PATTERSON UTI ENERGY INC - Quarter Report: 2006 March (Form 10-Q)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

Commission file number 0-22664

 

PATTERSON-UTI ENERGY, INC.

(Exact name of registrant as specified in its charter)

 

 

(325) 574-6300

(Registrant’s telephone number, including area code)

 

N/A
(Former name, former address and former fiscal year,
if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ     Accelerated filer o      Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

171,500,327 shares of common stock, $0.01 par value, as of May 1, 2006

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

TABLE OF CONTENTS

 

 

The following unaudited condensed consolidated financial statements include all adjustments which, in the opinion of management, are necessary in order to make such financial statements not misleading.

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

 

The interim condensed consolidated financial statements include the accounts of Patterson-UTI Energy, Inc. (the “Company”) and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

 

The interim condensed consolidated financial statements have been prepared by management of the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations, although the Company believes the disclosures included herein are adequate to make the information presented not misleading. In the opinion of management, all adjustments which are of a normal recurring nature considered necessary for presentation of the information have been included. The Unaudited Condensed Consolidated Balance Sheet as of December 31, 2005, as presented herein, was derived from the audited balance sheet of the Company. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

The Company’s former Chief Financial Officer (“former CFO”) has pleaded guilty to criminal charges arising out of his embezzlement of funds totalling approximately $77.5 million from the Company over a period of more than five years, ending November 3, 2005. The accompanying prior periods were previously restated to reflect the effects of the embezzlement in the periods of occurrence. Continuing professional and other costs related to the embezzlement are being recognized as operating costs when incurred.

 

The U.S. dollar is the functional currency for all of the Company’s operations except for its Canadian operations, which use the Canadian dollar as their functional currency. The effects of exchange rate changes are reflected in accumulated other comprehensive income, which is a separate component of stockholders’ equity (see Note 3 of these Notes to Unaudited Condensed Consolidated Financial Statements).

 

The Company provides a dual presentation of its earnings per share in its Unaudited Condensed Consolidated Statements of Income: Basic Earnings per Share (“Basic EPS”) and Diluted Earnings per Share (“Diluted EPS”). Basic EPS excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding. Diluted EPS is based on the weighted-average number of common shares outstanding and the assumed exercise of dilutive instruments, including stock options, warrants and restricted shares, less the number of treasury shares assumed to be purchased with the exercise proceeds. For the three months ended March 31, 2006 and 2005, all potentially dilutive options and warrants were included in the calculation of Diluted EPS. The following table presents information necessary to calculate earnings per share for the three months ended March 31, 2006 and

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2005 as well as cash dividends per share paid during the three months ended March 31, 2006 and 2005 (in thousands, except per share amounts):

 

 

 

 

The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the results to be expected for the full year.

 

 

The Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 123 (revised 2004), Share-Based Payment (“FAS123(R)”), on January 1, 2006 and recognizes the cost of share-based payments under the fair-value-based method. The Company uses share-based payments to compensate employees and non-employee directors. All awards have been options or restricted stock. Additionally, all awards are equity instruments and include only service conditions. The Company issues new shares when vested stock option awards are exercised and when restricted stock awards are granted. As a result of the adoption of FAS123(R), the Company recognized $2.5 million of compensation expense for the quarter ended March 31, 2006, net of taxes of $1.4 million. The Company also recognized income due to the cumulative effect of this change in accounting principle of $687,000, net of taxes of $398,000, related to previously expensed amortization of restricted (unvested) stock grants.

 

During 2005, the Company’s shareholders approved the Patterson-UTI Energy, Inc. 2005 Long-Term Incentive Plan (the “2005 Plan”) and the Board of Directors adopted a resolution that no future grants would

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

be made under any of the Company’s six other previously existing plans. The Company’s share-based compensation plans at March 31, 2006 follow:

 

 

 

 

A summary of the 2005 Plan follows:

 

 

Options granted under the 1997 Plan vest over three or five years as dictated by the Compensation Committee. These options typically had terms of ten years. All options were granted with an exercise price equal to the fair market value of the Company’s common stock at the time of grant. Restricted Stock Awards granted under the 1997 Plan vest over four years.

