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On Nov 13, 2013, we retained our Neutral recommendation on onshore contract driller Patterson-UTI Energy Inc. (PTEN - Analyst Report). Our investment thesis is supported by a Zacks Rank #3 (Hold).

Why the Reiteration?

Buoyed by Patterson-UTI’s growing premium land rig fleet and the expected demand uptick for such services; we think that the current valuation is fair and adequately reflects the company’s future growth prospects.

However, we remain wary of increased labor costs for contract drilling that may lead to slower margin growth going forward. Lastly, Patterson-UTI is faced with volatile natural gas fundamentals, which are expected to further limit its ability to generate positive earnings surprises.  

Detailed Analysis

We remain encouraged by the strong demand for Patterson-UTI’s services in the unconventional oil and liquids-rich plays. In particular, the company’s technologically-advanced ‘Apex’ rigs are the key to its success.

Patterson-UTI’s proprietary design makes the rigs move faster than conventional rigs, drill quicker and more efficiently than conventional rigs, and allows for a safer operating environment. As such, these rigs are better suited for the new demands of the exploration business and, therefore, command higher dayrates and utilization than rigs from other land drillers.

The second-largest North American land drilling contractor after Nabors Industries Ltd. (NBR - Analyst Report) is also benefiting from the 2010 acquisition of certain assets of Key Energy Services, an onshore well service rig provider. Through this transaction, Patterson-UTI has not only expanded its shale drilling ability, it also stands to benefit by coming out of their historical stronghold in the Appalachian Basin into the pressure pumping markets of the Barnett, Eagle Ford and Permian Basin.

We also like Patterson-UTI Energy’s recent decision to retire 36 rigs from its fleet. We expect the retirement to act as a positive step towards balancing the market, given the extreme overcapacity caused by depressed natural gas prices.

However, with natural gas fundamentals remaining volatile, we see no significant price upside for Patterson-UTI stock in the near-to-medium term. Plus, increased labor costs for contract drilling may put a brake on the segment’s margin expansion, which is likely to further limit the company’s ability to generate positive earnings surprises.

Stocks That Warrant a Look

While we expect Patterson-UTI to perform in line with its peers and industry levels in the coming months and advice investors to wait for a better entry point before accumulating shares, one can look at Matador Resources Co. (MTDR - Snapshot Report) and SM Energy Co. (SM - Analyst Report) as good buying opportunities. These U.S. upstream energy operators – sporting a Zacks Rank #1 (Strong Buy) – have solid secular growth stories with the potential to rise significantly from the current levels.

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