US land drilling 2008 outlook: soft start, strong finish

By Katie Mazerov, contributing editor

Think of a high-performing athlete at the top of his game, earning $20 million a year. His game falls off … and his salary slips to $16 million. A drop, to be sure, but he is still playing – and being compensated – at a very high level.

That is the analogy that energy research analyst Dan Pickering used to describe what he sees as the outlook for United States land drilling in 2008, in particular the first half of the year. “A soft scenario, but soft at a very high level,” said Mr Pickering, director of research at Tudor, Pickering & Co Securities.

With gas accounting for 85% of the land wells being drilled in the US, gas is the big story. “This story has disappointed in the last six months and will continue to be challenging over the next several months,” Mr Pickering said.

With a few qualifications and exceptions, his view is echoed by several industry analysts and drilling company executives, all presenting what amounts to a crash course in economics to explain the factors and phenomena that will impact land drilling in the next six to 12 months.

“It’s the grind of balancing supply and demand,” said Jim Wicklund, a partner at Spinnerhawk Capital Management, an all-energy hedge fund. “There is increasing concern that with the increase in domestic production and LNG imports at record levels, prices could stay flat for the next year to year-and-a half.”

On the demand side, Mr Pickering pointed to normal US gas consumption driven by power. “Weather can impact this … a hot summer, cold winter, hurricanes,” he noted. Also, there is the “ongoing trend in electrical consumption in the US that is fired by gas.”

A positive on the supply side is that Canadian gas exports, which historically have accounted for 17% to 20% of US gas consumption, are falling due to a decline in Canadian drilling activity. “The Canadian rig count has dropped 30% to 50%,” Mr Wicklund said.

But several other supply issues will likely make the coming year challenging:

• Wellhead production is up, and a record amount of gas is in storage.

• LNG imports are up. “The US has the most developed gas infrastructure in the world, so excess LNG comes here because we have the capacity to store and transport it,” Mr Pickering explained.

• Offshore gas production has been declining steadily for the last three to four years. “This will stabilize due to the Independence Hub coming on line, so that situation will be flattening instead of dropping,” he said.

Some of these factors have already combined to soften gas prices this year to an average of less than $6. And prices impact drilling. Add to that a growing rig supply, increasing costs to drill horizontal and more complicated wells, fluctuating demand and uncertainties about the economy, and the outlook points to flat, possibly slowing, drilling activity the first half of 2008. Most expect that a slowdown will correct the scenario, leading to an upward trend in the second half of the year.

“Gas prices are extremely soft, especially in the Rockies,” Mr Wicklund said. “If gas prices don’t recover due to weather, economic growth or reversal of production, then most E&P companies will scale back. It’s a self-correcting mechanism. With lower drilling levels, prices will reach equilibrium.

“Storage is at such high levels, people are giving it away. We have reached an all-time record in storage. Up until last year, the storage capacity had never been tested,” Mr Wicklund continued. “Last year it peaked at just under 3.5 trillion cu ft. Current forecasts predict 3.6 TCF this year. The more we put in storage, the more prices continue to go down. This is advantageous for consumers but bad for industry prices.”

The differential in gas prices further complicates the land drilling picture. The addition of some key pipelines in the Rockies will “ameliorate” the price differential, which may stimulate drilling in that region, Mr Wicklund said. But the average price of gas will likely remain the same, he cautioned, noting that if prices rise in the Rockies, they will drop in Louisiana.

A key indicator of market strength is the ever-fluctuating and closely watched rig count, which has already dropped below 1,800 this year, according to the Baker Hughes count. The prevailing view is that the rig count will stay flat or decline slightly in the coming months.

“Most analysts are acknowledging that persistently low gas prices could put off land rig drilling,” Mr Wicklund said, meaning the active rig count could stay flat or decrease. He added that gas prices, which averaged $8.82 in 2005, have dropped to an average of $6 in 2007. “If gas goes back to $8 or $9, it will correct.

“The bull philosophy says the rig count has to go up eventually,” he continued. “But the most realistic general consensus is that the domestic rig count will soften or decline over the short term until recovery. This could take (several) quarters. Just as the financial markets are uncertain, energy markets aren’t sure which way to go. If the economy slows down or we have a recession, energy demand will drop, then commodity prices will drop, and that will have an impact. Drilling activity will slow down.”

On the brink of the winter season, many are looking to weather as the key variable that could impact the drilling outlook, at least for the short term.

“This is a real sensitive market, and predicting (the outlook) is a hard question to answer. Weather is the wild card,” said Stacy Locke, president and CEO, Pioneer Drilling.

“Winter weather will play more of a role in what 2008 turns out to be,” Mr Locke said. “If the winter is not real cold, next year will be challenging. If the winter is mild, next year could be poor.” He noted that last year’s relatively mild winter, particularly in the Northeast, had a significant impact on supply and prices. “If we have a warm winter with full storage and increased production, prices will continue to go down,” he said. “Gas prices are always higher in winter. If we have a cold winter and a hot summer, things will be great. It’s an odds game.”

As for the rig situation, Mr Locke acknowledged that the increase in natural gas production has led to an increase in the rig supply. “We have more rig supply than demand, which leads to less rig utilization and lower dayrates. The dayrate environment is flat to declining,” he said. “Dayrates for a 1,000- to 1,500-hp rig are $14,500 to $19,000 without top drive and fuel.”