 

Options granted under the 2001 Plan vest over five years as dictated by the Compensation Committee. These options had terms of ten years. All options were granted with an exercise price equal to the fair market value of the Company’s common stock at the time of grant. Restricted Stock Awards granted under the 2001 Plan vest over four years.

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Options granted under the Non-Employee Director Plan vest on the first anniversary of the option grant. Non-Employee Director Plan options have five year terms. All options were granted with an exercise price equal to the fair market value of the Company’s common stock at the time of grant.

 

Options granted under the DSI plan typically vested at a rate of 33% per year with ten year terms. All options were granted with an exercise price equal to the fair market value of the Company’s common stock at the time of grant.

 

Options granted under the 1996 plan vested over one, four and five years as dictated by the Compensation Committee. These options had terms of five and ten years as dictated by the Compensation Committee. All options were granted with an exercise price equal to the fair market value of the Company’s common stock at the time of grant.

 

Options granted under the 1993 Plan, typically had terms of 10 years and vested over five years in 20% increments beginning at the end of the first year. All options were granted with an exercise price equal to the fair market value of the Company’s common stock at the time of grant.

 

Stock Options.  The Company accounted for all stock options under the intrinsic value method prior to January 1, 2006. Accordingly, no compensation expense was recognized in prior periods for stock options because exercise prices were equal to the grant date market value of the related common stock. The Modified Prospective Application (“MPA”) method is being applied to transition from the intrinsic value method to the fair-value-based method for stock options. The effects of the application of the MPA method follow:

 

 

The Company estimates grant date fair values of stock options with the Black-Scholes-Merton valuation model (“Black-Scholes”), except for stock options granted prior to 1996 that are not subject to FAS123(R) and were not subject to FAS123 pro forma disclosures. Weighted-average assumptions used to estimate grant date fair values for stock option granted in 2004 to 2006 follow:

 

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Stock option activity from January 1, 2006 to March 31, 2006 follows:

 

 

 

 

The weighted-average grant date fair value of stock options granted during the three months ended March 31, 2006 was $34.24. No stock options were granted during the three months ended March 31, 2005. No stock options were exercised during the three months ended March 31, 2006. The aggregate intrinsic value of stock options exercised during the three months ended March 31, 2005 was $13.9 million. Of the nonvested stock options as of March 31, 2006, 1.2 million shares are expected to vest. The aggregate intrinsic value of options expected to vest at March 31, 2006, is $14.5 million with a weighted average remaining contractual term of 7.93 years. As of March 31, 2006, there was $7.1 million of unrecognized compensation cost, net estimated forfeitures, related to nonvested stock options, which is expected to be recognized over a weighted average period of 1.1 years.

 

Restricted Stock.  Under all restricted stock awards to date, shares are issued when granted, nonvested shares are subject to forfeiture for failure to fulfill service conditions and nonforfeitable dividends are paid to nonvested holders of restricted shares. Restricted stock awards prior to January 1, 2006 were valued at the grant date market value of the underlying common stock, recognized as contra equity deferred compensation and amortized to expense under the “graded-vesting” method. Implementation of FAS123(R) did not change the accounting for the Company’s nonvested stock awards, except as follows:

 

 

The Company uses the “graded-vesting” attribution method to determine periodic compensation cost from restricted stock awards.

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Restricted stock activity from January 1, 2006 to March 31, 2006 follows:

 

 

Of the 834,200 shares of nonvested restricted stock granted at March 31, 2006, 643,000 shares are expected to vest. The intrinsic value of the shares expected to vest is $16.5 million with a weighted average grant date fair value of $25.65. At March 31, 2006, there was $12.2 million of unrecognized compensation cost related to restricted share-based compensation arrangements granted under the Company’s plans. That cost is expected to be recognized over a weighted-average period of 2.3 years. No restricted shares vested during the three months ended March 31, 2006 or 2005.

 

Dividends on Equity Awards.  Nonforfeitable dividends paid on equity awards are recognized as follows:

 

 

Vesting expectations, in regard to these dividend payments, correspond with forfeiture rate assumptions used to recognize compensation cost. Accordingly, reclassifications between retained earnings and compensation cost occur when the Company adjusts forfeiture rate assumptions or when actual forfeitures are ultimately recognized.

