ST. LOUIS–The market for oil country tubular goods has been a roller coaster over the past two and a half years. The growth in exploring for and developing oil and natural gas that occurred from 2003 through the third quarter of 2008 reversed itself as the recession dampened energy demand and pushed down prices. The Baker Hughes rotary rig count fell by more than half in the nine months between the beginning of fourth quarter 2008 and the end of second quarter 2009.

Since then, however, driven by strong, stable oil prices and a “gold rush mentality” with regard to developing prolific shale gas reserves, the Baker Hughes U.S. rotary rig count has improved by more than 80 percent. In fact, the 1,651 rigs active the week ending Aug. 20 was much closer to the drilling highs of June 2008 than the low point of the downturn in June 2009 (1,901 rigs in June 2008, compared with 895 in June 2009). OCTG demand, as it usually does, has been following the same track as rig counts. The train is once again climbing the hill.

To set the stage, it is important to look at developments over the past 10 years or so. Changes in energy demand from populous countries such as China and India have resulted in a paradigm shift in the oil and gas industry. Demand for oil and natural gas had been growing at a rapid pace prior to the economic meltdown, pushing energy prices to new highs. After the initial economic shock of late 2008 and early 2009, during which energy prices fell, oil prices began to gradually recover in response to continued, albeit slower, demand growth among emerging economies (particularly China). This has resulted in oil prices that are attractive enough–and more importantly, stable enough–to stimulate oil drilling activity in the United States. In fact, domestic oil drilling today is the strongest it has been in almost 20 years.

Natural gas is a different story. While gas prices remain on the low end of “relatively good,” improvements in horizontal drilling and production technology have led to dramatic natural gas production numbers from horizontal shale gas wells, and have stimulated activity in a variety of shale gas deposits. In addition, pipeline construction projects from 2006 to 2008 unlocked regional gas supply bottlenecks and improved regional price differentials–especially in the case of Rocky Mountain production–to boost drilling activity. Together, these factors have driven the growth in the rotary rig count for both oil and gas activity since mid-2009, and OCTG demand along with it.

Figure 1

U.S. OCTG Consumption (Short Tons)

OCTG consumption through the first half of 2010 was about 2.2 million tons, compared with 1.7 million tons in 2009 and 2.5 million tons in 2008. This represents dramatic consecutive year-to-year changes of -32 percent and +29 percent. The U.S. rig count for those same periods changed by -37 and +25 percent, respectively. While much of the economy remains in the doldrums, OCTG demand in the first half of 2010 was only 14 percent below the near record-setting levels of 2008 (Figure 1).

Dramatic Change

During the five-year growth cycle that began in 2003, the supply side of the OCTG industry changed dramatically. A wave of acquisitions left the domestic scene with fewer players. This, and escalations in steel and steel input costs related to high demand and steel industry consolidation, resulted in OCTG price levels that had not been seen by suppliers or purchasers since the early 1980s. With the domestic industry busy and high prices, import supply increased significantly. As the rig count began to shrink in late 2008, imports (the majority of which were from China) made up more than 67 percent of new pipe supply. In 2009, an investigation by the U.S. Department of Commerce determined that the imports from China had been unfairly traded, and calculated countervailing duties of between 10 and 16 percent and antidumping duties of between 32 and 99 percent. This left importers looking for other sources, but based on the rapid increase in import quantities (about 47 percent of new supply), that has not been an issue.

In addition to new or expanded import sources, the domestic industry began to execute expansion plans beginning in the latter half of the last decade. Today, the industry has expanded capacity, new certifications and new market entrants totaling more than 1 million tons. That is a lot of tons. When it is all up and running, our estimate is that domestic supply will have grown by more than one-third.

Based on the swings in demand, and the fact that this industry has become accustomed to working from stock, managing OCTG inventory has been a challenge, and it will continue to be. As the rig count slowed in 2008, imports that had been ordered with the expectation of sustained growth continued to flow in. This resulted in an inventory that is typically in the range of five to six months of supply to be well in excess of one year. This situation creates a great deal of leverage when the rig count is declining or increasing. As consumption fell in late 2008 and early 2009, OCTG producers had to deal with lower demand and inventory liquidations as the industry adjusted to a new level of drilling activity. Had the rig count fallen further or stagnated, this could have gotten messy.

As it was, excess inventory led to lower OCTG prices, which of course, led to inventory write-downs. Surprisingly, there were no major casualties from this event and inventory has been largely worked off with the rig count growth that began in the second half of 2009, and to rapidly (and not quite so rapidly) adjusted domestic and import supply. One factor to keep in mind is that expanding drilling into new areas usually means new pockets of inventory. The wider inventory is spread, the harder it is to manage as an industry. The expansion of shale gas drilling has certainly created opportunities for new inventory locations.

Supply-Side Issues

One issue that emerged in the supply sector is that with the renewed focus on oil drilling and developing shale gas, the most consumed OCTG products have evolved from 7.0- and 9.0-inch diameter products to 4.0- and 5.0-inch pipe. This has had the effect of reducing practical production capacity in the United States, measured in tons, by 25-35 percent. The reader may conclude that this has no effect because pipe is consumed by the foot. However, if one combines the practical capacity reduction with an increase in well depth of about 10 percent since 2004, the consumption of heavier walls in the 4.0- and 5.0-inch diameter products employed in the multistage fracturing environments of shale gas plays, and the continued improvement in drilling rig efficiency, this shift in product mix is a concern if the rig count continues to grow.

