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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
Form 10-K
 
     
(Mark One)    
 
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2006
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission File Number 0-22664
 
 
 
Patterson-UTI Energy, Inc.
(Exact name of registrant as specified in its charter)
 
     
Delaware   75-2504748
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
4510 Lamesa Highway, Snyder, Texas   79549
(Address of principal executive offices)
  (Zip Code)
 
Registrant’s telephone number, including area code:
(325) 574-6300
 
 
Securities Registered Pursuant to 12(b) of the Act:
None
 
Securities Registered Pursuant to 12(g) of the Act:
(Title of class)
 
Common Stock, $.01 Par Value
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     or No o
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     or No þ
 
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
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 Act).  Yes o     No þ
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2006, the last business day of the registrant’s most recently completed second fiscal quarter, was $4,638,987,745, calculated by reference to the closing price of $28.31 for the common stock on the Nasdaq National Market on that date.
 
As of February 22, 2007, the registrant had outstanding 156,543,478 shares of common stock, $.01 par value, its only class of voting common stock.
 
Documents incorporated by reference:
 
Definitive Proxy Statement for the 2007 Annual Meeting of Stockholders (Part III).
 


 

 
FORWARD LOOKING STATEMENTS
 
This Annual Report on Form 10-K (including documents incorporated by reference herein) contains statements with respect to our expectations and beliefs as to future events. These types of statements are “forward-looking” and subject to uncertainties. Readers are cautioned that such forward-looking statements should be read in conjunction with our disclosures under the heading “Risk Factors,” in Part I of this Report.
 
PART I
 
Item 1.   Business
 
Available Information
 
This Annual Report on Form 10-K, along with our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available free of charge through our Internet website (www.patenergy.com) as soon as reasonably practicable after we electronically file such material with, or furnish it to, the United States Securities and Exchange Commission (“SEC”).
 
Overview
 
Based on publicly available information, we believe we are the second largest operator of land-based drilling rigs in North America. The Company was formed in 1978 and reincorporated in 1993 as a Delaware corporation. Our contract drilling business operates primarily in:
 
  •  Texas,
 
  •  New Mexico,
 
  •  Oklahoma,
 
  •  Arkansas,
 
  •  Louisiana,
 
  •  Mississippi,
 
  •  Colorado,
 
  •  Utah,
 
  •  Wyoming,
 
  •  Montana,
 
  •  North Dakota,
 
  •  South Dakota, and
 
  •  Western Canada (Alberta, British Columbia and Saskatchewan).
 
As of December 31, 2006, we had a drilling fleet that consisted of 336 currently marketable land-based drilling rigs. A drilling rig includes the structure, power source and machinery necessary to cause a drill bit to penetrate earth to a depth desired by the customer. A drilling rig is considered currently marketable at a point in time if it is operating or can be made ready to operate without significant capital expenditures. We also have a substantial inventory of drilling rig components and equipment which may be used in the activation of additional drilling rigs or as replacement parts for marketable 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 offshore in the Gulf of Mexico and on land in Texas, Southeastern New Mexico, Oklahoma and the Gulf Coast


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region of Louisiana. 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 of West and South Texas, Southeastern New Mexico, Utah and Mississippi.
 
Industry Segments
 
Our revenues, operating profits and identifiable assets are primarily attributable to four industry segments:
 
  •  contract drilling,
 
  •  pressure pumping services,
 
  •  drilling and completion fluids services, and
 
  •  oil and natural gas development, exploration, acquisition and production.
 
All of our industry segments had operating profits in 2006, 2005 and 2004.
 
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 15 of Notes to Consolidated Financial Statements included as a part of Items 7 and 8, respectively, of this Report for financial information pertaining to these industry segments.
 
Contract Drilling Operations
 
General — We market our contract drilling services to major and independent oil and natural gas operators. As of December 31, 2006, we had 336 currently marketable land-based drilling rigs which were based in the following regions:
 
  •  107 in the Permian Basin region (West Texas and Southeastern New Mexico),
 
  •  50 in South Texas,
 
  •  44 in the Ark-La-Tex region and Mississippi,
 
  •  67 in the Mid-Continent region (Oklahoma and North Central Texas),
 
  •  48 in the Rocky Mountain region (Colorado, Utah, Wyoming, Montana, North Dakota and South Dakota), and
 
  •  20 in Western Canada (Alberta, British Columbia and Saskatchewan).
 