 

Prior Period Pro Forma Disclosures.  Prior to January 1, 2006, the Company accounted for share-based compensation under the intrinsic value method. Other than the restricted stock discussed above, no additional share-based compensation expense was reflected in prior period earnings since the exercise price was equal to the grant date market value of the underlying common stock for all stock options granted prior to January 1, 2006. The effect of share-based compensation, as if the Company had applied the fair-value-based method required by FAS123, on net income and earnings per share for prior periods presented follows (in thousands, except per share amounts):

 

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The following table illustrates the Company’s comprehensive income (expense) including the effects of foreign currency translation adjustments for the three months ended March 31, 2006 and 2005 (in thousands):

 

 

 

Property and equipment consisted of the following at March 31, 2006 and December 31, 2005 (in thousands):

 

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Our revenues, operating profits and identifiable assets are primarily attributable to four business segments: (i) contract drilling of oil and natural gas wells, (ii) pressure pumping services, (iii) drilling and completion fluid services to operators in the oil and natural gas industry, and (iv) the exploration, development, acquisition and production of oil and natural gas. Each of these segments represents a distinct type of business based upon the type and nature of services and products offered. These segments have separate management teams which report to the Company’s chief executive officer and have distinct and identifiable revenues and expenses. Separate financial data for each of our four business segments is provided below (in thousands).

 

 

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

 

Goodwill is evaluated to determine if the fair value of an asset has decreased below its carrying value. At December 31, 2005 the Company performed its annual goodwill evaluation and determined no adjustment to impair goodwill was necessary. Goodwill as of March 31, 2006 and December 31, 2005 is as follows (in thousands):

 

 

 

Accrued expenses consisted of the following at March 31, 2006 and December 31, 2005 (in thousands):

 

 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations,” (“SFAS No. 143”), requires that the Company record a liability for the estimated costs to be incurred in connection with the abandonment of oil and natural gas properties in the future. The following table describes the changes to our asset retirement obligations during the three months ended March 31, 2006 and 2005 (in thousands):

 

 

 

The Company maintains letters of credit in the aggregate amount of approximately $56 million for the benefit of various insurance companies as collateral for retrospective premiums and retained losses which could become payable under the terms of the underlying insurance contracts. These letters of credit expire at various times during each calendar year. No amounts have been drawn under the letters of credit.

 

The Company has signed non-cancelable commitments to purchase $112 million of equipment to be received throughout the remainder of 2006.

 

A receiver has been appointed to identify the assets of our former CFO in connection with his embezzlement of Company funds. The receiver will liquidate the assets and propose a plan to distribute the proceeds. While the Company believes it has a claim for at least the full amount of funds embezzled from the Company, other creditors have asserted or may assert claims with respect to the assets held by the receiver. As a result, recovery by the Company from the receiver is uncertain as to timing and amount, if any, of the proceeds from the liquidation of the assets held by the receiver. Recoveries, if any, will be recognized when they are considered collectable.

 

In December 2005, two derivative actions were filed in Texas state court in Scurry County, Texas, against the directors of the Company, alleging that the directors breached their fiduciary duties to the Company as a result of alleged failure to timely discover the embezzlement. The Board of Directors formed a special litigation committee to review and inquire about these allegations and recommend the Company’s response, if any. Further legal proceedings in these suits have been stayed pending completion of the work of the special litigation committee. The lawsuits seek recovery on behalf of and for the Company and do not seek recovery from the Company.

 

The Company is party to various other legal proceedings arising in the normal course of its business. The Company does not believe that the outcome of these proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition.

 

 

On March 2, 2006, the Company’s Board of Directors approved a cash dividend on its common stock in the amount of $0.04 per share. The cash dividend of approximately $6.9 million was paid on March 30, 2006. The amount and timing of all future dividend payments is subject to the discretion of the Board of Directors and will depend upon business conditions, results of operations, financial condition, terms of the Company’s credit facilities and other factors.

 

 

Between April 3 and April 7, 2006, the Company purchased 1,250,000 shares of its common stock at a weighted average purchase price of $32.75 per share. The total cost of the stock purchases was $40.9 million. This stock will be accounted for as treasury stock.