Additionally, the increase in rigs drilling horizontally (54 percent of all rigs in mid-August 2010 versus 44 percent a year ago and 30 percent two years ago), and the multistage frac completions of horizontal wells, the consumption of high-strength alloy OCTG has risen faster than overall consumption. Assuming operators continue to explore for oil and shale gas, which Preston Publishing believes will be the case, and technology does not move to new pipe sizes, we believe this reduction in practical capacity can be addressed by new OCTG producers and fairly traded imports. In other words, we believe that even in the case of continued rig growth and even with the many other factors in play, there will be no shortage of supply.

Further on the supply side is the rapid ramp-up of imports. Imports are a risk in a recovery because of the longer lead times associated with those supply sources, combined with the inventory leverage issue. The risk of inventory overhang also has been exacerbated by the increase in consumption of 4.0- and 5.0-inch diameter products. The industry recognizes the long lead time risk, and as a result, the initial import growth was from nearby countries such as Canada and Mexico. Growth has now expanded farther abroad as importers have become more confident in the recovery.

Another supply issue is steel costs. Consolidation and prudent management of capacity has allowed steel producers to move prices upward in periods of capacity utilization, which in the past, would never have supported such increases. Fortunately for OCTG producers, they largely have been able to manage capacity likewise, and have generally been able to recover the cost increases in their selling prices. Steel prices have declined as a result of a greater availability of supply, which will take some of the pressure off downstream manufacturers with regard to price in a continued weak U.S. economy.

Consumption Factors

On the consumption side, U.S. rig count growth was slowing in mid-August. Oil drilling continues to improve, based on the relative strength and stability of oil price levels. Clearly, on the natural gas front, some drilling activity has been supported by the desire of oil and gas companies to get their undrilled leases to a held-by-production status. It is difficult to determine exactly how much drilling has been based on that need.

Public sources tell us that at least some of the operators active in shale gas have more production capacity than take-away capacity. This, and the fact that some more developed shale gas regions experienced rig count declines along the same lines as the overall rig count, indicate that possibly as much as a few hundred rigs are involved in that effort. If this is the case and natural gas prices do not improve to the $6.00-$8.00 an Mcf range, we could see rig count declines on the gas side over the intermediate term as these activities are wrapped up.

While well permitting is, at least to some extent, a leading indicator, it is not perfect. Permits, of late, suggest some flattening or possibly a decline in drilling, but again, permits are not a perfect leading indicator. Frankly, we have been surprised by the continued gas rig count growth since June. Keep in mind that overall natural gas consumption is down because of the weakened manufacturing sector.

One concerning issue is that increasing domestic supply, increasing import levels and slowing demand growth have led to a situation where the gas market has begun to build inventory. If the rig count declines and we still have trouble slowing supply, the market will become less stable. We have been warning about this potential issue for the past few months.

For the U.S. OCTG market, combining these supply and demand factors gives a pretty good look at what to expect for tubulars products at least over the near term. Drilling and OCTG demand continue to increase despite our concerns about gas prices and supply that is not yet being brought to the market. OCTG production and imports have increased to meet demand as inventory has declined. Prices for OCTG products moved up because of increases in steel and steel input costs, then stabilized, and have subsequently come under pressure as steel and steel input costs have declined again–so far so good–and not a bad situation when compared with the rest of the economy.

That said, we are keeping a watchful eye on a potential rig count retraction, at least in the natural gas department. And we have some concerns about future inventory issues emerging as the supply sector becomes more fragmented with new capacity, little of which is on line today, and a quick reaction by importers to ramp supply in response to rig count growth.

Canadian, Global Markets

In Canada, where drilling has a more significant seasonal component, the rig count had recovered to 395 as of the middle of August. This compares with a rig count, during this same time frame, of 170 in 2009 and 426 in 2008. Contrary to drilling in the United States, and for that matter, most of the past 15 years in Canada, oil drilling accounts for about 60 percent of all drilling activity. This is not surprising when one considers that lower-48 shale gas production has displaced a significant portion of Canadian gas exports to the United States.

Tar sands oil development in Canada has been a focus for several years, and with the level and stability of oil prices, it continues to be a priority. We would expect oil drilling to continue to grow with natural gas activity being dependent on gas prices. There are, however, significant shale gas deposits in Canada that are attracting the interest of the producing community.

Internationally (outside of the United States, Canada, the Former Soviet Union and China), where the focus is more heavily weighted toward oil (78 percent of rigs drilling for oil versus fewer than 40 percent in the United States), the rig count has rebounded as well. Keep in mind that in much of the rest of the world, hydrocarbon development is being undertaken by state-owned companies for the purpose of funding economies. As a result, the global market does not experience near the degree of fluctuation in drilling activity that is seen in the U.S. market.

Still, the recession drove drilling activity down 10-13 percent by early 2009. As of July, drilling had recovered to prerecession levels and was continuing to increase. With the focus on oil, and LNG to a lesser extent, we would expect international rig counts to continue to grow at a measured pace as long as oil prices remain fairly strong and economic activity continues to expand.

From an OCTG supply perspective, as in the United States, there are trade orders in place in Canada against imported Chinese OCTG. The inventory of OCTG products is not a significant problem outside the United States and Canada because of the overall stability of the rig count and the fact that much of the business is direct with the end-user. From a market structure perspective, capacity expansion (especially in China and India) has kept the international market well supplied.