Behind the Falling Rig Count

It's hard to shake a feeling of impending doom these days, as sellside oil service analysts deliver a steady eulogy of downgrades to land drillers and pressure pumpers with onshore ties to North America.

The dirge grew even more somber in mid-October as evidence of falling rig rates, a slow Canadian summer for activity and self-reported pre-announcements of downgrades across all land-related service sectors reached critical mass.

The take-away is that the third quarter was a tough time for most service providers, regardless of sector, with the fourth quarter extending the bleak outlook of falling revenues, declining utilization, shrinking EBITDA, and projections of further margin compression in 2013. Consequently, analysts are scrambling to downgrade ratings for the oil services sector in general.

A peek behind the Wall Street angst reveals there are five major themes impacting the rig count as 2012 closes. They are interrelated and point to further activity declines, further reductions in service pricing and falling utilization through year-end.

Dry-gas basins have experienced the greatest decline, while tight-oil formation basins are experiencing rig-count growth.

It is unclear whether any of the five themes are enough to prevent a recovery early in January 2013. After all, West Texas Intermediate remains stubbornly above $90 and, with crude oil revenue now accounting for the overwhelming majority of revenue flow into the industry, operators will have money to spend in 2013, more money, in fact, than is currently on hand.

First off, where is the rig count declining? The answer is unconventional dry gas. Examples of year-over-year declines in the average quarterly rig count for third-quarter 2012 compared to third-quarter 2011 include the core Louisiana Haynesville down 80%, the Arkoma Woodford down 54%, and Colorado's Piceance Basin off 50%. Similarly, the Barnett shale and Greater Green River Basin are off more than 40%, while the Fayetteville and Marcellus shales have dipped 30% and 29% respectively.

In liquids plays, the Cana Woodford rig count is currently off 40% versus the same quarter in 2011, while the Granite Wash is down 23%. In contrast, the Eagle Ford shale rig count is up 1% and the Utica shale is up 384% versus the same quarter in 2011. All the tight oil basins are hosting more rigs, including the Cleveland/Tonkawa in the Texas Panhandle, where the count is higher by 8% versus the same quarter in 2011, and the Bakken shale, which has risen 25%. The Mississippi Lime is higher by 230%.

Driving the fall

As go the land drillers, so goes the rest of the service industry. These five trends are driving a falling rig count.

Greater rig efficiency. Operators in the Eagle Ford and Marcellus shales and the Cana Woodford touted efficiency gains during second-quarter 2012 earnings calls. Operators made significant progress in optimizing drilling and completion efforts as new plays matured and significantly reduced cycle time.

In newer plays, like the Eagle Ford and Marcellus, those gains were sizeable, sometimes reaching a 50% reduction in the drilling cycle versus earlier wells in the play.

But gains in the drilling cycle show the same profile as decline rates for unconventional wells. Massive gains are made quickly and then taper into a long tail of modestly incremental improvement. It is part of the unconventional cycle. As plays mature, operators capture gains in drilling time and the emphasis on improvement subsequently shifts to the completion cycle, particularly as a play nears the resource harvest phase. The Bakken is there. The Eagle Ford and Marcellus are quickly getting there. As a result, operators are drilling wells faster.

No more money. The consequence of drilling faster is the second theme: Operators have burned through their 2012 budgets.

"Lower commodity prices are one factor in the declining rig count," said Larry Pinkston, chief executive officer of Unit Corp., speaking at the IPAA OGIS meeting in San Francisco at the end of September. He addressed the reduced count in the Anadarko Basin, although his observations are relevant for the drilling market as a whole.

"But the major reason (for the declining rig count) is that operators have spent their budget… . Liquids prices, sure, that had something to do with it, but if people still had money in their budget, they'd still be drilling."

Market evolution. This is most apparent in the Permian Basin, as operators allocate capital expenditures to horizontal programs to explore new plays such as the Wolfcamp horizontal, or the Cline shale. Rigs that formerly focused on drilling targets in the Wolfberry, a stacked vertical commingled production play, have been let go. In some cases those rigs have moved to areas in the southern Midland Basin, where the Wolfcamp is shallower and smaller spec rigs can drill horizontal laterals.

Still, several rigs have not found work. The vertical oil-rig count in the Permian Basin, which is primarily Wolfberry-oriented, peaked early in second-quarter 2012 at more than 280 units, according to Smith International's rig count. That count had dropped to 240 at the end of the third quarter, while the horizontal rig count in the Midland Basin portion of the Permian Basin increased during the same period.

Oil and gas operators are filling cubicles with petrophysicists, geophysicists and other specialists to review tight-oil formations in the Permian. The process enables operators to identify sweet spots that make tight-formation wells economic even at $8- to $10 million a pop.

"With our mandate to drill close to within cash flow, we have to allocate capital, and we have great returns from the horizontal Bone Spring so, yes, we are taking vertical rigs out and shutting them down in the Yeso and Wolfberry or sending them to higher rates of return in the Bone Spring," noted Steve Pruett, senior vice president of corporate development at Concho Resources Inc., speaking at the San Francisco conference.

Commodity prices. Although natural gas rallied in September, when it became evident the U.S. would not fill underground storage, prices are still too low to revive the natural gas market. It is the same story for natural gas liquids (NGLs). Pricing has recovered since early summer but is well below previous levels, as takeaway issues create a flood of NGLs in the market. Consequently, operators in liquids-rich plays, which drove much of the increase in the 2011 rig count, are slowing activity.

Natural gas drilling likely will not recover until the market tops $4.50 on a sustainable basis. Black oil, the new term for crude oil, remains the prime driver in activity gains. With WTI above $90, operators will start 2013 with more cash on hand, and that circumstance usually coincides with higher demand for oilfield services.

2013 capex plans in flux. In plays like the Cana Woodford, which are dominated by a handful of operators, 2013 budgets are still evolving. Of the four main players, Devon Energy Corp., Marathon Oil Corp., QEP Resources Inc., and Cimarex Energy Inc., all participate to some extent in each other's wells.

"All of us are finding our nonoperated obligations are increasing because of these infill-drilling projects," notes Tom Jorden, chief executive for Cimarex, Denver. Jorden, speaking at OGIS, outlined the situation regarding the falling rig count in the Cana Woodford. "Everybody is trading plans for next year so we can all run on our capital. So a lot of what we do in the Cana next year is going to be a function of how much outside operated capital we are exposed to."

Cimarex will exit 2012 with four rigs active in the Cana, down from 12 at the beginning of the year. The company has yet to determine the number of rigs it will employ in 2013. "If we are in a nonoperated well, we're going to participate in that. So we're going to see what our nonoperated obligations are, and then the swing capital for Cana will be our operated capital."

The overall rig count in the Cana Woodford is down nearly two-dozen units from its 2011 peak.

Bottom line? Gas is bad, oil is good, while the status of NGLs is in flux. With a declining rig count, the land drilling sector has become an analog for the greater services market: demand is down, more capacity is arriving in an oversupplied market, and spot market pricing is dropping, while units that roll off contract are seeing contract renewals for shorter terms. Those themes are rippling through oil services and creating angst among sellside analysts in regards to fourth-quarter 2012 performance, with little visibility into 2013.