 

On April 26, 2006, the Company’s Board of Directors approved an increase in its quarterly cash dividend from $0.04 to $0.08 on each outstanding share of its common stock to be paid on June 30, 2006 to holders of record on June 15, 2006.

 

Management Overview — We are a leading provider of contract services to the North American oil and natural gas industry. Our services primarily involve the drilling, on a contract basis, of land-based oil and natural gas wells and, to a lesser extent, we provide pressure pumping services and drilling and completion fluid services. In addition to the aforementioned contract services, we also engage in the development, exploration, acquisition and production of oil and natural gas. For the three months ended March 31, 2006 and 2005, our operating revenues consisted of the following (dollars in thousands):

 

 

We provide our contract services to oil and natural gas operators in many of the oil and natural gas producing regions of North America. Our contract drilling operations are focused in various regions of Texas, New Mexico, Oklahoma, Louisiana, Mississippi, Colorado, Utah, Wyoming, Montana, North Dakota, South Dakota and Western Canada while our pressure pumping services are focused primarily in the Appalachian Basin. Our drilling and completion fluids services are provided to operators in Texas, Southeastern New Mexico, Oklahoma, the Gulf Coast region of Louisiana and the Gulf of Mexico. Our oil and natural gas operations are primarily focused in West and South Texas, Southeastern New Mexico, Utah and Mississippi.

 

We have been a leading consolidator of the land-based contract drilling industry over the past several years, increasing our drilling fleet to 403 rigs as of March 31, 2006. Based on publicly available information, we believe we are the second largest owner of land-based drilling rigs in North America. Growth by acquisition has been a corporate strategy intended to expand both revenues and profits.

 

The profitability of our business is most readily assessed by two primary indicators: our average number of rigs operating and our average revenue per operating day. During the first quarter of 2006, our average number of rigs operating increased to 300 from 292 in the fourth quarter of 2005 and 263 in the first quarter of 2005. Our average revenue per operating day increased to $18,840 in the first quarter of 2006 from $17,130 in the fourth quarter of 2005 and $12,490 in the first quarter of 2005. Primarily due to these improvements, we experienced an increase of approximately $101 million, or 174%, in consolidated net income for the first quarter of 2006 as compared to the first quarter of 2005.

 

Our revenues, profitability and cash flows are highly dependent upon the market prices of oil and natural gas. During periods of improved commodity prices, the capital spending budgets of oil and natural gas operators tend to expand, which results in increased demand for our contract services. Conversely, in periods of time when these commodity prices deteriorate, the demand for our contract services generally weakens and we experience downward pressure on pricing for our services. In addition, our operations are highly impacted by competition, the availability of excess equipment, labor issues and various other factors which are more fully described as “Risk Factors” included as Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2005, beginning on page 11.

 

Management believes that the liquidity of our balance sheet as of March 31, 2006, which includes approximately $475 million in working capital (including $253 million in cash), no long-term debt and $144 million available under a $200 million line of credit (availability of $56 million is reserved for outstanding letters of credit), provides us with the ability to pursue acquisition opportunities, expand into new regions, make improvements to our assets and survive downturns in our industry.

 

Commitments and Contingencies — The Company maintains letters of credit in the aggregate amount of approximately $56 million for the benefit of various insurance companies as collateral for retrospective premiums and

retained losses which could become payable under the terms of the underlying insurance contracts. These letters of credit expire at various times during each calendar year. No amounts have been drawn under the letters of credit.

 

The Company has signed non-cancelable commitments to purchase $112 million of equipment to be received throughout the remainder of 2006.

 

A receiver has been appointed to identify the assets of our former CFO in connection with his embezzlement of Company funds. The receiver will liquidate the assets and propose a plan to distribute the proceeds. While the Company believes it has a claim for at least the full amount of funds embezzled from the Company, other creditors have asserted or may assert claims with respect to the assets held by the receiver. As a result, recovery by the Company from the receiver is uncertain as to timing and amount, if any, of the proceeds from the liquidation of the assets held by the receiver. Recoveries, if any, will be recognized when they are considered collectable.