Our marketable drilling rigs have rated maximum depth capabilities ranging from 5,000 feet to 30,000 feet. Fifty-six of these drilling rigs are SCR electric rigs and 280 are mechanical rigs. An electric rig differs from a mechanical rig in that the electric rig converts the diesel power (the sole energy source for a mechanical rig) into electricity to power the rig. We also have a substantial inventory of drilling rig components and equipment which may be used in the activation of additional drilling rigs or as replacement parts for marketable rigs.
 
Drilling rigs are typically equipped with:
 
  •  engines,
 
  •  drawworks or hoists,
 
  •  derricks or masts,
 
  •  pumps to circulate the drilling fluid,
 
  •  blowout preventers,
 
  •  drill string (pipe), and
 
  •  other related equipment.


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Over time, components on a drilling rig are replaced or rebuilt. We spend significant funds each year on an ongoing program to modify and upgrade our drilling rigs to ensure that our drilling equipment is well maintained and competitive. We have spent $1 billion during the last three years on capital improvements to modify and upgrade our drilling rigs. During fiscal years 2006, 2005 and 2004, we spent approximately $531 million, $329 million and $141 million, respectively, on these capital improvements.
 
Depth and complexity of the well and drill site conditions are the principal factors in determining the size of drilling rig used for a particular job. We use our rigs for developmental and exploratory drilling, and they are capable of vertical or horizontal drilling.
 
Our contract drilling operations depend on the availability of:
 
  •  drill pipe,
 
  •  bits,
 
  •  replacement parts and other related rig equipment,
 
  •  fuel, and
 
  •  qualified personnel,
 
some of which have been in short supply from time to time.
 
Drilling Contracts — Most of our drilling contracts are with established customers on a competitive bid or negotiated basis. Typically, the contracts are short-term to drill a single well or a series of wells. Customer demand for drilling contracts with a term of one or more years increased during 2005 due to the scarcity of available drilling rigs in the market place. In response to this demand, we entered into several long-term contracts in 2005 and 2006. These long-term contracts provide for the use of drilling rigs for fixed periods of time during which multiple wells are drilled. During 2006, our average number of days to drill a well was approximately 21 days. We may continue to enter into long-term contracts when considered beneficial to the Company.
 
The drilling contracts obligate us to provide and operate a drilling rig and to pay certain operating expenses, including wages of drilling personnel and necessary maintenance expenses. Most drilling contracts are subject to termination by the customer on short notice. We generally indemnify our customers against claims by our employees and claims that might arise from surface pollution caused by spills of fuel, lubricants and other solvents within our control. The customers generally indemnify us against claims that might arise from other surface and subsurface pollution, except claims that might arise from our gross negligence.
 
The contracts provide for payment on a daywork, footage, or turnkey basis, or a combination thereof. In each case, we provide the rig and crews. Our bid for each contract depends upon:
 
  •  location, depth and anticipated complexity of the well,
 
  •  on-site drilling conditions,
 
  •  equipment to be used,
 
  •  estimated risks involved,
 
  •  estimated duration of the job,
 
  •  availability of drilling rigs, and
 
  •  other factors particular to each proposed well.
 
Daywork Contracts
 
Under daywork contracts, we provide the drilling rig and crew to the customer. The customer supervises the drilling of the well. Our compensation is based on a contracted rate per day during the period the drilling rig is utilized. We sometimes receive a lower rate when the drilling rig is moving, or when drilling operations are


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interrupted or restricted by adverse weather conditions or other conditions beyond our control. Daywork contracts typically provide separately for mobilization of the drilling rig.
 
Footage Contracts
 
Under footage contracts, we contract to drill a well to a certain depth under specified conditions for a fixed price per foot. The customer provides drilling fluids, casing, cementing and well design expertise. These contracts require us to bear the cost of services and supplies that we provide until the well has been drilled to the agreed depth. If we drill the well in less time than estimated, we have the opportunity to improve our profits over those that would be attainable under a daywork contract. Profits are reduced and losses may be incurred if the well requires more days to drill to the contracted depth than estimated. Footage contracts generally contain greater risks for a drilling contractor than daywork contracts. Under footage contracts, the drilling contractor assumes certain risks associated with loss of the well from fire, blowouts and other risks. Due to current market conditions and improved rates received under daywork contracts, we are entering into fewer footage contracts than we did in the past.
 
