Land drilling is highly cyclical, fragmented, and extremely competitive, historically challenged by chronic pricing pressure. As a result, drillers have found it difficult to consistently generate economic returns over the course of a cycle. However, in recent years the market leaders, Helmerich & Payne (HP), Nabors Industries (NBR) and Patterson-UTI Energy (PTEN), have carved out a growing, profitable niche by providing higher-horsepower AC-powered rigs to serve growing demand for unconventional production and horizontal drilling. These drillers, which control only about one-third of the overall land-rig market, make up about half of the unconventional shale-drilling market and about 85% of the industry's AC-drive rig fleet. As the industry continues to upgrade its fleet with more powerful and more efficient rigs, we anticipate that these premium-rig providers will benefit disproportionately over the medium term as mechanical and silicon-controlled rectifier, or SCR, rigs are gradually rendered obsolete.
Land Drilling Is a Challenging, No-Moat Industry
Land drilling is a commodity industry in which competitors have historically demonstrated little differentiation and customers have therefore had low switching costs. Contract land drillers provide rigs, equipment, and crew to drill wells for a contracted period or on a footage-per-well basis. Drilling rigs are not proprietary, assembled with parts from third-party suppliers, though they can be customized with technical specifications and modifications to suit particular well conditions. Contracts contain agreed-on day rates, and terms can range from six months to seven years depending on rig supply and demand. Contracts are often awarded on a bid basis, based often on price as well as the availability and condition of equipment. Customer relationships and differentiation on rig efficiency, quality of service, and safety track records, can help secure contracts and renewals, but historically, drillers have had little pricing power unless rigs are in short supply. Rigs that are not contracted out are available on a spot basis for short-term work or "stacked" (idled) if there is not sufficient demand. New rig orders are often supported by multiyear contracts, which protect contractors from capital outlay risk, as newbuilds with contracted terms of three years or longer can usually recoup most if not all of the rig's capital investment over the life of the contract. When rig demand is high, competitors also often build on speculation as well, owing to the long lead time (nine months to a year) of key rig components.
Drilling activity and profits are driven primarily by the commodity price outlook for oil and gas. Rig activity and new rig orders have historically been tied to movement in commodity prices, as the price outlook determines near-term drilling profitability and the capital spending budgets of drillers' exploration and production customers. Hence, when commodity prices drop, spot day rates can decline quickly toward cash costs as competitors try to keep up utilization. For short-term commodity price dislocations, customers tend to put rigs on standby, paying a discounted day rate. However, as the price outlook turns pessimistic for the medium term, customers cut drilling programs and either sublease rigs to competitors--even if it requires subsidizing the day rate--or pay contract termination fees, effectively buying out the remaining term. Customers also become less willing to sign long-term contracts for new or spot-market rigs. On the flip side, when the commodity price outlook and utilization are strong (greater than 80% utilization, generally), day rates can rise quickly until supply catches up with demand. Stacked rigs are reactivated (for a cost, if idled for a long time), and new rig orders--both contracted and speculative--resume.
Low barriers to entry and few scale benefits bring industry fragmentation and chronic pricing pressure. Larger competitors have been able to realize some benefits of scale and experience, though. Particularly with the rise in popularity of AC-drive rigs, larger customers who seek a newbuild program of multiple rigs, complete with proper insurance, trained crews, maintenance, and technical support, tend to look to the few larger operators with this infrastructure in place. Smaller players may not have the financial capital available to make the rig investments as quickly as demand can pick up. Similarly in downturns, small players, which tend to be more thinly capitalized, may not have the liquidity to withstand a sustained period of lower day rates and utilization.