 

In December 2005, two derivative actions were filed in Texas state court in Scurry County, Texas, against the directors of the Company, alleging that the directors breached their fiduciary duties to the Company as a result of alleged failure to timely discover the embezzlement. The Board of Directors formed a special litigation committee to review and inquire about these allegations and recommend the Company’s response, if any. Further legal proceedings in these suits have been stayed pending completion of the work of the special litigation committee. The lawsuits seek recovery on behalf of and for the Company and do not seek recovery from the Company.

 

Trading and Investing — We have not engaged in trading activities that include high-risk securities, such as derivatives and non-exchange traded contracts. We invest cash primarily in highly liquid, short-term investments such as overnight deposits, money markets, and highly rated municipal and commercial bonds.

 

Description of Business — We conduct our contract drilling operations in Texas, New Mexico, Oklahoma, Louisiana, Mississippi, Colorado, Utah, Wyoming, Montana, North Dakota, South Dakota and Western Canada. As of March 31, 2006, we owned 403 drilling rigs. We provide pressure pumping services to oil and natural gas operators primarily in the Appalachian Basin. These services consist primarily of well stimulation and cementing for completion of new wells and remedial work on existing wells. We provide drilling fluids, completion fluids and related services to oil and natural gas operators in Texas, Southeastern New Mexico, Oklahoma, the Gulf Coast region of Louisiana and the Gulf of Mexico. Drilling and completion fluids are used by oil and natural gas operators during the drilling process to control pressure when drilling oil and natural gas wells. We are also engaged in the development, exploration, acquisition and production of oil and natural gas. Our oil and natural gas operations are focused primarily in producing regions in West and South Texas, Southeastern New Mexico, Utah and Mississippi.

 

The North American land drilling industry has experienced periods of downturn in demand over the last decade. During these periods, there have been substantially more drilling rigs available than necessary to meet demand. As a result, drilling contractors have had difficulty sustaining profit margins during the downturn periods.

 

In addition to adverse effects that future declines in demand could have on us, ongoing factors which could adversely affect utilization rates and pricing, even in an environment of stronger oil and natural gas prices and increased drilling activity, include:

 

 

We cannot predict either the future level of demand for our contract drilling services or future conditions in the oil and natural gas contract drilling business.

 

Critical Accounting Policies

 

In addition to established accounting policies, our consolidated financial statements are impacted by certain estimates and assumptions made by management. No changes in our critical accounting policies have occurred since we issued our December 31, 2005, Form 10-K.

Liquidity and Capital Resources

 

As of March 31, 2006, we had working capital of approximately $475 million, including cash and cash equivalents of $253 million. For the three months ended March 31, 2006, our significant sources of cash flow included:

 

 

We used $7 million to pay dividends on the Company’s common stock and $114 million:

 

 

On March 2, 2006, the Company’s Board of Directors approved a cash dividend on its common stock in the amount of $0.04 per share. The dividend of approximately $6.9 million was paid on March 30, 2006.

 

Between April 3 and April 7, 2006, the Company purchased 1,250,000 shares of its common stock at a weighted average purchase price of $32.75 per share. The total cost of the stock purchases was $40.9 million. This stock will be accounted for as treasury stock.

 

On April 26, 2006, the Company’s Board of Directors approved an increase in its quarterly cash dividend from $0.04 to $0.08 on each outstanding share of its common stock to be paid on June 30, 2006 to holders of record on June 15, 2006. The amount and timing of all future dividend payments is subject to the discretion of the Board of Directors and will depend upon business conditions, results of operations, financial condition, terms of the Company’s credit facilities and other factors.

 

We believe that the current level of cash and short-term investments, together with cash generated from operations, should be sufficient to meet our capital needs. From time to time, acquisition opportunities are evaluated. The timing, size or success of any acquisition and the associated capital commitments are unpredictable. Should opportunities for growth requiring capital arise, we believe we would be able to satisfy these needs through a combination of working capital, cash generated from operations, our existing credit facility and additional debt or equity financing. However, there can be no assurance that such capital would be available.

