers now appear to be getting down with the downgrade groove that’s so popular on Wall Street.

Hart Energy reviewed economics in the land drilling sector through the first quarter 2012. That review shows the land sector actually peaked at record revenue levels in the fourth-quarter 2012 before lower rig counts and rising costs began to squeeze margins.

Overall margin for the sector reached 39% in the fourth-quarter 2011 before dropping a percentage point in the first-quarter 2012.

Specifically, the land drillers generated $4.09 billion during the first quarter on drilling services, exceeding the $4-billion mark for only the second time in history. It amounted to a $16.3-billion annual run rate. On a quarterly basis, the sector actually peaked at $4.1-billion during the fourth quarter 2011.

In general, publicly held drillers accounted for 49% of rig count on a quarterly average basis during the first quarter 2012, the highest market share since the third quarter 2008.

Generally, one industry rule of thumb is that the publicly held drillers supply the incremental final rigs as the cycle peaks, gaining share, then rapidly lose share as those incremental units become the first to lay down once the cycle turns. For example, publicly held drillers fell to the low 40-percentile range during the fourth quarter 2009 through the second quarter 2010 as privately held operators gained market share coming out of the post-2008 cycle collapse.

Land Drillers Witnessed $14.9 Billion Revenue Run in 2011

It turns out that 2011 was a very good year for land drillers. The sector generated $14.9 billion in aggregate revenue, topping the previous high of $14.25 billion in 2008. It is painful to recall, but land drilling revenues fell to $7.8 billion in 2009 following the commodity price collapse and troubles in global financial markets. While a decline that steep is not likely in 2012 (at least not yet), this year’s early drop in natural gas prices, followed at mid-year by a retrenchment in NGL and oil prices, confirms that the sector has passed an inflection point.

Commodity price levels in June 2012 suggest the industry may be returning to an era reflective of 2010 when it comes to revenue flow for the oil and gas industry. Should that pan out, land drillers could witness a 26% decline in revenue, or a nominal drop of $3.9 billion.

Graph shows quarterly revenue for the land drilling sector in billions of dollars. Revenue growth appears to have peaked for the group. The dashed line shows equivalent revenue levels for the land drilling sector during periods when the commodity prices were similar to levels the industry witnessed in June.


The U.S. land sector generated $11 billion during 2010. But a return to 2010 revenue levels may feel worse than it looks since the annual run rate for the sector during the first quarter 2012 was closer to $16.4 billion.

First quarter 2012 numbers show land revenues were up 31.4% on a year-over-year basis while expenses climbed 29.3%, providing a slight expansion in margin. Sequentially, it was a different story. Overall industry revenue actually retreated incrementally for the land drillers on lower rig count, although revenue per rig rose 3.3%. Unfortunately, those higher revenues were offset by a 5.5% gain in expense per rig, signifying the beginnings of a margin squeeze.

Drillers cited higher first-quarter 2012 expenses on the basis of labor and the costs associated with moving equipment from dry gas basins to markets with liquids rich or oil-directed programs. That economic headwind was supposed to have cleared in the second quarter. The recent spate of pre-announcements among land drillers confirms that labor and other costs continue to rise while revenues stay flat. If those pre-announcements pan out industry-wide, it becomes a clear indication that the economic cycle for land drillers is now officially following commodity prices lower.

Rising Costs And Flat Revenues Confirm A Margin Squeeze

First-quarter numbers show annualized revenue per rig of $9.0 million--the first time ever to exceed the $9-million level. Kudos go to a larger volume of newbuild technology rigs working in the shale plays. Expense per rig reached $5.58 million during the first quarter 2012, also a record, while gross margin per rig, a metric similar to operating income, came in at an annualized rate of $3.45 million. That margin fell short of the $3.77 million recorded in the first quarter 2009 when rigs were laying down while drillers were collecting full rig rates under take or pay term contracts.

The land drilling cycle appears to be cresting with the highest top line revenues in history--along with costs--although nominal margin remains about the same as the 2008 peak.

Going forward, the overarching macro trend of lower oil and gas revenues means lower operator spending. With the land drillers adding to capacity in 2012, both margins and revenues are destined to go lower in the second half of 2012, and may fall lower yet if some of the more bearish 2013 forecasts unfold.