Grant Prideco (GRP)

[frenchee]

Drilling Down
By Dan Amoss

If the "law of diminishing returns" could ever be repealed, energy exploration companies would certainly vote in favor. But energy services companies would not. Indeed, the law of diminishing returns may be the energy services industry's staunchest ally, as well as the primary reason why stocks like Grant Prideco (NYSE: GRP ) and National-Oilwell Varco (NYSE: NOV ) are likely to reward investors over the coming decade.

The North American natural gas industry is a real-time illustration of the law of diminishing returns. Exploration and production (E&P) companies are sinking an ever-growing number of wells, but extracting an ever-shrinking quantity of natural gas. In other words, the North American natural gas industry is becoming very "drilling-intensive." That's bad news for the E&P companies, but good news for the folks who provide the drill rigs and pipes and other equipment that the explorers use.

The following charts illustrate the rising trend in drilling intensity. This data is publicly available on the websites of the Energy Information Administration (EIA ) and oilfield equipment and service company Baker Hughes (NYSE: BHI ).



The blue line is the Baker Hughes natural gas rig count in the "lower 48" United States, including offshore basins. By "gas" rigs, Baker Hughes refers to rigs drilling for natural gas in U.S. territory. Out of the total U.S. rig count, gas rigs now comprise about 84% of active rigs, with oil rigs comprising the other 16%.

As you can see, the past ten years of data refute the oft-repeated assertion: "A surge of drilling activity will lead to a glut of natural gas and cause prices to crash." Obviously, gas prices have not crashed, despite the sharply rising rig count.

The second chart combines the two data sets from the first chart. It shows the monthly U.S. gas production, divided by the monthly rig count. A simple regression line shows a clear trend running from 3 billion cubic feet (Bcf) per month per rig ten years ago to 1Bcf per month per rig in 2006:




What conclusions can we derive from these charts? Well, they lend heavy support to the view that drilling demand will more than absorb any increase in the rig population. Most E&P companies are earning huge returns on invested capital at current gas prices. So they will bid aggressively to put newly-built rigs to work on their drilling projects.

Another conclusion? Just maintaining current natural gas production will require a steady uptrend in rig activity. Both of these conclusions lead to one over-arching conclusion: the drilling boom is not over yet.

So disregard headlines about the impending wave of new rigs destroying the drillers' profit margins. Instead, keep an eye on the price of natural gas. The trend of natural gas will be the primary driver of drilling activity, and thus, of profit growth at companies like GRP and NOV.