Results of Operations

 

The following tables summarize operations by business segment for the three months ended March 31, 2006 and 2005:

 

 

Revenues and direct operating costs increased as a result of the increased number of operating days, as well as an increase in the average revenue and average direct operating costs per operating day. Operating days and average rigs operating increased primarily as a result of increased demand for our contract drilling services and the increase in the number of marketable rigs in our fleet due to our ongoing rig activation program. Average revenue per operating day increased as a result of increased demand and pricing for our drilling services. Average direct operating costs per operating day increased primarily as a result of increased compensation costs and an increase in the cost of maintenance for our rigs. Significant capital expenditures were incurred during the first quarter of 2006 to activate additional drilling rigs to meet increased demand, to modify and upgrade our existing drilling rigs and to acquire additional related equipment such as drill pipe, drill collars, engines, fluid circulating systems, rig hoisting systems and safety enhancement equipment. Increased depreciation expense was due to acquisitions and capital expenditures in 2006 and 2005.

 

 

Revenues and direct operating costs increased as a result of the increased number of jobs, as well as an increase in the average revenue and average direct operating cost per job. The increase in jobs was attributable to increased demand for our services and increased operating capacity which was added. Increased average revenue per job was due to increased pricing for our services and an increase in the number of larger jobs. Average direct operating costs per job increased as a result of increases in the cost of sand and other materials used in our operations as well as an increase in the number of larger jobs. Selling, general and administrative expenses increased primarily as a result of the expanding operations of the pressure pumping segment. Increased depreciation expense for the 2006 quarter was largely due to the expansion of the pressure pumping segment through capital expenditures. Significant capital

expenditures were incurred during the first quarter of 2006 to modify and upgrade existing equipment and to add additional equipment to the segment’s expanded operations to meet increased demand.

 

 

Revenues and direct operating costs increased as a result of an increase in the average revenue and direct operating costs per job. Average revenue and direct operating costs per job increased primarily as a result of an increase in the size of jobs completed in the Gulf of Mexico as well as an increase in the size of our smaller land-based jobs. Selling, general and administrative expense increased in 2006 primarily due to increased incentive compensation resulting from higher profitability levels.

 

 

Revenues decreased primarily due to decreases in the net daily production of natural gas. Average net daily oil and natural gas production decreased as a result of production declines and the sale of certain oil and natural gas properties during 2005. Depreciation, depletion and impairment expense includes approximately $602,000 incurred during the three months ended March 31, 2005 to impair certain oil and natural gas properties. Depreciation and depletion further decreased in 2006 as a result of decreased oil and natural gas production.

 

Selling, general and administrative expenses increased primarily as a result of compensation expense related to the issuance of restricted shares to certain key employees in the second quarter of 2005 and the first quarter of 2006, and compensation expense related to the adoption of a new accounting standard, FAS 123(R), in the first quarter of 2006 requiring the expensing of stock options. Gain (loss) on sale of assets includes gains recognized on the sale of certain oil and natural gas properties and other equipment. Interest income increased as a result of higher cash balances and interest rates in 2006. Embezzled funds and related expenses in 2005 includes payments made to or for the benefit of Jonathan D. Nelson, our former CFO, for assets and services that were not received by the Company and in 2006 includes continuing professional and other costs related to the embezzlement.

 

Prior to the adoption of FAS 123(R) on January 1, 2006, the Company accounted for all stock options under the intrinsic value method. Accordingly, no compensation expense was recognized in prior periods for stock options because exercise prices were equal to the grant date market value of the related common stock. The MPA method is being applied to transition from the intrinsic value method to the fair-value-based method for stock options (see Note 2 of these Notes to Unaudited Condensed Consolidated Financial Statements).

 

Volatility of Oil and Natural Gas Prices and its Impact on Operations

 

Our revenue, profitability, and rate of growth are substantially dependent upon prevailing prices for oil and natural gas, with respect to all of our operating segments. For many years, oil and natural gas prices and markets have been volatile. Prices are affected by market supply and demand factors as well as international military, political and economic conditions, and the ability of OPEC to set and maintain production and price targets. All of these factors are beyond our control. Natural gas prices fell from an average of $6.23 per Mcf in the first quarter of 2001 to an average of $2.51 per Mcf for the same period in 2002. During this same period, the average number of our rigs operating dropped by approximately 50%. The average market price of natural gas improved from $3.36 in 2002 to $7.94 in the first quarter of 2006, resulting in an increase in demand for our drilling services. Our average number of rigs operating increased from 126 in 2002 to 300 in the first quarter of 2006. We expect oil and natural gas prices to continue to be volatile and to affect our financial condition and operations and ability to access sources of capital. A significant decrease in expected market prices for natural gas could result in a material decrease in demand for drilling rigs and reduction in our operation results.

