Bad News Ahead for Patterson-UIT and Land Drilling Peers

The Company: Patterson-UTI Energy, one of the largest onshore drilling contractors in North America.
The Filing: FORM 10-Q filed with the SEC on August 1, 2008.
The Finding: The North American gas drilling industry suffered an earthquake of uncertain magnitude last week when Chesapeake Energy, third-largest overall producer of natural gas in the US, slashed its drilling capital expenditure budget by $3.2 billion, or 17 percent, for the second half of 2008 through 2010. Contract drillers, like Patterson-UTI Energy, which are highly dependent on onshore drilling activity, will likely witness an adverse tectonic shift in forward demand for its drilling rigs and services.

The Upshot: The volatility of natural gas prices, and to a lesser extent oil, inherently as made contract drilling a cyclical growth industry for many years. During 2006, the average market price of natural gas retreated from then record highs of $8.98 per Mcf in 2005 to an average of $6.94 per in Mcf in 2006, resulting in customers of Patterson moderating their drilling activities during 2007. Further compounding the slowdown, too, was an excess of capacity from the introduction into the market of newly constructed land drilling rigs in the United States in early 2007.

In the first half of 2008, prices for natural gas rebounded to an average of $10.33 per Mcf, leading to the characteristic increase in drilling activity and equipment rental. The two primary metrics used to assess the health of the company's contract drilling business are the average number of rigs in operation and revenue being generated per rig:

For the month of August, the company had an average of 278 rigs in operation, up from 244 per day as of the second-quarter 2008 ended June 30; and,
Average revenue per operating day, declined 35.7 percent in the second quarter of 2008 to $18,740 from last year, due to several rigs activated late in the quarter.

Chairman Mark Siegel told analysts on the company's July 31 earnings call that Patterson-UTI remained bullish on customer demand and in response the company expected its rig account for the third-quarter to increase sequentially by approximately 30 rigs. In addition, management expected its third-quarter per drilling day margin would increase by approximately $300 per day. This optimistic guidance, however, assumed continued strong commodity prices, with natural gas prices at $9 or higher.

As of September 26, 2008, NYMEX Natural Gas Futures for October delivery closed down $0.252 at $7.472 per MMbtu.

The Question: Could a sustained pullback in natural gas prices, combined with excess capacity in industry new builds, adversely impact the outlook for drill rig utilization and put a cap on spot day rates at Patterson-UTI and its competitors?

David Phillips

David Phillips has more than 25 years' experience on Wall Street, first as a financial consultant and then as an equity analyst for several investment banking firms. He sifts through SEC filings for his blog The 10Q Detective, looking for financial statement soft spots, such as depreciation policies, warranty reserves and restructuring charges. He has been widely quoted in outlets such as BusinessWeek, The International Herald Tribune, Investor's Business Daily, Kiplinger's Personal Finance, and The Wall Street Journal.

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