Overriding any scale advantage, however, is the industrywide argument among small and large players alike: Of all factors, the crew (provided by the driller) matters most. As a result, many players have been able to consistently compete where their crews have extensive knowledge and experience of the local terrain and drilling conditions. But the crew, which makes up about 60% of the driller's costs, cannot command premium day rates alone, in our opinion. Consequently, the industry is fragmented, and competition is largely regional. However, land rigs (and crews) are also mobile. Therefore, when it becomes economical, drillers or customers may move rigs from a region of low demand to one of higher demand in order gain better utilization, though likely at the expense of shifting the problem of oversupply to a new location. Combined with low barriers to entry (as a typical rig costs only $15 million to $20 million), the industry is therefore prone to supply and demand imbalances. The top three players (Helmerich & Payne, Patterson-UTI Energy, and Nabors Industries) make up 30% of the market, with the balance made up of E&P operators (which constitute 15% of the fleet) and hundreds of mostly private companies.
New rig technologies have recently provided some drillers with a tangible source of differentiation and cost benefit for customers. In recent years, high-spec drilling rigs (which use AC-powered top drives and moving systems) have proved to be much more efficient for customers than conventional, mechanical rigs, and hence have been able to garner premium pricing and long-term contracts. However, we do not believe that using top-of-the-line drilling technology provides a sustainable edge, as drilling innovations such as top drives and steering technology are not proprietary. As rig technology trends gain widespread acceptance, we generally expect all proven "high-spec" features to eventually become part of the industry's standard offering.
Though scale, experience, and reputation can proffer more business opportunities, barriers to entry remain low, competition is fierce, and pricing pressure is therefore a chronic condition. These volatile and difficult industry dynamics have made it difficult for industry participants to differentiate in what is ultimately a commodity service and to consistently earn returns above the cost of capital.
Drilling Efficiency Gains From New Rig Technology and Process
For decades, U.S. land drilling was driven primarily by natural gas pricing. As gas prices moved, so did E&P players' cash flows, capital spending budgets, and rig utilization. Drilling activity and the national rig count (affected by new rigs added, idle rigs activated, and obsolete rig retirements) were therefore strongly correlated to these price movements (though with a lag because of the several months needed for new rig orders and long-term contracts).
Development of unconventional shale resources has brought on a new dynamic in recent years that has weakened these historical price/rig activity correlations. In particular, unconventional oil and gas wells often require horizontal/directional drilling up to 6,000 feet, a process that favors electric-powered top drives and higher-horsepower draw-works. As a result, a new class of Tier 1 AC-powered rigs, featuring better control of torque and penetration rates, has emerged over the past few years. The new rigs' faster and more precise drilling has bolstered the potential of unconventional production, and hence horizontal drilling, oil/liquids-directed drilling, and premium rig demand have all taken off.
These drilling efficiencies have, in turn, translated into real cost savings for oil and gas producers. Helmerich & Payne, which owns the largest fleet of AC rigs in the industry, estimates that its typical FlexRig can drill and complete a well in only 15 days, roughly half of the time it would take a conventional rig. The time savings convert into a material cost savings for customers, despite higher day rates. H&P estimates that a new rig can save customers $480,000 per well and drill 12 more wells per year.
Southwestern Energy (SWN), an E&P operator in the Marcellus and Fayetteville shale plays, has reported remarkable productivity gains as a result of these changes in rig technologies over the last five years. In 2012, Southwestern's average time to drill a well declined to 7 days, a 61% improvement from 18 days in 2007, and average lateral length increased 81% over the same period to 4,833 feet. Similarly, its wells per year per rig improved more than 138% from 18 wells in 2007 to its last report of 43 wells in 2011. These improvements have translated into lower costs: Southwestern's total drilling and completion costs per well have steadily decreased over the past five years from $3 million in 2008 to $2.5 million in 2012.
In addition to rig innovation, drillers have also improved the drilling process through pad drilling and batch drilling to further cut costs. As high-spec rigs have allowed greater precision and control of the drilling path, drillers and their customers have been able to optimize well placement, so that they now favor drilling multiple wells per pad rather than just one as in the past. Where the terrain allows, the pad-drilling approach is most optimal because of its reduced nonproductive days (used for travel and set-up) and shared construction costs, equipment, and facilities. The smaller surface footprint further reduces environmental impact and risk. This, combined with a batch-process approach (drilling several wells' surface holes at once, then their intermediate sections, then their laterals), have enabled cost savings of about $2.5 million per pad, or $500,000 per well, from reusing tools and equipment across wells.