 

The North American land drilling industry has experienced many downturns in demand over the last decade. During these periods, there have been substantially more drilling rigs available than necessary to meet demand. As a result, drilling contractors have had difficulty sustaining profit margins during the downturn periods.

 

Impact of Inflation

 

We believe that inflation will not have a significant near-term impact on our financial position.

 

We currently have no exposure to interest rate market risk as we have no outstanding balance under our credit facility. Should we incur a balance in the future, we would have exposure associated with the floating rate of the interest charged on that balance. The revolving credit facility calls for periodic interest payments at a floating rate ranging from LIBOR plus 0.625% to 1.0% or at the prime rate. The applicable rate above LIBOR is based upon our debt to capitalization ratio. Our exposure to interest rate risk due to changes in LIBOR is not expected to be material.

 

We conduct some business in Canadian dollars through our Canadian land-based drilling operations. The exchange rate between Canadian dollars and U.S. dollars has fluctuated during the last several years. If the value of the Canadian dollar against the U.S. dollar weakens, revenues and earnings of our Canadian operations will be reduced and the value of our Canadian net assets will decline when they are translated to U.S. dollars.

 

Disclosure Controls and Procedures — We maintain disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) designed to ensure that the information required to be disclosed in the reports that we file with the

SEC under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure.

 

Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, and due to the material weaknesses in the Company’s internal control over financial reporting as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, our CEO and CFO concluded that our disclosure controls and procedures were not effective at a reasonable level of assurance, as of March 31, 2006. For a discussion of the material weaknesses, see Item 9A of our Annual Report on Form 10-K for the year ended December 31, 2005.

 

Changes in Internal Control Over Financial Reporting — Our management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f). With the participation of our CEO and CFO, our management evaluates any changes in our internal control over financial reporting that occurred during each fiscal quarter which have materially affected, or are reasonably likely to materially affect, such internal control. At December 31, 2005, the Company’s assessment of the effectiveness of its internal control over financial reporting concluded that material weaknesses in its control environment and controls over property and equipment existed. During the first three months of 2006, the Company has implemented, or is in the process of implementing, remediation steps to address these material weaknesses. You can find more information about these material weaknesses and the actions that we have taken and are planning to take to remediate the material weaknesses in Item 9A of our Annual Report on Form 10-K for the year ended December 31, 2005.

 

Except as discussed above, there were no changes in the Company’s internal control over financial reporting during its most recently completed fiscal quarter that have materially affected or are reasonably likely to materially affect its internal control over financial reporting, as defined in Rule 13a-15(f) under the Exchange Act.

 

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 2 of this Report contains forward-looking statements which are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. These statements include, without limitation, statements relating to: liquidity; financing of operations; continued volatility of oil and natural gas prices; source and sufficiency of funds required for immediate capital needs and additional rig acquisitions (if further opportunities arise); and other matters. The words “believes,” “plans,” “intends,” “expected,” “estimates” or “budgeted” and similar expressions identify forward-looking statements. The forward-looking statements are based on certain assumptions and analyses we make in light of our experience and our perception of historical trends, current conditions, expected future developments and other factors we believe are appropriate in the circumstances. We do not undertake to update, revise or correct any of the forward-looking information. Factors that could cause actual results to differ materially from our expectations expressed in the forward-looking statements include, but are not limited to, the following:

 

 

For a more complete explanation of these various factors and others, see “Risk Factors” included as Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2005, beginning on page 11.

 

You are cautioned not to place undue reliance on any of our forward-looking statements, which speak only as of the date of this Report or, in the case of documents incorporated by reference, the date of those documents.

 

(a) Exhibits.

 

The following exhibits are filed herewith or incorporated by reference, as indicated:

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

PATTERSON-UTI ENERGY, INC.

 

Cloyce A. Talbott
(Principal Executive Officer)
Chief Executive Officer

 

John E. Vollmer III

(Principal Financial and Accounting Officer)

Senior Vice President-Corporate Development,
Chief Financial Officer, Secretary and Treasurer

 

DATED: May 5, 2006