The current upturn in oil and natural gas drilling is likely to be more prolonged than similar cycles in past years judging from producers’ confidence, a top executive of Key Energy Services Inc., a leading drilling and well services equipment company, told financial analysts and producers last week.

“What’s different today… a belief in optimism, a conviction on the part of customers and producers that perhaps this cycle is going to be a little different [longer] than past cycles. We can’t stand here and promise that it will be. But what we’re seeing now is more inquiries to us about longer term contracts, two-to-three-year contracts with firm provisions” for well services and rig operations, said Key Energy CFO Thomas K. Grundman during the IPAA 2001 Oil & Gas Investment Symposium in New York City last Tuesday. “We haven’t seen that before at rates that are approaching that [level].”

This “great market” is largely being driven by favorable prices for oil and gas. Oil prices remain “very strong, at very attractive levels,” and natural gas prices will stay in the “$5.50/Mcf range over the next year,” Grundman predicted. “People can go out and hedge and take that price risk out of their production. Capital budgets have reflected [this] optimism on the part of producers.”

Key Energy’s third-quarter results, which were announced last week, also mirrored this industry optimism. The East Brunswick, NJ-based company reported net income of about $17.4 million, up from a loss of $4.2 million for the year-earlier period, on revenues of $226 million. The improved results stemmed from the strong demand for Key Energy’s drilling and well service equipment in all of its domestic and international markets, especially by gas producers, the company said. Key Energy is highly leveraged in the North American natural gas market, which Grundman estimated accounts for more than 60% of its revenues.

Reflecting the company’s growth, Grundman noted that Key Energy’s EBITDA (earnings before interest expense, taxes, depreciation, depletion, amortization and bad debt expense) margin was only $4.5 million for the first quarter of 1999, but its EBITDA margin reported last week for the latest quarter was $61 million. That’s equal to about $250 million on an annualized basis.

In addition, Key Energy started out with about 50 well service rigs in the early 1990s, Grundman said. Today, it has about 1,380 service rigs serving seven regions in the United States — the Permian Basin, Gulf Coast, Oklahoma, Michigan/Appalachian Basin, Rocky Mountains, the Four Corners Region and California — and Canada and Argentina. About 350 of the rigs currently are idle, he noted. The company has about 40% of the U.S. market, with few competitors, or at least, “no one having any real competitive punch.”

Over the past couple of years, Key Energy has managed to position itself much better financially, Grundman said. In its current quarter, the company’s debt-to-capital ratio was reduced to below 55%, he noted, adding that it has repaid more than $350 million in debt over the past two years. Also, Key Energy’s interest expense for the most recent quarter fell to $13.5 million from more than $21 million two years ago.

“[W]e’ve lowered our fixed charges to the point that when we go through the next downturn, we will remain cash flow positive,” he told the IPAA gathering. In fact, due to all of the consolidation in the rig and well services business, “we’re actually looking forward to being much more predatory in the next down cycle.”

On a segment-by-segment basis, Grundman reported that Key Energy’s well servicing business is experiencing a gross margin of 35%, “which is unheard of in the industry,” while its drilling business “has now jumped up to more than 30% on a gross margin basis.”

Even if neither segment should show any growth over the next two years, Grundman said the company still will be okay financially. “…..[O]ur long-term debt will fall down to close to $300 million and our debt-to-capital [ratio] gets down to just over 35%.” He estimated the “implied value” of Key Energy stock will be $20/share for 2001 and 2002.

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