Turnkey Contracts
 
Under turnkey contracts, we contract to drill a well to a certain depth under specified conditions for a fixed fee. In a turnkey arrangement, we are required to bear the costs of services, supplies and equipment beyond those typically provided under a footage contract. In addition to the drilling rig and crew, we are required to provide the drilling and completion fluids, casing, cementing, and the technical well design and engineering services during the drilling process. We also assume certain risks associated with drilling the well such as fires, blowouts, cratering of the well bore and other such risks. Compensation occurs only when the agreed scope of the work has been completed, which requires us to make larger up-front working capital commitments prior to receiving payments under a turnkey drilling contract. Under a turnkey contract, we have the opportunity to improve our profits if the drilling process goes as expected and there are no complications or time delays. However, given the increased exposure we have under a turnkey contract, profits can be significantly reduced and losses can be incurred if complications or delays occur during the drilling process. Turnkey contracts generally involve the highest degree of risk among the three different types of drilling contracts: daywork, footage and turnkey. Due to current market conditions and improved rates received under daywork contracts, we are entering into fewer turnkey contracts than we did in the past.
 
Revenues by Contract Type — Information regarding our revenues by contract type for the last three years follows:
 
                         
    Year Ended December 31,  
Type of Revenues
  2006     2005     2004  
 
Daywork
    100 %     98 %     88 %
Footage
    0       1       6  
Turnkey
    0       1       6  
 
Contract Drilling Activity — Information regarding our contract drilling activity for the last three years follows:
 
                         
    Year Ended December 31,  
    2006     2005     2004  
 
Average rigs operating(1)
    296       276       211  
Number of rigs operated
    331       307       259  
Number of wells drilled
    5,050       4,594       3,534  
Number of operating days
    108,221       100,591       77,355  
 
 
(1)  A rig is operating when it is drilling, being moved, assembled, dismantled or otherwise earning revenue under contract.


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Drilling Rigs and Related Equipment — Certain drilling rig information with respect to rigs that were currently marketable as of December 31, 2006 follows:
 
                         
Depth Rating (Ft.)
  Mechanical     Electric     Total  
 
5,000 to 9,999
    33             33  
10,000 to 11,999
    49       3       52  
12,000 to 13,999
    60       5       65  
14,000 to 15,999
    120       21       141  
16,000 to 30,000
    18       27       45  
                         
Totals
    280       56       336  
                         
 
At December 31, 2006, we owned and operated 336 trucks and 439 trailers used to rig down, transport and rig up our drilling rigs. Our ownership of trucks and trailers reduces our dependency upon third parties for these services and enhances the efficiency of our contract drilling operations particularly in periods of high drilling rig utilization.
 
Most repair and overhaul work to our drilling rig equipment is performed at our yard facilities located in Texas, New Mexico, Oklahoma, Wyoming, Utah and Western Canada.
 
Pressure Pumping Operations
 
General — We provide pressure pumping services to oil and natural gas operators primarily in the Appalachian Basin. Pressure pumping services are primarily well stimulation and cementing for the completion of new wells and remedial work on existing wells. Most wells drilled in the Appalachian Basin require some form of fracturing or other stimulation to enhance the flow of oil and natural gas by pumping fluids under pressure into the well bore. Generally, Appalachian Basin wells require cementing services before production commences. The cementing process inserts material between the wall of the well bore and the casing to center and stabilize the casing.
 
Equipment — Our pressure pumping equipment at December 31, 2006 follows:
 
  •  36 cement pumper trucks,
 
  •  35 fracturing pumper trucks,
 
  •  37 nitrogen pumper trucks,
 
  •  20 blender trucks,
 
  •  7 bulk acid trucks,
 
  •  44 bulk cement trucks,
 
  •  14 bulk nitrogen trucks,
 
  •  3 bulk nitrogen trailers,
 
  •  40 bulk sand trucks,
 
  •  21 connection trucks,
 
  •  3 acid pumper trucks, and
 
  •  10 sand pneumatic trucks.
 
Drilling and Completion Fluids Operations
 
General — We provide drilling fluids, completion fluids and related services to oil and natural gas operators offshore in the Gulf of Mexico and on land in Texas, Southeastern New Mexico, Oklahoma and the Gulf Coast region of Louisiana. We serve our offshore customers through six stockpoint facilities located along the Gulf of


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Mexico in Texas and Louisiana and our land-based customers through eleven stockpoint facilities in Texas, Louisiana, Oklahoma and New Mexico.
 
