SPECIAL FOCUS: NORTH AMERICAN OUTLOOK

Small E&P firms to determine direction of US land market

While large E&P companies involved in exploitation of unconventional reserves continue employing a large number of rigs, small firms, more prone to seasonal behavior, will direct overall trends for the year.

Richard Mason, Publisher, The Land Rig Newsletter

Is it the pause that refreshes, or a signal of a maturing land market? With the first half of the year behind the industry, the US land market is still a puzzle when discussion turns to how drilling activity will play out in 2007. Depending on which rig count one follows, activity is either slightly up (Baker Hughes, by 4.6%) or has decreased by as much as 100 rigs at various times since October 2006.

Operators are on record for single digit percentage increases in 2007 capital expenditures for the onshore market, according to various industry spending surveys. The question is whether increased field costs account for the increased Capex, while drilling levels stay similar to 2006. The land market has certainly witnessed its share of extenuating circumstances. Persistent late winter weather in the first half of 2007 yielded to a very wet second quarter, particularly in south-central US drilling markets, hobbling rig moves and slowing drilling programs well into summer.

A BIFURCATED MARKET

Numbers from Fort Worth-based RigData, a permit and rig activity tracking service, show first quarter 2007 drilling volume dropped 6.3% sequentially to 54 million ft in the major US onshore drilling markets, exceeding the mild 1.4% decline in the fourth quarter 2004. On a nominal basis, the first quarter decline amounted to 3.5 million ft versus the prior quarter. For background, consider that the onshore market has more than doubled its quarterly footage run rate from a trough of 22 million ft in the first quarter 2002 to a peak of 58 million ft in the final quarter of 2006, the most recent high. During that time, the onshore market evolved into two segments as higher commodity prices and technology advancements opened unconventional reserves to economic exploitation (see World Oil, pg. 43, August 2006).

It helps to examine multiple data points to see whether the market has softened or just paused to catch its breath. Recent industry metrics confirm the onshore market has bifurcated, with each segment exhibiting measurable, though dissimilar, characteristics. Those metrics support the general consensus that the US onshore market has undergone a transformation that emphasizes unconventional oil and gas targets, typically defined as tight sands, shales and coalbed methane. The bifurcation is reflected in industry data points such as rig counts, footage and rig employment patterns among E&P companies; the metrics associated with unconventional drilling grow, while those tied to conventional activity fluctuate seasonally, or respond to price-based market events.

The issue remains whether the unconventional phase of evolution in the onshore market is flattening out after non-stop growth over the last three years-just when the conventional segment reaches the latter stages of maturity. First quarter 2007 experienced a decline in footage for only the second time in four years, according to RigData tallies. The event had two manifestations: while overall footage dropped, non-vertical footage increased. Non-vertical footage is a reliable proxy for unconventional activity.

Migration to onshore. Growth in the unconventional market is tied to the diffusion of technologies from the offshore environment to onshore applications. It also illustrates a migration of independent E&P firms who exited the offshore shelf and moved onshore into unconventional plays. The June 2007 announcement that Newfield Exploration is selling its Gulf Coast shelf properties to concentrate on the Woodford Shale, Monument Butte and other US land positions was the latest in a series of transactions. These date to 2004 and involve offshore independents gaining positions in unconventional plays through acquisitions, including Noble Energy/ Patina Oil and Gas (2004), Kerr McGee/Westport (2004) and Pioneer Natural Resources/Evergreen (2004). At the same time, several land-based E&P firms amassed onshore properties in unconventional plays through acquisitions, including EnCana/Tom Brown Inc. (2004), ConocoPhillips/Burlington Resources (2005) and Anadarko Petroleum Corporation/Kerr McGee/Western Gas Resources (2006).

These events represented a modern-day land rush as large E&P firms jockeyed for positions in unconventional shales or tight sands. Everyone either had an unconventional play, or was looking to get into one. The trend culminated in 2006, which was the year of the shales. Production grew significantly from the Fayetteville and Woodford shales (both closing in on 100 MMcfd) as well as continued extension of the Barnett Shale play. That land rush is largely finished, and the industry is actively monetizing the reserves, which may be a sign that the onshore unconventional play is transitioning from an expanding discovery phase to a more mature, stable exploitation phase.

