US drilling activity has been a roller coaster ride over the past 4 years. As activity climbed steadily through 1997, it appeared the industry was returning to boom times with more than 1,000 rigs at work. By April 1999, however, following the collapse of oil to 1986 prices and an erosion in natural gas prices, the rig count had fallen to 496-the lowest US rig count in the 50 years for which there are reliable records.
Offshore drilling rigs fell to less than 100 and active land rigs, to 385. Just 125 rigs were drilling for oil, and 371 were targeting gas reserves.
The US rig count has recently reached a monthly average of 1,278, including 156 offshore and 1,100 on land, with 219 drilling for oil and 1,058 targeting gas. Despite recent concerns about falling natural gas prices and the plateau in rig activity, the last 2 years have produced a surge in activity unmatched since the 1970s.
With the strongest growth in the demand for land rigs since the early 1980s, drilling contractors have responded in earnest to the challenge of supplying rigs to a market that, until recently, could best be characterized as a "feeding frenzy."
While the offshore market captured the attention of the industry during the 1995-97 deepwater rig building cycle, the renewal of the US land rig fleet dominated the 2000-01 picture. Land rig day rates have exceeded the level necessary to provide attractive returns on new construction, stimulating large-scale rig refurbishment and reactivation efforts, together with the first significant new construction activity in 20 years.
Ironically, the offshore arena, including the once-booming deepwater segment, has not reached the level of profitability required to support further renewal of the fleet and may not in the near future. What has led to these trends, and what does the future hold for the contract-drilling segment, which arguably has been in the front seat on this roller-coaster ride?
Industry backdrop
The collapse of North American drilling in 1999 set the gas market up for a rebound. After an average of 560 rigs drilling for natural gas in 1997-98, the gas rig count dropped to 371 rigs in April 1999 (Fig. 1). Estimates at the time indicated that about 600 natural gas rigs were required to sustain deliverability, yet fewer than 500 rigs on average were active during the year. Subsequently, natural gas storage levels began to fall faster than normal in early 2000.
Simultaneously, natural gas demand began to grow at a more rapid clip, leaving storage at 2.75 tcf or about 250 bcf below normal, entering the 2000-01 heating season (Fig. 2). In addition, a cold 2000-01 winter following three successive above-average-temperature years set the stage for $9/Mcf gas.
The natural gas rig count surged, and drilling contractors began to marshal all their resources to add capacity to a market hungry for additional rigs. In 2000, E&P capital expenditures in the US surged by 40%, and at yearend 2000, operators planned to increase spending by an additional 20% in 2001, with a clear preference for gas drilling over oil drilling.
Some operators had overspent first-half budgets by midyear 2001, partially due to higher service costs, however, causing some to pause and reassess spending plans, particularly those that were highly active on the Gulf of Mexico shelf.
Operators, including Apache Corp. and Chevron Corp., released Gulf of Mexico jack ups, creating softness in the market and lower day rates. The drop in natural gas prices from more than $4.00/Mcf to just above $3.00/Mcf from late June into July exacerbated the slowdown, causing Gulf of Mexico jack up utilization to fall below 80% by early August for the first time since October 1999. The slowdown that rapidly occurred offshore has not yet spilled over to the land market, but signs of an imminent pause onshore are already evident.
Natural gas prices in the coming months will determine the length of this activity pause and the depth to which it will impact operators' spending plans. While significant underpinnings of strength in natural gas fundamentals remain over the longer-term, a near-term supply-demand imbalance has led to considerable uncertainty.
Land rig market
The US land rig market has experienced a renaissance over the past year. A portion of the industry often overlooked as the most fragmented, commodity-like segment suddenly began to bloom in 2000, driven by a nearly insatiable demand for rigs to find and produce natural gas in onshore basins.
Contractors began refurbishing and reactivating rigs, some of which had been stacked for over 15 years. Some companies, such as Helmerich & Payne International Drilling Co. (H&P), chose to expand their new-rig construction program to meet rising demand, while Nabors Industries Inc., Patterson-UTI Energy Inc., and others began to draw upon their large stockpiles of idle equipment acquired during the slow years of the mid-late 1990s.
Supporting these efforts were customers willing to pay attractive, even above estimated replacement day rates in order to secure scarce supply to meet their stepped-up drilling requirements.
According to the Reed-Hycalog rig census, there were 1,370 available land rigs in 2000, about 925 of which were operational by yearend 2000, yielding utilization of 68% and a remaining available capacity of 445 rigs. By midyear 2001, the land rig count had risen to about 1,100 rigs, meaning that about 175 net rigs were added during a 6-month period or about 30 rigs/month.
We estimate that Nabors, which controls nearly 30% of the available rig fleet, added about half of these rigs, while the others were divided among the other large contractors (Patterson, Grey Wolf Drilling, Unit Drilling Corp., and H&P) as well as smaller niche players.
In addition to building and reactivating rigs, contractors relocated several to the US from international markets such as Latin America and the Middle East. For the first time in 2 decades, the economics of operating land rigs in the US became more attractive than many project opportunities overseas, particularly for smaller land rigs.
The economics of land rig refurbishment and even new construction have become so attractive that most contractors will admit that rates are now above replacement cost pricing. Rig refurbishment projects cost $500,000-5,000,000, depending on the condition of the rig and component replacement requirements. At the low end, rigs that require only new drill pipe and other miscellaneous small parts can be reactivated relatively quickly, while the larger refurbishment projects, often involving diesel-electric rigs, can take several months and require a large investment.
