Yesterday, one of the largest onshore contract drillers in the U.S., Patterson-UTI Energy Inc. (PTEN), declared its Sep 2009 drill rig count to average 81, up from 72 in the previous month. The company operated 77 rigs in the U.S. and 4 in Canada in September, compared to 69 rigs in the U.S. and 3 rigs in Canada during August.

Patterson’s activity levels in the U.S. peaked in early Oct 2008, with a rig count of 275. Since then, the company has been witnessing a steep and rapid decline on the back of decreased demand largely caused by lower commodity prices for natural gas.

Favorable prices over the last few years led to increased natural gas drilling, with the total onshore rig count scoring an all-time high in 2008. As a result, after remaining essentially flat for almost 9 years (1998?2006), natural gas production went up by around 5.5% in 2007 and in excess of 9% in 2008.

Natural gas prices rallied earlier last year, reaching over $13 per million British thermal units (MMBtu) in July 2008, before trending down to a seven-year low level of sub-$2 per MMBtu (we are referring to Henry Hub spot prices here). Continued strong domestic production (from a number of unconventional natural gas fields) and recessionary consumption (due to the economic downturn), particularly in the industrial sector, are at the core of the commodity’s current woes.

Prices have rebounded somewhat over the past few weeks, currently settling at well over $3 per MMBtu, helped by some bullish storage data from the EIA as well as indications of an uptick in industrial production levels. But with the U.S. natural gas storage levels still remaining 16% above their five-year average, we do not see any sustained price gains on the commodity front.

Producers scaled back drilling operations over the past several months in the midst of falling commodity prices and tighter access to credit. However, the recent numbers suggest that companies are beginning to bring oil and gas rigs back on line amid signs of economic stabilization that could drive up energy demand.

The overall picture, though, remains weak, particularly for natural gas, whose inventories are threatening to surpass the all-time high level. The supply picture is expected to reverse in the coming months as the lagging effect of the sharp drop in domestic drilling activity takes hold.

Until then, we prefer to stay on the sidelines with land drillers such as Patterson-UTI, as reduction in rig utilization and drilling margins continue to weigh on the company. Heavy investments in rig construction during the last few years has helped increase the size of the overall drilling fleet, which is now coming back to gnaw at the industry as demand drops.

With the current U.S. land rig count down roughly 50% from its all-time peak (achieved in Aug 2008), we believe this idled drilling capacity will continue to weigh on dayrates and margins into 2010, even as the outlook for natural gas improves towards the end of 2009, in our view. Patterson-UTI remains particularly exposed to this weak outlook for land drilling given its commodity rig fleet and lack of contract coverage.

On the positive side, the company’s premium newbuild fleet and stellar financial health (free cash flow positive and a debt-free balance sheet) should help it weather the downturn better than its peers such as Nabors Industries (NBR). Additionally, in the context of the current economic conditions, we view Patterson’s decision to reduce its quarterly cash dividend to 5 cents per share as a step in the right direction.

We currently rate Patterson shares as Neutral.

Zacks Investment Research
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