SEASONALITY IN RIG USE

The publicly held national drillers reported as many as 160 rigs stacking out for lack of work during first quarter 2007 earnings reports. Footage dropped sequentially, and The Land Rig Newsletter surveys found day rates initially declining between 10 and 15% after the first of the year, indicating the supply of drilling rigs exceeded demand for drilling services. At mid-year 2007, day rates had firmed for intermediate rig classes in many geographic markets at levels that were 15 to 20% below 2006 peaks. They were still falling in modest increments of a few hundred dollars a day for smaller class rigs, particularly in the Midcontinent and Permian basin.

Why the decline? Yet the question persists: Has the market grown soft, or was it simply snakebit by a combination of external events like weather? Rig employment patterns provide some markers to watch in the third quarter. For example, the conventional market is characterized by greater seasonality in rig count than the unconventional market. This is evident when measuring the number of companies employing land rigs. That total fluctuates up and down by as much as 70 companies annually, hovering around an average of 525 operators. Figure 1 illustrates the cycle on a quarterly basis. The trend line shows fewer operators employing rigs during the first half the year and more operators employing rigs in the second half. These oscillations relate to seasonality for smaller E&P firms, tied more often to conventional oil and gas targets, who are assembling prospects, financing and resources early in the year and moving into the field in the second half of the year. These companies seldom appear in the various industry spending surveys, yet their behavior has significant influence on rig employment in the second half of the year. The number of operators employing land rigs dropped to the lowest levels in three years during the first half of 2007; the unanswered question is whether this segment of rig employment will re-enact seasonal patterns or remain on the sidelines in 2007.

Fig. 1. Seasonal rig employment patterns.

Changing structure in onshore rig demand. The market exhibits greater concentration in rig employment among fewer firms whose main emphasis is on exploitation of unconventional oil or gas reserves. Figure 2 contrasts rig employment for the largest and smallest drilling programs. In early 2004, both segments accounted for roughly 40% of rig employment. However large independents have increased rig counts aggressively over the last three years, with most of these involved in unconventional natural gas programs. Currently the most aggressive drilling programs, which consist of about three dozen E&P firms employing 10 or more rigs, account for 55% of rig employment, while the smallest drilling programs, which consist of roughly 425 E&P firms employing three rigs or less, have seen share decline to about one third of the market.

Fig. 2. The growing contrast of rig activity by program size.

The Land Rig Newsletter studies indicate the Top 5 E&P rig employment programs have grown from 14% of active rigs in the second quarter 2005 to 20% of active rigs in the second quarter 2007. Even at peak rig counts in October 2006, the Top 5 rig employment programs reflected 18% of active rigs. The cast changes by quarter, but the largest domestic land drilling programs include Chesapeake Energy Corporation, XTO Energy, Inc., ConocoPhillips Company, Devon Energy Corporation, EOG Resources, Inc., EnCana Corporation and Anadarko Petroleum Corporation, who employ anywhere from 45 to 140 rigs each. A change in rig employment behavior among a half dozen E&P firms can have significant impact on rig demand nationally. The thesis is that growth through the larger E&P firms is blocking prospects in unconventional plays and relegating smaller E&P firms to a shrinking pool of highly mature conventional prospects. The smaller E&Ps find these prospects marginally economic and subject to fluctuations in commodity prices and service cost pressures.

Figure 2 also shows that rig use by large E&P firms flattened in the first half of 2007 following notable expansion after 2004, raising the question of whether the most aggressive firms have peaked in rig employment following the 2004-06 land grab. The graph also shows seasonality among the smaller E&P drilling programs. If large E&P companies have peaked, rig count direction for the remainder of 2007 rests solely on the seasonal behavior of small and privately held E&P firms.

