Land drillers, as a group, are attractively valued today. We believe fears of another collapse in drilling activity similar to 2009 are overdone. While these drillers have no economic moat, their current competitive position is perhaps the best in the past decade. Prior industry cycles were driven by supply/demand dynamics, but with a U.S. fleet of mostly mechanical rigs that were refurbished over time as they aged. In our view, there was little differentiation between the top drillers and the rest of the industry. However, the shift toward horizontal and oil-directed drilling away from vertical and gas-directed drilling, thanks to the emergence of various shale plays in the United States, has driven huge demand for new premium land rigs, allowing the industry's top drillers to differentiate themselves from smaller peers by offering more powerful rigs.
Industry leader Helmerich & Payne (NYSE:HP) has benefited the most from this trend, thanks to its historical focus on premium rigs, but Nabors (NYSE:NBR) and Patterson-UTI Energy (NASDAQ:PTEN) also have put together respectable collections of new and powerful rigs. We estimate the top three players in the industry control about 50% of the unconventional shale drilling market and perhaps 90% of the industry's most powerful rigs, versus about 30% of the overall land rig market. The increased consolidation should let the land drillers command more sustainable pricing power during the next few years. The drillers also have a path to growth as alternating-current-powered rigs continue to take share of the overall land rig market as older mechanical rigs are retired, which should help buffer earnings in a typically volatile industry.
Shift to Shale Drilling Has Been Overall Positive for Industry
The land drilling industry has benefited from two major changes in recent years. The first is the shift from vertical drilling toward horizontal and directional drilling. This has been a decade-long trend, but it really took off in 2009 as oil and gas companies realized that horizontal drilling dramatically improved well productivity and economics. In early 2009, the number of active horizontal and vertical rigs stood at around 400 each; today, there are almost 1,200 active horizontal rigs and 600 active vertical rigs. The rigs required for this type of oil-directed, horizontal drilling tend to be around 1,500 horsepower and AC (alternating current) or SCR (silicon-controlled rectifier) powered. The vast majority of mechanical rigs built in the 1980s cannot drill these new wells economically. Thus, land drillers benefit from ordering new rigs that can earn day rates in the $20,000-plus range and land multiyear contracts. These rigs are very profitable replacements for a mechanical rig earning day rates around $12,000. Given the attractive liquids-associated economics for exploration and production companies, we expect demand for premium drilling rigs will continue to increase and take share from mechanical rigs during the next few years.
The second major shift in drilling is from gas to oil. The industry has translated its success in exploiting shale gas into drilling for oil trapped in tight sands and shales, particularly since natural gas prices deteriorated and oil prices remained high. Oil-directed drilling has increased from fewer than 200 active rigs in mid-2009 to almost 1,200 active rigs at the start of 2012. In contrast, natural gas drilling activity increased to almost 1,000 active rigs in late 2010 from the low 700s in mid-2009, before declining to just below 800 today.
Drillers' Fleets Reflect a Premium Shift
In the past few years, drillers have been adding premium rigs to their fleets to meet demand. Given the size of the top three drillers versus the rest of the industry, we think they have some bullish competitive dynamics for the first time in years. We estimate the largest drillers control about 50% of the industry's premium rig capacity and about 90% of the industry's Tier 1 rigs (primarily AC rigs). For the Tier 2 (older but upgraded SCR rigs) and Tier 3 (stock SCR) rigs, we estimate they control about 40% and 12% of each niche, respectively. The companies are adding around 110 new rigs in 2012, which should maintain their premium rig lead over smaller peers. Nabors and Patterson also recently retired more than 150 mechanical rigs (around 15% of their U.S. fleets); H&P retired the remaining 7 mechanical rigs left in its fleet, confirming the industry's shift toward premium rigs.
There is plenty of support for continued demand for premium rigs and healthy results from the land drillers. The attractive liquids economics versus conventional dry gas basins should be very beneficial. For example, the liquids portions of the Marcellus, Granite Wash, and Eagle Ford basins can still generate solid returns even with Henry Hub prices at less than $3 per thousand cubic feet. Furthermore, the steep decline curves in shale plays versus more conventional basins will continue to attract more rigs to keep production levels rising. Finally, years of drilling inventory and the ability of joint ventures between E&Ps and international investors to continually fund a portion of drilling activity should keep demand for premium rigs reasonably steady during the next year.
Driller Fundamentals Remain Positive Despite Gas Weakness
We think investors are overly focused on the drillers' natural gas exposure, which isn't the majority of their business. All of the major oil and gas land drillers are in good position, as they are weighted on a revenue basis about 75%/25% toward oil drilling (per company disclosures) versus the overall rig count's 60%/40% split toward oil. The difficult dynamics in natural gas almost certainly will lead to lower levels of dry gas drilling in 2012, particularly in the Haynesville and Barnett basins. However, despite difficult natural gas economics for several years, it has taken a year and a half to shed about 200 natural gas rigs from the mid-2010 peak level of almost 1,000 active natural gas rigs. During the same time frame, the oil-directed rig count has added almost 600 rigs, outpacing the gas rig declines 3 to 1. The lower natural gas rig count will be a headwind for the drillers, especially as more than 200 gas rigs have been shed since October 2011. But we forecast that overall drilling activity levels will increase in 2012 versus 2011, as oil-directed rig additions will continue to outpace laid-down natural gas rigs.