For the drillers, the growth in pad drilling has contributed to the rising popularity of self-moving systems, which allow land rigs to walk/skid between wells on a pad without having to fully disassemble and reassemble the rig. Rigs with moving systems can walk with hydraulic feet or skid along rails to move 25 to 30 feet between wells in only about two hours, with the rig set-up largely intact. In contrast, the traditional option, which entails "rigging up" and "rigging down" and moving by truck or other equipment, can take five days. Demand for rig moving options has been so robust that drillers have been adding walking or skidding systems to both new and existing AC and SCR rigs recently, as well as modifying rig design to allow greater walking clearance between the rig floor and the ground to enable the rig to navigate around pad obstacles between wells.
Helmerich & Payne's Early Bet on AC-Drive Rig Technology
Helmerich & Payne recognized the potential value of more flexible and powerful rigs early and became the first major player to invest in AC rig technology in 2002. Its first AC-powered rig, the FlexRig 3, immediately delivered impressive, consistent performance, commanded premium day rates, and triggered a steady shift in H&P's fleet toward nearly all AC-drive rigs. While Patterson-UTI Energy and Nabors Industries instead opted to continue to utilize and refurbish their mechanical and SCR rig fleets, H&P capitalized on its first-mover advantage and market trends. In the 10 years since the launch of the FlexRig 3, H&P doubled its market share to 13.5% and took the industry lead of the AC-rig market at now 40% of supply. Meanwhile, partly because they were slower to embrace customers' shifting preference toward AC-drive rigs, Patterson-UTI's and Nabors' market shares declined over the same period by 50% and 40%, respectively.
In addition to gaining market share, H&P's bold investment decision proved very profitable, as H&P's premium day rates also enabled improving margins and returns since its first AC-rig investments in 2002.
We also believe H&P has gained valuable drilling experience with its newer rigs, as it has continually focused on improving productivity and cutting costs. Since 2007, the firm's footage per day increased by over 50% and average well depth increased by over 40%. Additionally, we believe H&P's now largely uniform fleet has enabled assembly, maintenance, and training cost benefits as well.
While we believe H&P still has room to run in the near term thanks to its premium fleet, we also anticipate that gaining further efficiency from its fleet will be only incremental as these technologies and the unconventional drilling process mature. The industry's rapid efficiency gains have been impressive, but it's important to recognize that these outsized gains merely demonstrate how inefficient unconventional drilling was before. With all major players (including the large public companies and private firms alike) able to offer viable competitive high-spec rigs, they have been able to mutually gain from their horizontal drilling and hydraulic fracturing experience simultaneously, and the best and most efficient practices are becoming the industry norms. As rig technology continues to mature, the drilling process appears to be entering a factorylike manufacturing phase.
Consequently, we expect operators, contractors, and rig equipment manufacturers to continue to refine the drilling process, albeit at a slower pace than when unconventional drilling first took off several years ago.
Today, services and equipment firms are working on improving downhole motors, fluid-handling systems, automation, and "smart drilling systems," all of which ultimately contribute to better monitoring and control of horsepower and penetration rate. Some contractors have also upgraded rigs to employ bi-fuel systems that can run on diesel and natural gas when available. Nabors has commented that it believes automation and remote monitoring will be the next step change in rig technology.
Patterson-UTI and Nabors: Rig Refurbishment and Fleet Upgrades
While H&P made early investments in completely new AC rigs, Nabors and Patterson-UTI took a more gradual approach by first refurbishing their older mechanical and SCR rigs. Nabors, for instance, upgraded 30 SCR rigs to an SCR-Plus version, which with its added features (typically a top drive, digitized auto-drill functionality, and increased pump capacity) is reportedly as capable as an AC-drive rig. Between its AC and SCR-Plus rigs, it has built up a fleet of roughly 245 premium-quality rigs at a rapid clip since 2005.