Drilling Fluids — Drilling fluid products and systems are used to cool and lubricate the bit during drilling operations, contain formation pressures (thereby minimizing blowout risk), suspend and remove rock cuttings from the hole and maintain the stability of the wellbore. Technical services are provided to ensure that the products and systems are applied effectively to optimize drilling operations.
 
Completion Fluids — After a well is drilled, the well casing is set and cemented into place. At that point, the drilling fluid services are complete and the drilling fluids are circulated out of the well and replaced with completion fluids. Completion fluids, also known as clear brine fluids, are solids-free, clear salt solutions that have high specific gravities. Combined with a range of specialty chemicals, these fluids are used to control bottom-hole pressures and to meet specific corrosion, inhibition, viscosity and fluid loss requirements.
 
Raw Materials — Our drilling and completion fluids operations depend on the availability of the following raw materials:
 
Drilling
barite and bentonite
Completion
calcium chloride, calcium bromide and zinc bromide
 
We obtain these raw materials through purchases made on the spot market and supply contracts with producers of these raw materials.
 
Barite Grinding Facility — We own and operate a barite grinding facility with two barite grinding mills in Houma, Louisiana. This facility allows us to grind raw barite into the powder additive used in drilling fluids.
 
Other Equipment — We operate 20 trucks and 83 trailers and lease another 33 trucks which are used to transport drilling and completion fluids and related equipment.
 
Oil and Natural Gas Operations
 
General — We are engaged in the development, exploration, acquisition and production of oil and natural gas. Our oil and natural gas business operates primarily in producing regions of West and South Texas, Southeastern New Mexico, Utah and Mississippi. We significantly expanded our oil and natural gas operations in 2004 through our acquisition of TMBR/Sharp Drilling, Inc. (“TMBR”). The oil and natural gas assets acquired in the acquisition of TMBR included both proved reserves and undeveloped properties.
 
Customers
 
The customers of each of our four business segments are oil and natural gas operators or purchasers of these commodities. Our customer base includes both major and independent oil and natural gas operators. During 2006, no single customer accounted for 10% or more of our consolidated operating revenues.
 
Competition
 
Contract Drilling and Pressure Pumping Businesses — Our land drilling and pressure pumping businesses are highly competitive. At times, available land drilling rigs and pressure pumping equipment exceed the demand for such equipment. The equipment can also be moved from one market to another in response to market conditions.
 
Drilling and Completion Fluids Business — The drilling and completion fluids industry is highly competitive and price is generally the most important factor. Other competitive factors include the availability of chemicals and experienced personnel, the reputation of the fluids services provider in the drilling industry and relationships with customers. Some of our competitors have substantially more resources and longer operating histories than we have.


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Oil and Natural Gas Business — There is substantial competition for the acquisition of oil and natural gas leases suitable for development and exploration and for experienced personnel. Our competitors in this business include:
 
  •  major integrated oil and natural gas operators,
 
  •  independent oil and natural gas operators, and
 
  •  drilling and production purchase programs.
 
Our ability to increase our oil and natural gas reserves in the future is directly dependent upon our ability to select, acquire and develop suitable prospects. Many of our competitors have facilities and financial and human resources greater than ours.
 
Government and Environmental Regulation
 
All of our operations and facilities are subject to numerous Federal, state, foreign, and local laws, rules and regulations related to various aspects of our business, including:
 
  •  drilling of oil and natural gas wells,
 
  •  containment and disposal of hazardous materials, oilfield waste, other waste materials and acids,
 
  •  use of underground storage tanks, and
 
  •  use of underground injection wells.
 
To date, applicable environmental laws and regulations have not required the expenditure of significant resources. We do not anticipate any material capital expenditures for environmental control facilities or extraordinary expenditures to comply with environmental rules and regulations in the foreseeable future. However, compliance costs under existing laws or under any new requirements could become material, and we could incur liability in any instance of noncompliance.
 
Our business is generally affected by political developments and by Federal, state, foreign, and local laws and regulations that relate to the oil and natural gas industry. The adoption of laws and regulations affecting the oil and natural gas industry for economic, environmental and other policy reasons could increase costs relating to drilling and production. They could have an adverse effect on our operations. Several state and Federal environmental laws and regulations currently apply to our operations and may become more stringent in the future.
 
We use operating and disposal practices that are standard in the industry. However, hydrocarbons and other materials may have been disposed of or released in or under properties currently or formerly owned or operated by us or our predecessors. In addition, some of these properties have been operated by third parties over whom we have no control of their treatment of hydrocarbon and other materials or the manner in which they may have disposed of or released such materials.
 
