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In its weekly release, Houston-based oilfield services company Baker Hughes Inc. ([url=http://www.zacks.com/stock/quote/bhi]BHI[/url]) reported a fall in the U.S. rig count (number of rigs searching for oil and gas in the country), reflecting the growing oil spill in the U.S. Gulf of Mexico (GoM) and ensuing drilling ban in the region that pared back activity. In fact, rigs operating in the GoM plunged by 50% this week to a 16-year low of 23.

Rigs exploring and producing in the U.S. totaled 1,506 for the week ended June 4, 2010 (as clear from the first chart below from Baker Hughes). This is down by 29 from the previous week’s tally and represents the first decline in six weeks. However, the current nationwide rig count is 72% higher from the 2009 low of 876 (set in the week ended June 12, 2009) and significantly exceeds the prior-year level of 887. It rose to a 22-year high in 2008, peaking at 2,031 in the weeks ended August 29 and September 12.



The natural gas rig count decreased for the fifth time in the last 7 weeks to 947 (a loss of 20 from the previous week). Despite the week-over-week decline, the number of natural gas rigs is just 26 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 41% lower than its peak of 1,606 in late summer 2008. In the year-ago period, there were 700 active natural gas rigs. This is shown in the following chart, also from Baker Hughes.



The oil rig count was down by 10 to 545, the second loss in last 3 weeks. Despite this, the current tally is considerably higher than the previous year’s count of 179 (the lowest for 2009), as shown in the following chart from Baker Hughes.



The miscellaneous rig count (which primarily drill for geothermal energy), at 14, was up 1 from the previous week.

Producers had scaled back oil and gas drilling operations over the past year (leading to a drastic reduction in rig count) in the midst of falling commodity prices and tighter access to credit. However, during recent months, companies have been beginning to bring rigs back on line amid signs of economic stabilization that could drive up energy demand.

Amid this growing optimism and expectations of faster-than-expected economic recovery, oil prices recently hit an 18-month high, climbing towards $86 per barrel. This pushed the nationwide rig count above 1,500 working units for the week ended May 14, 2010, for the first time in more than a year.

However, during the last few days, a weaker-than-expected U.S. payrolls data and a stronger dollar have renewed apprehensions about the global growth (and hence energy demand). As a result, oil prices have slumped to around $70 per barrel. Additionally, high levels of product inventories (gasoline and distillate stocks remain above the upper boundary of the average range for this time of year), along with soaring commercial oil supplies, continue to point towards weak fundamentals, in our view.

The overall picture also remains weak for natural gas. The specter of a continued glut in domestic gas supplies still exists, with storage levels remaining 15% 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 42% from a seven-year low reached last July) that signals a supply glut later this year in the face of sluggish industrial activity. Meanwhile, production from dense rock formations (shale) remains robust, and demand from power plants remains soft.

There are concerns among traders that the market will be oversupplied in the short- to medium-term, with rig counts going up and industrial demand still struggling due to the weak economy.

However, more than the oil/natural gas outlook, it is the uncertainty related to the huge oil spill accident in the GoM and the subsequent moratorium on offshore drilling in the region (at water depths of more than 500' through November 30, 2010), which is expected to have a negative impact on rig counts in the following weeks.

As a reminder, on Apr 20, offshore driller Transocean Inc’s ([url=http://www.zacks.com/stock/quote/rig]RIG[/url]) ultra-deepwater Horizon drilling platform, contracted to British major BP Plc ([url=http://www.zacks.com/stock/quote/bp]BP[/url]), sank following a fire and explosion while operating in the U.S. Gulf of Mexico off Louisiana ’s coast. The incident killed 11 workers and caused likely the worst oil spill in U.S. history.

The deepwater drilling ban invoked in the wake of the Horizon disaster took the Gulf rig count down by 50% to 23, the lowest level since August 1993. Oil drilling was down by 2/3rds to 9 rigs from 27 a week ago, while gas rigs fell to 14 from 19.

Considering the potential fallout from the GoM incident, we take a bearish stance on offshore contract drilling services provider like Transocean, Diamond Offshore ([url=http://www.zacks.com/stock/quote/do]DO[/url]), Ensco Plc ([url=http://www.zacks.com/stock/quote/esv]ESV[/url]), Rowan Companies ([url=http://www.zacks.com/stock/quote/rdc]RDC[/url]), and Noble Corp. ([url=http://www.zacks.com/stock/quote/ne]NE[/url]), fearing an adverse effect to their contract backlogs.

In particular, we remain wary of Transocean and Diamond Offshore because of their big presence in the GoM. We currently have Zacks #4 Ranks (Sell) on both of these stocks, expecting them to underperform the overall market. The remaining companies (Ensco, Rowan, and Noble) currently have Zacks #3 Ranks (Hold), meaning that these stocks are expected to perform relatively the same as the overall market during the next 1-3 months.

Land drillers such as Nabors Industries ([url=http://www.zacks.com/stock/quote/nbr]NBR[/url]), Patterson-UTI Energy ([url=http://www.zacks.com/stock/quote/pten]PTEN[/url]) and Helmerich & Payne ([url=http://www.zacks.com/stock/quote/hp]HP[/url]) are also expected to remain under pressure (all with Zacks #3 Ranks). Although we expect the land rig count to continue with its steady rise during 2010, the large amount of excess capacity in the sector will weigh on dayrates and margins well into the year.

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