New 1,500 hp rigs, such as those H&P is constructing, require an investment of $9-10 million and take 9-12 months to build. Day rates for reactivated and new rigs, depending on size and their ancillary equipment, e.g., top drives, were $13,000-22,000 in early summer, with the average rates estimated to be $15,000-17,000 (Fig. 3).
With estimated cash operating costs of $7,000-8,000/day, relatively minor refurbishment projects (up to $1.5 million investment) achieve payout in 2-6 months, while larger refurbishment projects ($5 million) can take up to 18 months to achieve payout. Depending on assumptions made related to day rates, operating costs, depreciation, taxes, and other costs, the overall returns on these projects typically range from "very good" to "outstanding."
Nabors, estimated to have 50% of the rigs capable of being reactivated, has aggressively expanded its marketed fleet over the past year. Since September 2000 when its rig reactivation and refurbishment program began in earnest, the company has returned 120 rigs to service at an average cost of $1 million/rig.
Many of these units were larger, diesel-electric rigs, but many were also smaller mechanical rigs. However, due to the recent softening of demand for incremental rigs, Nabors has suspended its rig reactivation program until market conditions improve. The company has also offered voluntary $500/day rate reductions to some of its largest customers.
Other contractors such as H&P, South Texas Drilling Service, and Rowan Companies Inc are pursuing new construction rather than acquiring and refurbishing older rigs. Perhaps the most aggressive of these is H&P, which has recently stepped up its new rig construction program. In addition to 12 new rigs announced last year, the company plans this year to build an additional 25 new land rigs for delivery in 2002-03.
The company's FlexRig design, a 1,500 hp, highly mobile rig, has proven successful in the field, due largely to rapid rig up-rig down and other technological features that increase drilling efficiency. Beginning in 1997, in order to test the market for a new land rig design, H&P built six new FlexRigs that met with good customer acceptance and stayed almost fully utilized, even during the sharp downturn of 1999. As a result, the company considered the rigs "recession resistant" and planned 37 more.
The company intends to add two rigs/month to the fleet beginning in early 2002, up from one/month currently. It has delivered 8 of the 12 rigs announced last year, 7 of which have term contracts of 2-3 years with day rates estimated at $15,000.
Offshore rig market
Demand for offshore rigs in the Gulf of Mexico, particularly on the continental shelf, has been less robust than for land rigs. Although day rates for jack ups approached their 1997 highs earlier this year, rates have begun to drop as rig utilization has fallen below 80% (Fig. 4).
Deepwater rig demand remains more robust, particularly the demand for ultradeepwater equipment. In addition, offshore rig utilization in international markets remains strong and is beginning to draw jack ups out of the Gulf of Mexico, albeit probably not in sufficient number to restore the supply-demand balance this year.
As offshore rig day rates remain too weak to encourage much new construction, the number of new offshore rigs under construction has dropped to 23 from a high of 68 in 1998. Most of the orders over the past year have been for heavy duty, harsh environment, and ultrapremium jack ups, which are well suited for deep and difficult drilling applications.
Of the 50 new rigs delivered since 1997 in the most recent offshore rig construction cycle, 33 were semisubmersibles and drillships to service the deepwater market. In total, the industry has invested more than $10 billion on new construction over the past 4 years. This dwarfs the estimated $1 billion expenditure in 2000-02 the industry expects to make on refurbishment and renewal of the US land fleet.
A good way to assess the economics of new offshore rig construction is through Global Marine's SCORE (Summary of Current Offshore Rig Economics) indicator. The SCORE compares the profitability of contract day rates with the level achieved in the early 1980s and expresses day rates globally as a percentage of the level that would stimulate speculative new construction.
It currently stands at about 52%, compared with a high 31/2 years ago of 73% and over 100% in the early 1980s (Fig. 5). In June, the SCORE for Gulf of Mexico rigs declined for the first time in 2 years, while the SCORE in international markets continued to improve, pushing the worldwide SCORE higher.
Bright future
The impact of natural gas storage buildup on natural gas prices remains uncertain, and that has led to reduced demand-both for jack ups in the Gulf of Mexico and for land rigs. The weaker near-term natural gas fundamentals seem associated more with the demand side rather than the supply side. A cool early summer, demand destruction caused by high prices earlier this year, a weak US economy, and the industry's continued use of fuel oil over natural gas have all limited gas demand growth, while deliverability has begun to increase.
These short-term issues may be alleviated as gas demand is restored at lower prices. In addition, the anticipated reduction in drilling activity will slow the growth in supply, and the supply-demand imbalance will reverse itself. The question is how long this process will take to run its course.
We expect that land-drilling contractors will enjoy a healthy market next year, although the boom conditions of early 2001 are unlikely to return overnight. Due to industry consolidation benefits, pricing discipline should become apparent as demand softens, and profitability should hold up well. On the offshore side, movement of rigs out of the Gulf of Mexico to stronger international markets will be required to restore higher utilization and day rates.
Contractors with operations overseas will enjoy the benefits of diversification, while everyone is reminded again of the volatility of the Gulf of Mexico jack up market. Overall, the longer-term outlook for those with a horizon beyond 6 months looks rather bright indeed.
The author
Mark S. Urness is vice-president of Salomon Smith Barney Inc., where he has been a senior energy analyst since April 1994, covering the offshore drilling industry as well as oilfield equipment and services. During 1990-94, he was vice-president of Phibro Energy Inc. in charge of upstream ventures. Urness also previously worked for BP Amoco Corp. (now BP PLC) as senior economic analyst/senior petroleum engineer from 1982. He is a member of SPE and is a registered professional engineer in Texas. Urness has an MBA in finance from the University of Houston and a BS in chemical engineering from the University of Wisconsin.