The Federal Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended, commonly known as CERCLA, and comparable state statutes impose strict liability on:
 
  •  owners and operators of sites, and
 
  •  persons who disposed of or arranged for the disposal of “hazardous substances” found at sites.
 
The Federal Resource Conservation and Recovery Act (“RCRA”), as amended, and comparable state statutes govern the disposal of “hazardous wastes.” Although CERCLA currently excludes petroleum from the definition of “hazardous substances,” and RCRA also excludes certain classes of exploration and production wastes from regulation, such exemptions by Congress under both CERCLA and RCRA may be deleted, limited, or modified in the future. If such changes are made to CERCLA and/or RCRA, we could be required to remove and remediate previously disposed of materials (including materials disposed of or released by prior owners or operators) from properties (including ground water contaminated with hydrocarbons) and to perform removal or remedial actions to prevent future contamination.


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The Federal Water Pollution Control Act and the Oil Pollution Act of 1990, as amended, and implementing regulations govern:
 
  •  the prevention of discharges, including oil and produced water spills, and
 
  •  liability for drainage into waters.
 
The Oil Pollution Act is more comprehensive and stringent than previous oil pollution liability and prevention laws. It imposes strict liability for a comprehensive and expansive list of damages from an oil spill into waters from facilities. Liability may be imposed for oil removal costs and a variety of public and private damages. Penalties may also be imposed for violation of Federal safety, construction and operating regulations, and for failure to report a spill or to cooperate fully in a clean-up.
 
The Oil Pollution Act also expands the authority and capability of the Federal government to direct and manage oil spill clean-up and operations, and requires operators to prepare oil spill response plans in cases where it can reasonably be expected that substantial harm will be done to the environment by discharges on or into navigable waters. We have spill prevention control and countermeasure plans in place for our oil and natural gas properties in each of the areas in which we operate and for each of the stockpoints operated by our drilling and completion fluids business. Failure to comply with ongoing requirements or inadequate cooperation during a spill event may subject a responsible party, such as us, to civil or criminal actions. Although the liability for owners and operators is the same under the Federal Water Pollution Act, the damages recoverable under the Oil Pollution Act are potentially much greater and can include natural resource damages.
 
Our operations are also subject to Federal, state and local regulations for the control of air emissions. The Federal Clean Air Act, as amended, and various state and local laws impose certain air quality requirements on us. Amendments to the Clean Air Act revised the definition of “major source” such that emissions from both wellhead and associated equipment involved in oil and natural gas production may be added to determine if a source is a “major source.” As a consequence, more facilities may become major sources and thus would be required to obtain operating permits. This permitting process may require capital expenditures in order to comply with permit limits.
 
Risks and Insurance
 
Our operations are subject to the many hazards inherent in the drilling business, including:
 
  •  accidents at the work location,
 
  •  blow-outs,
 
  •  cratering,
 
  •  fires, and
 
  •  explosions.
 
These hazards could cause:
 
  •  personal injury or death,
 
  •  suspension of drilling operations, or
 
  •  serious damage or destruction of the equipment involved and, in addition to environmental damage, could cause substantial damage to producing formations and surrounding areas.
 
Damage to the environment, including property contamination in the form of either soil or ground water contamination, could also result from our operations, particularly through:
 
  •  oil or produced water spillage,
 
  •  natural gas leaks, and
 
  •  fires.


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In addition, we could become subject to liability for reservoir damages. The occurrence of a significant event, including pollution or environmental damages, could materially affect our operations and financial condition.
 
As a protection against operating hazards, we maintain insurance coverage we believe to be adequate, including:
 
  •  all-risk physical damages,
 
  •  employer’s liability,
 
  •  commercial general liability, and
 
  •  workers compensation insurance.
 
We believe that we are adequately insured for public liability and property damage to others with respect to our operations. However, such insurance may not be sufficient to protect us against liability for all consequences of:
 
  •  personal injury,
 
  •  well disasters,
 
  •  extensive fire damage,
 
  •  damage to the environment, or
 
  •  other hazards.
 
We also carry insurance coverage for major physical damage to our drilling rigs. However, we do not carry insurance against loss of earnings resulting from such damage. In view of the difficulties that may be encountered in renewing such insurance at reasonable rates, no assurance can be given that:
 
  •  we will be able to maintain the type and amount of coverage that we believe to be adequate at reasonable rates, or
 
  •  any particular types of coverage will be available.
 