Patterson-UTI, likewise, has been rapidly adding to its premium rig count, now at 117 APEX rigs, over the last few years. Though each firms' premium rig counts still lag H&P's 267 rigs, it is important to highlight that Patterson and Nabors also maintain sizable fleets of mechanical and SCR rigs and operate other oilfield service segments that contribute up to a third of profits.
Now that the large land drillers (as well as small private players) all have viable and competitive rigs, H&P may have difficulty maintaining its premium margins long term. Competition in the AC-rig niche is rising as Patterson, Nabors, and others continue to "high-grade" their fleets. As Nabors and Patterson add new rigs and retire less-capable rigs, their average day rates are set to rise at a faster clip than H&P over the medium term.
In our projections for each company through 2017, we therefore expect the big three to continue to reap benefits through premium day rates and margins on their expanding AC-drive fleets over the medium term. In 2013, new-rig delivery estimates have continued to come down over the course of the year with an uncertain outlook on oil prices, from 150 rigs to now about 100 (75% of which will likely be AC-drive rigs, by H&P's estimates). Of these, H&P plans to deliver about 20, Patterson 13, and Nabors 18, which will make up about 70% and 50% of the industry's AC and total rig newbuilds this year. After this sluggish 2013, once the commodity price outlook stabilizes for E&P customers (in favor of either oil or gas), we forecast drilling activity, rig utilization, and new orders to improve margins and returns for H&P, Nabors, and Patterson through 2017.
Note that by supplying roughly 70% of the industry's AC rigs, less than the big three's current market share of about 85% of AC rigs, our forecasts imply a declining combined market share, increasing competition in the premium space, and eventual (beyond our 2017 forecasts) margin erosion. To begin to capture this in our company projections, we therefore assume lower newbuild investment rates in perpetuity (decreasing capital spending to 1.3 to 1.6 times depreciation after 2017, compared with an average of 2.2 times depreciation for Nabors, Patterson, and H&P over the last five years) and 3% terminal growth for all three firms.
It's also worth highlighting that in a relatively down year for the drillers in 2013, we expect the big three's supply share to actually increase to 70% from about 40% of new rig deliveries last year (a stronger year of more than double the demand). We believe that this ability to deliver rigs in a period of great price uncertainty in fact demonstrates the scale and capital advantage of H&P, Nabors, and Patterson, compared with smaller peers. In our view, this financing flexibility is pivotal as it allows for longer-term newbuild program planning and the ability to deliver quality rigs (and crew) on a timely, consistent basis, a highly valuable consideration for larger E&P customers with committed medium-term drilling plans.
Mechanical Rigs: Down but Not Out
The combined impact of improving rig technologies, the growth in unconventional and liquids-focused drilling, and pad drilling have kept demand for AC-drive and upgraded SCR rigs fairly steady and strong. High utilization for these 1,000- to 2,000-horsepower rigs, however, has come at the expense of conventional mechanical rigs (generally below 1,000 horsepower) that have fallen out of favor and are being displaced by higher-spec rigs. Conventional rigs have seen their market share of the rig count decline commensurately from about 1,000 in 2008 to about 600 in early 2013, while AC rigs roughly doubled to 580 rigs over the same period.
Given the continued development of unconventional shale plays and horizontal drilling, we anticipate that many mechanical rigs with sub-1,000 horsepower will be retired over the next cycle. Cold-stacked, lower-horsepower rigs (idled for a long period with no active crew and hence minimal maintenance costs) are most vulnerable to obsolescence, as it can cost $3 million to $4 million to bring these rigs back to work. Depending on market day rates, we estimate it could take three to five years to recoup the cost.
While the long-term outlook for mechanical rigs isn't particularly bright, they are not immediately doomed either. Patterson and Nabors maintain sizable fleets of mechanical and SCR rigs, about 195 rigs and 120 rigs, respectively. Of these, only about 40% are active. We believe some of these underutilized assets are capable of earning solid returns for current shallow-basin work and future gas-directed drilling.
