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According to data from Houston-based oilfield services company Baker Hughes Inc. (BHI - Free Report) , the number of rigs searching for oil and gas in the U.S. rose for the week ended Jan. 15, 2010, reflecting intensified drilling activity by the producers in response to higher commodity prices.

As shown in the first chart below from Baker Hughes, rigs exploring and producing in the U.S. totaled 1,248 during the week. This is up by 28 from the previous week’s tally and represents the 12th gain in the past 13 weeks. The current nationwide rig count is 42% higher than the 2009 low of 876 (set in the week ended June 12).

However, the combined oil and gas rig count is still down by 320 from the year-ago period. It rose to a 22-year high in 2008, peaking at 2,031 in the weeks ended Aug. 29 and Sept. 12.

The natural gas rig count increased by 30 to a 10-month high of 811 -- the 20th gain in last 26 weeks -- after bottoming at 665 on July 17, 2009 (its lowest level since May 3, 2002). However, the rig count remains 50% lower than its peak of 1,606 in late summer 2008. In the year-ago period, there were 1,235 active natural gas rigs. This is shown in the following chart, also from Baker Hughes.

The oil rig count was down by 2 to 425, reversing the positive momentum from the past 16 weeks. However, the tally is up more than 31% from the previous year’s count of 324, as shown in the following chart from Baker Hughes. Oil rig count peaked at 442 in early Nov. 2008.

The miscellaneous rig count, at 12, remains unchanged 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 weeks, companies have been beginning to bring rigs back on line amid signs of economic stabilization that could drive up energy demand.

Oil prices jumped over 75% in 2009 (following a 54% dip in 2008), while gas futures have also gained significantly from their Sept. 2009 lows. This pushed the nationwide rig count above 1,200 working units for the week ended Jan. 8, 2010, for the first time in almost a year.

The overall picture, though, remains weak, particularly for natural gas, whose inventories remains more than 4% above their five-year average and much higher than the normal range at this time of the year. While drilling has declined significantly over the past 12 months (as reinforced by the still-depressed natural gas rig count), production has not slowed that much.

As a result, there is a feeling that more cuts in rig count may be required to bring the oversupplied market into equilibrium, particularly with gas inventories at fairly high levels and industrial demand still down sharply due to a lackluster economy.

The bulk of the decline in rig count has occurred in vertical gas drilling rigs, which drill straight down in search of conventional gas deposits. The number of vertical drilling rigs has dropped over 42% since the beginning of 2009.

On the other hand, horizontal/directional rig count (encompassing new drilling technology that have the ability to drill and extract gas from dense rock formations, also known as shale formations) have fallen at a much slower pace, with rig count down just 6% from the Jan 2009 levels, as depicted in the following chart from Baker Hughes. Consequently, gas production from the highly prolific shale plays have continued to surge, fueling the glut in domestic natural gas volumes over the last few years.

The gap between supply and demand is expected to reverse in the coming months as producers bet on forecasts for colder weather and the lagging effect of the sharp drop in domestic drilling activity takes hold.

Until then, we believe that natural gas woes (especially in North America) will continue to hamper energy service firms like Halliburton Company (HAL - Free Report) , Schlumberger Limited (SLB - Free Report) , Baker Hughes, National Oilwell Varco (NOV - Free Report) , and Weatherford International Ltd. (WFT - Free Report) . These oilfield service names have seen their revenues and earnings plunge in the last few quarters on the back of lower volumes and a very competitive pricing environment. We have Neutral recommendations on all of the above-mentioned companies.

In particular, we remain wary of oilfield service providers like Smith International Inc. , given its high North American exposure (from the W-H Energy acquisition) in the face of a collapse in the region’s drilling activities.

We also maintain our Neutral recommendations for land drillers such as Nabors Industries (NBR - Free Report) and Patterson-UTI Energy (PTEN - Free Report) . 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.

We are positive on oilfield companies like Cameron International that derives about two-thirds of its revenue from outside North America. Cameron’s international operations are expected to be a key growth driver for the firm going forward and will play an offsetting role to the relatively soft U.S. drilling scene.



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