Sunday, August 02, 2009

Contract Termination Fees Inflate Nabors Industries' Earnings

The operating performance of the land drilling contractor Nabors Industries (NBR-$17.03) continues to be hurt by low natural gas prices in the U.S. Lower 48 states and the resultant decrease in drilling activities as producers shut in unprofitable wells. Although weak demand for rigging and well-servicing will likely continue to weigh on dayrate revenues and margins into 2010, the company is seeing an earnings boost from “prepaid cancelled domestic rigs,” which are cash payments from exploration clients allowing for early contract terminations, according to quarterly regulatory filings:

… customers released rigs and delayed drilling projects in response to the significant drop in natural gas prices and the tightening of the credit markets. Operating revenues earned during the three months [a decrease of 43 percent to $249.8 million] and six months [a decrease of 24 percent to $639.7 million] ended June 30, 2009, includes $17.5 million and $48.8 million, respectively, related to early contract termination revenue including approximately $7.7 million and $13.1 million, respectively, which would have been earned during the current period regardless of early termination.

The decline in rig count is hurting margins, but contract terminations are disingenuously inflating reported operating metrics. In the second quarter, average margins were $10,250 per rig day, but would have been $8,900 per day, if not for that portion of the lump-sum payments that would have been earned in future quarters.

Chief Executive Eugene Isenberg said on the second-quarter
earnings call that he believed “that the third quarter will likely represent a bottom in all operations, although it remains difficult to predict the timing and pace of the eventual upturn in natural gas driven activity.”

At July 29, rig count activity in U.S. Lower 48 Land Drilling operations decreased from the October 2008 peak of 273 rigs to 93 rigs. Well-servicing activity is down, too, off approximately 51 percent from its October peak to current estimated rig hours of 51,796.

Natural gas has been holding in the $3.30-$3.60-per-thousand-cubic-feet [mcf] range and storage at natural gas hubs is higher year-over-year. In addition, with no sign of increased rig additions at this time, the 10-Q Detective believes that operating income for Nabors' third quarter could be down sequentially more than the guidance of 50 percent (from the second quarter) provided by the company for its domestic operations.

Nabors still has a substantial number of rigs that are on contract not only through the end of this year, but for 2010, too, when the company is going to have an average of 70 rigs on contract, which will mitigate the downside, according to Isenberg.

In the opinion of the 10-Q Detective, the supply-demand imbalance of gas reserves remains dependent on an uncertain economic turnaround. A visible increase in U.S. onshore rig activity will unlikely occur until gas prices reach $6.00 to $7.00 per mcf, for promising shale plays, such as Fayetteville and Woodford, require such market prices to make production worthwhile. Until market conditions improve, Nabors will need to depend on early termination revenue to lift income and cash flow during the downturn.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

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