In addition to insurance coverage, we also attempt to obtain indemnification from our customers for certain risks. These indemnity agreements typically require our customers to hold us harmless in the event of loss of production or reservoir damage. These contractual indemnifications may not be supported by adequate insurance maintained by the customer.
 
Employees
 
We had approximately 9,000 full-time employees at December 31, 2006. The number of employees fluctuates depending on the current and expected demand for our services. We consider our employee relations to be satisfactory. None of our employees are represented by a union.
 
Seasonality
 
Seasonality does not significantly affect our overall operations. However, our pressure pumping division in Appalachia and our drilling operations in Canada are subject to slow periods of activity during the Spring thaw. In addition, our drilling operations in Canada are subject to slow periods of activity during the Fall.
 
Raw Materials and Subcontractors
 
We use many suppliers of raw materials and services. These materials and services have historically been available, although there is no assurance that such materials and services will continue to be available on favorable terms or at all. We also utilize numerous independent subcontractors from various trades.


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Item 1A.   Risk Factors.
 
From time to time, we make written or oral forward-looking statements, including statements contained in this Annual Report on Form 10-K, our other filings with the SEC, press releases and reports to stockholders. These forward-looking statements 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, sources and sufficiency of funds and impact of inflation. The words “believes,” “budgeted,” “expects,” “project,” “will,” “could,” “may,” “plans,” “intends,” “strategy,” or “anticipates,” and similar expressions are used to identify our forward-looking statements. We do not undertake to update, revise, or correct any of our forward-looking information.
 
We include the following cautionary statement in accordance with the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995 for any forward-looking statement made by us, or on our behalf. The factors identified in this cautionary statement are important factors (but not necessarily all of the important factors) that could cause actual results to differ materially from those expressed in any forward-looking statement made by us, or on our behalf. Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, we caution that, while we believe such assumptions or bases to be reasonable and make them in good faith, assumed facts or bases almost always vary from actual results. The differences between assumed facts or bases and actual results can be material, depending upon the circumstances.
 
Where, in any forward-looking statement, we express an expectation or belief as to the future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis. However, there can be no assurance that the statement of expectation or belief will result, or be achieved or accomplished. Taking this into account, the following are identified as important risk factors currently applicable to, or which could readily be applicable to, us:
 
   We are Dependent on the Oil and Natural Gas Industry and Market Prices for Oil and Natural Gas. Declines in Oil and Natural Gas Prices Have Adversely Affected Our Operations.
 
Our revenue, profitability and rate of growth are substantially dependent upon prevailing prices for oil and natural gas. For many years, oil and natural gas prices and, therefore, the level of drilling, exploration, development and production, have been extremely volatile. Prices are affected by:
 
  •  market supply and demand,
 
  •  international military, political and economic conditions, and
 
  •  the ability of the Organization of Petroleum Exporting Countries, commonly known as OPEC, to set and maintain production and price targets.
 
All of these factors are beyond our control. The average market price of natural gas has improved from $3.36 in 2002 to $6.94 in 2006 resulting in an increase in demand for our drilling services. Our average number of rigs operating increased from 126 in 2002 to 296 in 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 market prices for natural gas would likely result in a material decrease in demand for drilling rigs and reduction in our operating results.
 
A General Excess of Operable Land Drilling Rigs Adversely Affects Our Profit Margins Particularly in Times of Weaker Demand.
 
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.


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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 high oil and natural gas prices and increased drilling activity, include:
 
  •  movement of drilling rigs from region to region,
 
  •  reactivation of land-based drilling rigs, or
 
  •  construction of new drilling rigs.
 
As a result of an increase in drilling activity and increased prices for drilling services, construction of new drilling rigs has increased significantly. 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.
 
Shortages of Drill Pipe, Replacement Parts and Other Related Rig Equipment Adversely Affects Our Operating Results.
 
During periods of increased demand for drilling services, the industry has experienced shortages of drill pipe, replacement parts and other related rig equipment. These shortages can cause the price of these items to increase significantly and require that orders for the items be placed well in advance of expected use. These price increases and delays in delivery may require us to increase capital and repair expenditures in our contract drilling segment. Severe shortages could impair our ability to operate our drilling rigs.
 
The Various Business Segments in Which We Operate Are Highly Competitive with Excess Capacity which may Adversely Affect Our Operating Results.
 