UNCONVENTIONAL DRILLING UNPHASED BY DECLINE

Unconventional efforts often employ non-vertical drilling to apply precision-placed multi-stage fracture stimulations downhole to open low porosity reserves that were previously uneconomic. Non-vertical drilling therefore serves as a proxy for tracking unconventional efforts. Evidence of market bifurcation is present in Figure 3, which illustrates trend lines for quarterly footage in vertical and non-vertical configurations. Vertical footage declined 10% during the first quarter 2007, falling to fourth quarter 2005 levels. The decline is tied to conventional drilling with small E&P firms seasonally stepping back from the rig market. In contrast, non-vertical footage volume, a proxy for unconventional oil and gas targets, rose from 26% of the footage market in the fourth quarter 2006 to 29% in the first quarter 2007.

Fig. 3. Footage drilled in vertical and non-vertical wells.

The unconventional market has two major bookends. The first is the shale plays in the south-central United States including the Barnett, Fayetteville, and Woodford shales; the second is tight sands and shales in Wyoming and Colorado. Horizontal drilling is more common in the south-central US, while directional drilling more frequently manifests in Colorado and Wyoming. Horizontal footage rose 40% year over year, including 7% sequentially during the first quarter 2007. Much of the gain derives from expansion in drilling activity in the Fayetteville (Arkansas) and Woodford Shales (Oklahoma), coupled with continued expansion in the Barnett Shale play in North Texas. The Barnett Shale accounted for 54% of horizontal footage in the first quarter 2007 and is equivalent in volume to the combined directional footage in Colorado and Wyoming, Fig. 4. Similarly, directional footage grew 14% sequentially in Colorado in the first quarter 2007 and was up 47% year over year.

Fig. 4. Non-vertical footage drilled in the Barnett Shale vs. Colorado and Wyoming.

RIG CAPACITY EXPANDS; PRICING IS SOFT

Two major 2007 questions for operators involve rig capacity and rig pricing. RigData recorded more than 140 rigs entering the market in the first five months of 2007, led primarily by newbuild programs at Helmerich & Payne I.D.C. and Nabors Industries. RigData estimates more than 275 units are headed to the fleet in 2007, based on contractor surveys. That has created concern that rig supply will vastly exceed demand for drilling services in 2007. However, attrition plays a role in net capacity additions. According to the Reed Tool Census, attrition historically ranges between 4 and 8% of the rig fleet. With attrition similar to historical levels, net growth in the US land fleet should be half to two-thirds of rig additions in 2007. For example, while the land fleet witnessed the addition of 140 new units during the first five months of 2007, the marketed fleet actually declined by 35 units during the same period, indicating that refurbished or newbuild units are replacing legacy conventional rigs.

Figure 5 shows capacity additions clearly overshot demand for drilling services in late 2006. Percentage utilization of the US land fleet declined steadily from 84% in January 2006 to 80% when rig count peaked in October 2006. Afterwards utilization fell rapidly to 74% in March 2007. Utilization improved to 77% at the end of the second quarter 2007, but had not yet reached the 80% level at which rig pricing tends to strengthen.

Fig. 5. Marketed rig counts compared to active rig counts. .

A majority of leading indicators suggest activity will improve in the second half of 2007 and should be enough to absorb additional rig capacity. Rig pricing should firm, though it is unlikely to repeat the peak levels seen in the second half of 2006. That has been the forecast story line all year, yet those expectations had not yet shown in field activity. The answer to whether the land market has entered a more mature phase, or is simply pausing to catch its breath depends on the rig employment patterns of small and privately held E&P firms in 2007, the “dark matter” of the US land drilling universe.

THE AUTHORS
	Richard Mason, is publisher of The Land Rig Newsletter, a monthly publication that provides trends analysis for the land-based contract drilling sector of the oil and gas industry. He previously worked 10 years as a field historian for the Texas Tech University archives, collecting historical materials on petroleum, agriculture and irrigation development in the American Southwest. Mr. Mason is a 1974 graduate of Ohio University with a bachelor of arts degree, with honors, in history.