In its weekly release, Houston-based oilfield services company Baker Hughes Inc. (BHI) reported a rise in the U.S. rig count (number of rigs searching for oil and gas in the country), reflecting intensified drilling activity despite recent price declines for both commodities.
 
Rigs exploring and producing in the U.S. totaled 1,557 for the week ended July 2, 2010. This is up by 5 from the previous week’s rig count and represents the highest level achieved this year. The current nation-wide rig count is 78% higher from the 2009 low of 876 (set in the week ended June 12, 2009) and significantly exceeds the prior-year level of 928. It rose to a 22-year high in 2008, peaking at 2,031 in the weeks ending August 29 and September 12.
 
Natural Gas Rig Count
 
The natural gas rig count increased for the third time in the last 4 weeks to 960 (a gain of 2 from the previous week). Buoyed by the week-over-week improvement, the number of natural gas rigs is just 13 short of the 14-month high of 973 hit during the week ended April 16. The U.S. gas drilling rig count has rebounded strongly after bottoming to a 7-year low of 665 on July 17, 2009. Still, the rig count remains 40% lower than its peak of 1,606 in late summer 2008. In the year-ago period, there were 688 active natural gas rigs.
 
Oil Rig Count
 
The oil rig count was up by 4 to 587, the seventh gain in the last 9 weeks. The current tally is considerably higher than the previous year’s rig count of 229. It has recovered nicely from a low of 179 in June 2009, more than threefold in number.
 
Miscellaneous Rig Count
 
The miscellaneous rig count (primarily drilling for geothermal energy), at 10, was down one from the previous week.
 
Fundamentals Remain Depressed
 
Despite robust drilling activity over the last few weeks, surging inventories (for both oil and gas) continue to place downward pressure on commodity prices.
 
High oil supplies, together with concerns about the pace of the economic recovery in the U.S and China – the world’s biggest crude users – have dragged the oil prices to around $72 a barrel, down from an 18-month high of around $86 per barrel reached in late April/early May.  
 
The overall picture also remains weak for natural gas. The specter of a continued glut in domestic gas supplies still looms, with storage levels remaining at 12% above their five-year average. Further pressurizing the commodity is the rapid rise in the number of drilling rigs working in the U.S. (the natural gas rig count has climbed 44% from a seven-year low reached last July) and continued robust production from dense rock formations (also known as ‘shale’). This has created a massive oversupply, sending natural gas prices plummeting from $13 per million Btu (MMBtu) four years ago to just around $5.0 per MMBtu today (referring to Henry Hub spot prices), notwithstanding hot weather and expectations of an active Atlantic hurricane season.
 
GoM Effect
 
In tandem with the commodity price outlook, the uncertainty related to the huge oil spill accident in the Gulf of Mexico (GoM) and government attempts to impose a deepwater drilling moratorium in the region (at water depths of more than 500 feet through November 30, 2010) is also expected to have some impact on rig counts in the following weeks.
 
As a reminder, on April 20, offshore driller Transocean Inc’s (RIG) ultra-deepwater Horizon drilling platform, contracted to British major BP plc (BP), sank following an explosion while operating in the U.S. GoM off the coast of Louisiana. The incident killed 11 workers and caused what is touted as the worst oil spill in U.S. history.
 
The deepwater drilling ban invoked in the wake of the Horizon disaster (later ruled illegal by a federal judge) has dragged down rig count in the GoM by a whopping 65% since the week ended May 28.
 
Our Take
 
Considering the potential fallout from the GoM incident, we take a bearish stance on offshore contract drilling services providers such as Transocean, Diamond Offshore (DO), Ensco plc (ESV), Rowan Companies (RDC), Pride International (PDE), and Noble Corp. (NE), fearing a threat to their revenue and profitability.
 
In particular, we remain concerned about Transocean and Noble (both with Zacks #5 Rank or Strong Sell) because of their active involvement in GoM. We believe these stocks will underperform the overall market over the coming 1−3 months.
 
For Transocean, the operator of the doomed Deepwater Horizon drill rig in the GoM spill, earnings are likely to suffer from the uncertainty in the near- and medium term outlook for deepwater drilling. We further believe that Transocean − and the entire industry − will be subject to more stringent regulations in the future. The company has already warned investors regarding the risks associated with the Horizon rig disaster, including legal costs, government investigations and lost revenue.
 
While investors should be happy with Noble’s $2.16 billion Frontier Drilling acquisition, this hardly helps the company to move the needle in the positive direction. Noble shares currently trade at a significant discount to its peer group, highlighting concerns over the GoM drilling uncertainties. Another key concern is Noble’s highest concentrated jackup exposure (43 out of total 63 rigs), which we believe will continue to face challenges in renewing/obtaining contracts on favorable terms.
 
This accounts for our Zacks #5 Ranks on Transocean and Noble, the lowest rating given by Zacks and applied to 5% of all the stocks ranked by it.
 
The remaining companies (Diamond Offshore, Ensco, Rowan, and Pride) currently have Zacks #3 Ranks (Hold), meaning that these stocks are expected to perform in line with the overall market during the next 1−3 months.
 
Land drillers such as Nabors Industries (NBR) and Patterson-UTI Energy (PTEN) are also expected to remain under pressure (both with Zacks #3 Ranks). Although we expect the land rig count to continue with its steady rise during 2010 (currently at 1,529 rigs, up 74% year over year), the large amount of excess capacity in the sector will weigh on day rates and margins well into the year.
Read the full analyst report on “BHI”
Read the full analyst report on “RIG”
Read the full analyst report on “BP”
Read the full analyst report on “DO”
Read the full analyst report on “ESV”
Read the full analyst report on “RDC”
Read the full analyst report on “PDE”
Read the full analyst report on “NE”
Read the full analyst report on “NBR”
Read the full analyst report on “PTEN”
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