On the other hand, the ongoing industry challenge of keeping up with personnel needs is a “bit better because we have more stacked rigs. We’re not experiencing the turnover we were, but when you stack rigs, you have to let people go,” he pointed out.

And while the newer, more efficient rigs don’t necessarily command higher dayrates, they are desirable for their efficiency. “Drilling contractors strive to build better rigs, which can move quickly, drill a clean hole and move on,” he said. “There is a better chance of keeping a rig busy if it’s a modern, efficient rig.”

Ron Hale, senior vice president of business development at Grey Wolf Drilling, added this perspective: “If we begin to see a slowing of our economy on top of the excess supply that we are currently experiencing, prices will continue to be depressed. Operators will then begin holding on to their production until the price of natural gas improves.

“We are seeing this occur more frequently in the Rockies where the pipeline restrictions are causing significant pricing differentials.

“When the (Rockies Express) pipeline goes on line early next year, it will help eliminate some of the pricing pressure that exists in that market, making it more attractive for operators to drill more wells,” he explained.

Mr Hale agreed that the outlook for 2008 is difficult to predict as there are “so many variables. There are some who believe there has been a decline in drilling activity when, in fact, drilling has increased.

“Today, the industry is operating more rigs than we were a year ago, with most of the increase being the newly built rigs entering the market. In some cases, the newbuilds are replacing older rigs, resulting in an excess supply of rigs.

“From a drilling contractor’s perspective, this excess supply has caused much more competitive pricing opportunities for operators to contract rigs and continue drilling,” Mr Hale continued. “However, all of this will be short-lived if pricing of natural gas continues to decline.”

In assessing the factors at play, particularly current supply and import levels, Denny Smith, director of corporate development, Nabors Industries, is also looking for things to be “flat-ish for the near term, at least the first half of 2008. We think the rig count will hold steady…we may add another couple hundred rigs at best. Next year is likely to be challenging, but late ’08 could set up for a strong finish,” he said. “The fourth quarter of ’08 may change depending on weather and other factors.

“If we do end up with a moderate to soft market, we could set up for snap back,” he said.

Mr Smith said he also believes weather remains an important variable. “A moderate winter in Europe could impact the influx of LNG,” he said. “And if we have a mild winter in the US, we will continue to have a big supply.”

He does, however, foresee some positive events impacting the market, including the opening of the Rockies Express and other pipelines, which will reduce price differentials and lead to reduction in the stockpile of gas in the West.

“Price differentials, when you look at the Henry Hub in Louisiana and the Opal Hub in Wyoming, have been as large as $2 or $3 per MCF,” he said. “In the spring and fall, when gas demand is especially low, there is a real big difference.”

He noted that Opal prices have, on occasion, dropped as low as $1 per MCF, while Henry Hub have been around $6.

Although Canadian gas production has dropped, Mr Smith projected that increased oil exploration and production activity in the vast Canadian oil sands over the next several years will trigger a boost in gas demand.

The oil sands will “require a lot of gas to process and separate the sand and oil. It’s huge, going like crazy,” he said. The increased need for Canadian gas in that endeavor could further reduce Canadian gas exports to the US, which in turn will help balance out the supply in the United States.

While oil is not a huge driver of domestic drilling, accounting for less than 25% of US land drilling, it does have a place in the grand scheme of things, suggested Marshall Adkins, managing director of energy research at Raymond James & Associates. “Oil pulls gas prices with it, and oil prices are moving up,” he said. “Most (drilling) activity is natural gas-directed, so oil prices are relevant as they relate to gas prices.

“Oil prices will continue to move higher due to limited global supply and growing international demand,” he said.

Gas prices, however, will remain flat for the near term, Mr Adkins said. “We’re looking for lower prices through the first half of 2008; prices will firm up in the back of 2008.”

Supply is a key factor, more so than the economy, he said. “Manufacturing drives demand for gas. As long as prices stay low, demand will stay high.

“Operators are stubbornly ignoring current prices and looking ahead,” Mr Adkins noted. “The commodities market is saying gas prices will do better in 2008. Operators are basing their plans on $7.25 for the next several months…maybe higher for 2008.”

Mr Adkins agreed that the growing rig supply is creating a situation of more rig supply than demand. “There are more rigs, so prices will drive lower. We’ve added new rigs, so the capacity has gone up …. a couple hundred per year, but we’re retiring old ones,” he said. “We’re drilling faster… and rigs are more efficient. However, this is offset by the fact that we are drilling deeper and more complicated wells.”

Price will be the determining factor, he said. “At $7.25 (gas prices), we’re not going to see an improvement in drilling activity. At $9, we’ll see a 10% increase.”

Mr Pickering speculates the rig count will go down by 50 to 150 units due to soft market conditions through the second quarter of 2008. However, the rig supply will continue to grow, meaning the “utilization trend will go down … to around 85%,” he said. “We’ve added a lot of capacity with new rigs and more efficient rigs, so we can drill more rigs with the same rig count.”

In assessing the overall gas environment, Mr Pickering said there could be a “pause in drilling activity exacerbated by the incremental rig supply.”

Still, his overall outlook remains positive. “Rig activity has found a new level; the days of the rig count being under 1,000 are over,” he said. “The market will have a tough time being depressed for a long time. There is such a fine balance between supply and demand that when the market slows down, a shift for even two months can bring things back to equilibrium quickly.”

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