Our land drilling and pressure pumping businesses are highly competitive. At times, available land drilling rigs and pressure pumping equipment exceed the demand for such equipment. This excess capacity has resulted in substantial competition for drilling and pressure pumping contracts. The fact that drilling rigs and pressure pumping equipment are mobile and can be moved from one market to another in response to market conditions heightens the competition in the industry.
 
We believe that price competition for drilling and pressure pumping contracts will continue for the foreseeable future due to the existence of available rigs and pressure pumping equipment.
 
In recent years, many drilling and pressure pumping companies have consolidated or merged with other companies. Although this consolidation has decreased the total number of competitors, we believe the competition for drilling and pressure pumping services will continue to be intense.
 
The drilling and completion fluids services industry is highly competitive. Price is generally the most important factor. Other competitive factors include the availability of chemicals and experienced personnel, the reputation of the fluids services provider in the drilling industry and relationships with customers. Some of our competitors have substantially more resources and longer operating histories than we have.
 
Labor Shortages Adversely Affect Our Operating Results.
 
During periods of increasing demand for contract drilling services, the industry experiences shortages of qualified drilling rig personnel. During these periods, our ability to attract and retain sufficient qualified personnel to market and operate our drilling rigs is adversely affected, which negatively impacts both our operations and profitability. Operationally, it is more difficult to hire qualified personnel which adversely affects our ability to mobilize inactive rigs in response to the increased demand for our contract drilling services. Additionally, wage rates for drilling personnel are likely to increase, resulting in higher operating costs.
 
Continued Growth Through Rig Acquisition is Not Assured.
 
We have increased our drilling rig fleet in the past through mergers and acquisitions. The land drilling industry has experienced significant consolidation, and there can be no assurance that acquisition opportunities will be


11


 

available in the future. Additionally, we are likely to continue to face intense competition from other companies for available acquisition opportunities.
 
There can be no assurance that we will:
 
  •  have sufficient capital resources to complete additional acquisitions,
 
  •  successfully integrate acquired operations and assets,
 
  •  effectively manage the growth and increased size,
 
  •  successfully deploy idle or stacked rigs,
 
  •  maintain the crews and market share to operate drilling rigs acquired, or
 
  •  successfully improve our financial condition, results of operations, business or prospects in any material manner as a result of any completed acquisition.
 
We may incur substantial indebtedness to finance future acquisitions and also may issue equity securities or convertible securities in connection with any such acquisitions. Debt service requirements could represent a significant burden on our results of operations and financial condition and the issuance of additional equity would be dilutive to existing stockholders. Also, continued growth could strain our management, operations, employees and other resources.
 
The Nature of our Business Operations Presents Inherent Risks of Loss that, if not Insured or Indemnified Against, Could Adversely Affect Our Operating Results.
 
Our operations are subject to many hazards inherent in the contract drilling, pressure pumping, and drilling and completion fluids businesses, which in turn could cause personal injury or death, work stoppage, or serious damage to our equipment. Our operations could also cause environmental and reservoir damages. We maintain insurance coverage and have indemnification agreements with many of our customers. However, there is no assurance that such insurance or indemnification agreements would adequately protect us against liability or losses from all consequences of these hazards. Additionally, there can be no assurance that insurance would be available to cover any or all of these risks, or, even if available, that insurance premiums or other costs would not rise significantly in the future, so as to make such insurance prohibitive.
 
We have elected in some cases to accept a greater amount of risk through increased deductibles on certain insurance policies. For example, we maintain a $1.0 million per occurrence deductible on our workers’ compensation, general liability and equipment insurance coverages.
 
Violations of Environmental Laws and Regulations Could Materially Adversely Affect Our Operating Results.
 
The drilling of oil and natural gas wells is subject to various Federal, state, foreign, and local laws, rules and regulations. The cost of compliance with these laws and regulations could be substantial. A failure to comply with these requirements could expose us to substantial civil and criminal penalties. In addition, Federal law imposes a variety of regulations on “responsible parties” related to the prevention of oil spills and liability for damages from such spills. As an owner and operator of land-based drilling rigs, we may be deemed to be a responsible party under Federal law. Our operations and facilities are subject to numerous state and Federal environmental laws, rules and regulations, including, without limitation, laws concerning the containment and disposal of hazardous substances, oil field waste and other waste materials, the use of underground storage tanks and the use of underground injection wells.
 
Some of Our Contract Drilling Services are Provided Under Turnkey and Footage Contracts, Which are Financially Risky.
 
