Grey Wolf to Benefit From Accelerated Natural Gas Drilling

Understanding the big picture for natural gas drillers requires a look at both the natural gas supply\demand picture and the outlook for rig day-rates (the price drillers are paid).

Natural gas fundamentals bode well for prices. Figures below come from the Energy Information Administration [EIA]. Consumption from 2001-2006 held steady in a 6% range with variation mostly due to weather; however, use for electricity generation soared 50% in the last decade. Half of new electricity plants in the next 3 years will be gas fired and natural gas will be used heavily to increase ethanol production.

While demand is steady to increasing, the production picture is eroding. The average well today is 35% less productive than 10 years ago. The EIA reports 301,811 wells in 1996 and 448,641 in 2006 with total production slightly down.

The import picture is also bleak. Imports supply about 18% of domestic need, with 80% of imports coming from Canada. Canada, however, faces similar production issues as the U.S and their domestic use will spike as the Alberta tar sands project will use massive quantities of natural gas. Imports of liquefied natural gas [LNG] could help but are constrained by a lack of infrastructure. LNG terminals require huge investment and are vehemently opposed everywhere (think mushroom cloud). Only about 2.6% of current supply comes from LNG and although a couple of new terminals will come on line in 2008, NIMBY politics promises that further increases in supply will be slow in coming.

Certainly the need for increased drilling is clear. In fact, drilling activity has more than doubled since 1999. 2006 saw a peak and drillers made record profits as the industry witnessed virtual 100% utilization. During this time, drilling capacity came on-line quickly as drillers were able to pull rigs from storage. As the cycle has continued, efficient new rigs have been entering the market and some of this older supply has been scrapped or exported.

Drilling equities have pulled back significantly as 2007 saw drilling activity abate and pressure on day-rates relative to 2006. Drillers, however, have remained solidly profitable, utilization remains historically high, and over-building of capacity does not seem likely as most new rigs are "built for purpose" and contracted in advance for up to 3 years. In fact, Baker Hughes (BHI) shows continued quarter-over-quarter increases in utilization; it is only the pace of increase that has slowed.

Grey Wolf (GW) is my favorite driller. The company has about a $1 billion market cap, its rig fleet is fairly modern, and it offers premium services such as turn-key drilling and top-drives (motors that make rigs more efficient) which add significantly to base day rates. The company's most recent 10-Q gives a promising picture. Grey Wolf has over $250 million in cash, a quick ratio of 3.5, a share repurchase plan with $50 million recently added, and new rigs are conservatively added under term contracts that insure a full return of capital. The company has $275 million in long-term convertible notes hanging over the stock, however, the interest rates are low and the company can redeem $150 million of these notes in May of 2008. The notes convert in the $6.50 range.

The company gave the following bullish forecast:

Announcements of new rig orders in the U.S. market over the past several months have been for built-for-purpose rigs. We believe the vast majority of the new rigs will be delivered by the end of 2007. We also believe that the new rigs that have come into the market have generally displaced low-end equipment. The ability to provide equipment that addresses the challenges of deep, directional or multi-well site drilling is critical to meeting our customers' needs in the most active domestic land drilling markets. Our fleet is well suited to these drilling opportunities given the recent acquisition of new rigs and substantial rig upgrades completed over the past three years.

In 2007, Grey Wolf's stock price suffered form unfavorable comparisons with 2006 performance, but 2008 may be more forgiving. The company is strong financially, has a forward PE of 8 compared to the S&P at 14, and estimates may prove to be low. Aggressive investors may wish to sell $5 puts on GW, which have favorable premiums.

Disclosure: Author has a long position in GW

Comments

[jbougearel]

Excellent piece of work here

John Bougearel
successfultradingtips....