Conventional rigs have proved useful in several basins where vertical drilling is still prominent (such as the Permian) or in shallower basins with horizontal drilling (such as the Mississippian Lime). Additionally, in numerous plays such as the Fayetteville, Marcellus, and Permian, mechanical rigs have proved valuable when used in tandem with higher-horsepower rigs. Conventional rigs are often used to drill the initial vertical shaft of a well and followed up by a "fit for shale" rig, which later handles the horizontal/directional laterals. Employing the mechanical rig for the vertical portion can reportedly save $50,000 to $100,000 per well. Drillers have also been able to improve mud systems, add automation, and enhance mobility to make conventional rigs suitable for such niche markets so that the rigs can earn an economic return on low, largely depreciated book values.
Moreover, the industry's conventional rig fleet wields significant upside value, when dry gas drilling picks up again in the U.S. With the gas-drilling rig count at an 18-year low at about 350 rigs, there is considerable upside from adding 100 to 200 rigs once the natural gas pricing outlook improves. We believe it is precisely this scenario of revitalized gas-drilling activity that preserves the option value of Nabors' and Patterson's older idle rigs. When natural gas prices rise and stabilize, a payback period of several years (or less depending on day rates at the time) becomes reasonable, poising these rigs to again earn economic returns.
Nabors has estimated the potential value of idle rigs (mostly mechanical and SCR) going back to work. According to its estimates, 20-60 of its "warm-stacked" (or "ready status") idle rigs could bring in an additional $40 million-$175 million of EBITDA or up to a 20% increase from Nabors' U.S. land drilling EBITDA in 2012. Notably, Nabors also has a significant international drilling footprint, and therefore could also move conventional rigs globally if commodity prices (and mobilization costs) warrant. Thus, despite the outdated nature of mechanical rigs, we believe their option value remains solid.
Our Drilling Outlook
The big three drillers now make up 85% of AC-rig supply (with H&P itself responsible for 41% of all AC rigs) and only about 30% of the total industry fleet, which highlights the still relatively low penetration rate of AC rigs into the total drilling market. This bodes well for new rig growth prospects, between both replacement demand of roughly 600 rigs that are more than 25 years old, and the continuing rise of unconventional drilling and production.
While H&P, Nabors, and Patterson currently dominate AC rig supply, we don't think greater market share converts to any sustainable competitive advantage. Because of the low barriers to entry, land drilling remains a commodity industry. Notably, of 223 rigs delivered in 2012, the big three introduced only about 40%, while the remaining 130 rigs (which we assume are higher-quality AC or SCR rigs) came from smaller players. Over time, we therefore project that AC-rig supply will diversify sufficiently to become the standard rig offering, gradually eliminating premium rig differentiation and economic returns.
For the big three drillers over the near and medium term, we expect Helmerich & Payne to continue to lead the pack with its best-in-class fleet and execution, while Nabors and Patterson continue to high-grade their fleets and find selective value for their older mechanical and SCR rigs. Currently, H&P and Patterson-UTI are both trading closely to our fair value estimates, while Nabors appears the most undervalued. Of the group, we'd highlight H&P as the highest-quality land driller, given the strength of its fleet and track record of execution, and Nabors wields the most valuation upside, trading at 0.75 times our fair value estimate of $20. Nabors is currently trading for less than its tangible book value per share of about $19 per share, but its recovery story bears considerably more risk, given a promising turnaround plan amid a sordid stewardship track record and almost global underperformance across its business segments over the last few years. Its recovery is therefore likely to take time. Patterson-UTI, could be an attractive alternative if its stock were to trade at a discount as well, and we'd highlight its recent buyback of 7% of its shares outstanding at undervalued prices.
Thus, despite the broadly unattractive no-moat characteristics of land drilling, we continue to believe the big three are set to extract value whenever possible in the context of a volatile and somewhat unpredictable industry backdrop. Because of their scale, stable financial position, capital access, and lengthy experience navigating industry peaks and troughs, we believe H&P, Nabors, and Patterson are well positioned to grow and prosper for the medium term.