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In its weekly release, Houston-based oilfield services company Baker Hughes Inc. (BHI - Analyst Report) reported a growth in the U.S. rig count (number of rigs searching for oil and gas in the country), reflecting intensified drilling activity.

Rigs exploring and producing in the U.S. totaled 1,567 for the week ended July 9, 2010. This is up by 10 from the previous week's rig count and represents the uppermost level achieved this year. The current nation-wide rig count is 79% higher from the 2009 low of 876 (set in the week ended June 12, 2009) and significantly exceeds the prior-year level of 916. It rose to a 22-year high in 2008, peaking at 2,031 in the weeks ending August 29 and September 12.

Natural Gas Rig Count

The natural gas rig count increased for the fourth time in the last 5 weeks to 964 (a gain of 4 from the previous week). Buoyed by the week-over-week improvement, the number of natural gas rigs is just 9 short of the 14-month high of 973 during the week ended April 16. The U.S. gas drilling rig count has rebounded strongly after bottoming out to a 7-year low of 665 on July 17, 2009. Still, the rig count remains 40% lesser than its peak of 1,606 in late summer 2008. In the year-ago period, there were 672 active natural gas rigs.

Oil Rig Count

The oil rig count was up by 5 to 592, the eighth increase in the last 10 weeks. The current tally is noticeably higher than the previous year's rig count of 234. It has recovered nicely from a low of 179 in June 2009, more than threefold in number.

Miscellaneous Rig Count

The miscellaneous rig count (primarily drilling for geothermal energy) at 11, was up one from the previous week.

Fundamentals Remain Depressed

Despite robust drilling activity over the last few weeks, surging inventories (for both oil and gas) continue to push down commodity prices.

Towering oil supplies, together with concerns about the pace of the economic recovery in the U.S and China ' the world's biggest crude users ' have dragged oil prices to around $75 a barrel, down from around $86 per barrel in late April/early May 2010, the peak in the preceding 18 months.

The complete picture also remains weak for natural gas. The specter of a continued glut in domestic gas supplies still looms, with storage levels remaining at 12% above their five-year average. Further pressuring the commodity is the rapid rise in the number of drilling rigs working in the U.S. (the natural gas rig count has climbed 45% from a seven-year low reached last July) and continued robust production from dense rock formations (also known as 'shale').

This has created a massive oversupply, sending natural gas prices plummeting from $13 per million Btu (MMBtu) four years ago to just over $4.0 per MMBtu today (referring to Henry Hub spot prices), notwithstanding hot weather and expectations of an active Atlantic hurricane season.

GoM Effect

In tandem with the commodity price outlook, the uncertainty related to the mammoth oil spill accident in the Gulf of Mexico (GoM) and the government's attempts to impose a deepwater drilling moratorium in the region (through November 30, 2010) is also expected to have some influence on rig counts in the following weeks.

As a reminder, on April 20, offshore driller Transocean Inc's (RIG - Analyst Report) ultra-deepwater Horizon drilling platform, contracted to British major BP Plc (BP - Analyst Report), sank following an explosion while operating in the U.S. GoM off the coast of Louisiana. The incident killed 11 workers and caused what is touted as the worst oil spill in U.S. history.

The deepwater drilling ban invoked in the wake of the Horizon disaster (later ruled illegal by a federal judge and then replaced by a revised deepwater drilling ban) has dragged down rig count in the GoM by a whopping 65% since the week ended May 28.

Our Take

Considering the potential fallout from the GoM incident, we take a bearish stance on offshore contract drilling services providers such as Transocean, Diamond Offshore (DO - Analyst Report), Ensco Plc (ESV - Analyst Report), Rowan Companies (RDC - Analyst Report), Pride International (PDE - Analyst Report), and Noble Corp. (NE - Analyst Report), fearing a threat to their revenue and profitability.

In particular, we remain concerned about Transocean and Noble (both with Zacks #5 Rank or Strong Sell) because of their active involvement in GoM. We believe these stocks will underperform the overall market over the coming 1-3 months.

For Transocean, the operator of the doomed Deepwater Horizon drill rig in the GoM spill, earnings are likely to suffer from the uncertainty in the near- and medium term outlook for deepwater drilling. We further believe that Transocean - and the total industry - will be subject to more stringent regulations in the future. The company has already warned investors regarding the risks associated with the Horizon rig disaster, including legal costs, government investigations and lost revenue.

While investors should be jovial with Noble's $2.16 billion Frontier Drilling acquisition, this scarcely helps the company to move into positive territory. Noble shares currently trade at a significant discount to its peer group, highlighting concerns over the GoM drilling uncertainties. Another key concern is Noble's highest concentrated jackup exposure (43 out of total 63 rigs), which we believe will continue to face challenges in renewing/obtaining contracts on favorable terms.

This accounts for the Zacks #5 Rank on Transocean and Noble, the lowest rating given by Zacks and applied to 5% of all the stocks it ranks.

The remaining companies (Diamond Offshore, Ensco, Rowan, and Pride) currently have Zacks #3 Rank (Hold), meaning that these stocks are expected to perform in line with the overall market during the next 1-3 months.

We are positive on onshore contract drillers such as Patterson-UTI Energy (PTEN - Analyst Report) and Helmerich & Payne (HP - Analyst Report). The Zacks #2 Rank (Buy) rating on the companies reflects their premium newbuild rig fleet. The demand for the newbuilds have remained far more robust compared to older commodity units given their ability to drill the more challenging wells in the emerging resource plays. As such, the dayrates for these rigs are expected to hold up much better.

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