We also think investors are too concerned about the mechanical rig exposure for the major land drillers. The land drillers' fleet numbers do include a large number of mechanical rigs, but we believe most of these rigs are stacked and candidates for retirement. In our view, the vast majority of drillers' active rigs are premium ones. For example, we estimate that Patterson's fleet still has almost 200 mechanical rigs, but its fourth-quarter active rig count of 232 probably includes around 145 premium rigs and another 87 decent mechanical rigs that can still work in today's more demanding environment. Patterson plans to add 30 premium rigs in 2012, which should help boost its rig count and provide a path for growth even as some of its natural gas directed rigs are potentially laid down.
Overall, we think Patterson, Nabors, and H&P are positioned to deliver higher revenue driven by new-build rig additions in 2012. Furthermore, we forecast higher margins in 2012 as the incremental premium rig being added to the fleet is far more profitable than the fleet average. For example, premium day rates are around $25,000 versus Nabors' and Patterson's low-$20,000 fleet average, which is being weighed down by mechanical rigs. Furthermore, Patterson has delivered some of the industry's best performances during the past several quarters; it has increased its average day rate by about $5,000 during the past seven quarters, while H&P's and Nabors' averages have only improved $3,200 and $4,700, respectively. In fact, Patterson consistently has taken rig share from Nabors and H&P. In the first quarter of 2010, Patterson, Nabors, and H&P had 126, 159, and 154 active rigs, respectively. Last quarter, Patterson had 208 active rigs (a gain of 82 rigs) on average in the U.S., versus 202 (a 43-rig gain) for Nabors and 224 (a 70-rig gain) for H&P. The rig gains look starker going back further, as Patterson has added 147 rigs since the second quarter of 2009 versus Nabors' 59 and H&P's 122. We think as the industry continues to shift toward premium rigs with higher day rates, Patterson should continue to outperform its peers. Again, while land drillers as a whole are undervalued, we view Patterson as the cheapest and best way to play the group.
Patterson's Priced for a Major Collapse in Drilling, but Market Fears Are Overblown
In the bad days of 2008-09, oil dropped from $147 per barrel to below $40, and gas prices dropped from the mid-teens to less than $3 per mcf. Drillers suffered along with the rest of the industry. Patterson's revenue cratered 62% and the firm went from earning nearly $350 million in net income in 2008 to losing $38 million in 2009. That said, we think several considerations make the 2009 scenario unlikely in 2012. First, U.S. E&P budgets look to increase 9%-10% to around $122 billion in 2012 versus a sharp decline in 2009. Liquids-directed drilling is holding up the industry, even in the face of decade-low gas prices. Second, Patterson had 131 rigs under contract going into 2012 versus around 30 rigs under contract in 2008. This will provide significant cash flow stability even if gas drilling fundamentals weaken further. The picture is similar for Patterson's pressure-pumping segment, and we estimate it has about 30%-50% of its under-construction capacity already under contract. Thus, Patterson's ability to withstand a downturn is better that it has been in some time.
And yet, Patterson's current stock price implies a collapse in drilling similar to 2008-09. To get to a $20 stock price, we have to assume an active rig count of roughly 150, a 20% drop in pressure-pumping prices to around $75-$80 per job, and pressure-pumping margins averaging around 25%. These assumptions compare poorly with results from the fourth quarter of 2011, which saw 232 active rigs, pressure-pumping prices of $103 per job, and margins closer to 32%. While we agree that gas-directed drilling activity is likely to pull back in 2012 thanks to spectacularly bad economics, we note that Patterson currently has 131 rigs under contract, implying it would barely operate any rigs on the spot market under the assumptions necessary to justify the current stock price. Under these assumptions, essentially all of the company's income would come from already-contracted rigs or potential contract termination payments. This also would imply a substantial decline in oil-directed drilling, where the liquids economics are still superb.
Our 2012 base case assumes 240 active rigs on average, day rates of $23,000, flat pressure-pumping pricing at $100 per job, pressure-pumping margins of around 34%, and modest increases in pressure-pumping activity. Based on these assumptions, we think Patterson will generate $1.20 billion in earnings before interest, taxes, depreciation, and amortization this year (in line with consensus estimates of $1.18 billion), which supports our $43 fair value estimate.
Patterson's current stock price implies a forward EBITDA multiple of 2.6 times, compared with a historical forward multiple of 5-7 times. Our fair value estimate implies a 5.7 times multiple. While we freely admit our EBITDA estimate could be off if 2012 is sharply lower than recent quarters, it is challenging to justify the assumptions currently baked into the stock price. We find Patterson extremely compelling at these levels.
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