Yesterday, one of the largest onshore contract drillers in the U.S., Patterson-UTI Energy, Inc. (PTEN) said its August 2009 drill rig count averaged 72, up from 65 in the previous month. The company operated 69 rigs in the U.S. and 3 in Canada in August, compared to 63 rigs in the U.S. and 2 rigs in Canada during July.

Patterson’s activity levels in the U.S. peaked in early October 2008, with a rig count of 275. Since then, the company has witnessed a steep and quick 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 making a new 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 Btu (MMBtu) in July 2008 before trending down. Prices have since dropped sharply to the current level of around $2.2 (we are referring to Henry Hub spot prices here).

Recessionary demand and strong supplies continue to weigh on prices. This unfavorable commodity-price backdrop together with the credit crisis has led to capex reductions by exploration and production players (natural gas producers), both public as well as private.

The resultant drop-off in onshore drilling activities has weighed on the fortunes of all oilfield service players in general and land drillers such as Patterson-UTI, in particular through a reduction in rig utilization and drilling margins. 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 bite the industry as demand has dropped.

With the current U.S. land rig count down roughly 51% from its all-time peak (achieved in August 2008), we believe this idled drilling capacity will continue to weigh on dayrates and margins into 2010, even as natural gas’ outlook 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.
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