A portion of our contract drilling is performed under turnkey and footage contracts, which involve significant risks. Under turnkey drilling contracts, we contract to drill a well to a certain depth under specified conditions at a fixed price. Under footage contracts, we contract to drill a well to a certain depth under specified conditions at a


12


 

fixed price per foot. The risk to us under these types of drilling contracts are greater than on a well drilled on a daywork basis. Unlike daywork contracts, we must bear the cost of services until the target depth is reached. In addition, we must assume most of the risk associated with the drilling operations, generally assumed by the operator of the well on a daywork contract, including blowouts, loss of hole from fire, machinery breakdowns and abnormal drilling conditions. Accordingly, if severe drilling problems are encountered in drilling wells under such contracts, we could suffer substantial losses.
 
Anti-takeover Measures in Our Charter Documents and Under State Law Could Discourage an Acquisition and Thereby Affect the Related Purchase Price.
 
We are a Delaware corporation subject to the Delaware General Corporation Law, including Section 203, an anti-takeover law enacted in 1988. We have also enacted certain anti-takeover measures, including a stockholders’ rights plan. In addition, our Board of Directors has the authority to issue up to one million shares of preferred stock and to determine the price, rights (including voting rights), conversion ratios, preferences and privileges of that stock without further vote or action by the holders of the common stock. As a result of these measures and others, potential acquirers might find it more difficult or be discouraged from attempting to effect an acquisition transaction with us. This may deprive holders of our securities of certain opportunities to sell or otherwise dispose of the securities at above-market prices pursuant to any such transactions.
 
Item 1B.   Unresolved Staff Comments.
 
None.
 
Item 2.   Properties
 
Our corporate headquarters are located in Snyder, Texas. We also have a number of offices, yards and stockpoint facilities located in our various operating areas.
 
Our corporate headquarters are located at 4510 Lamesa Highway, Snyder, Texas, and our telephone number at that address is (325) 574-6300. There are a number of improvements at our headquarters, including:
 
  •  office buildings with approximately 37,000 square feet of office space and storage,
 
  •  a shop facility with approximately 7,000 square feet used for drilling equipment repairs and metal fabrication,
 
  •  a truck shop facility with approximately 10,000 square feet used to maintain, overhaul and repair our truck fleet,
 
  •  a truck fabrication and rigup shop with approximately 3,000 square feet used to prepare new trucks for service,
 
  •  an engine shop facility with approximately 20,000 square feet used to overhaul and repair the engines that power our drilling rigs, and
 
  •  a welding shop with approximately 10,000 square feet.
 
We have regional administrative offices, yards and stockpoint facilities in many of the areas in which we operate. The facilities are primarily used to support day-to-day operations, including the repair and maintenance of equipment as well as the storage of equipment, inventory and supplies and to facilitate administrative responsibilities and sales.
 
Contract Drilling Operations — Our drilling services are supported by several administrative offices and yard facilities located throughout our areas of operations including:
 
  •  Texas,
 
  •  New Mexico,
 
  •  Oklahoma,
 
  •  Colorado,


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  •  Utah,
 
  •  Wyoming, and
 
  •  Western Canada.
 
Pressure Pumping — Our pressure pumping services are supported by several offices and yard facilities located throughout our areas of operations including:
 
  •  Pennsylvania,
 
  •  Ohio,
 
  •  West Virginia,
 
  •  Kentucky,
 
  •  Tennessee,
 
  •  Wyoming,
 
  •  Colorado, and
 
  •  New York.
 
Drilling and Completion Fluids — Our drilling and completion fluids services are supported by several administrative offices and stockpoint facilities located throughout our areas of operations including:
 
  •  Texas,
 
  •  Louisiana,
 
  •  New Mexico, and
 
  •  Oklahoma.
 
Oil and Natural Gas — Our oil and natural gas operations are supported by administrative and field offices in Texas.
 
We own our headquarters in Snyder, Texas, as well as several of our other facilities. We also lease a number of facilities and we do not believe that any one of the leased facilities is individually material to our operations. We believe that our existing facilities are suitable and adequate to meet our needs.
 
Item 3.   Legal Proceedings.
 
In December 2005, two purported derivative actions were filed in Texas state court in Scurry County, Texas and in May 2006, a derivative action was filed in federal court in Lubbock, Texas, in each case against our directors, alleging that the directors breached their fiduciary duties to us as a result of alleged failure to timely discover the embezzlement of approximately $77.5 million by our former CFO, Jonathan D. Nelson. The Board of Directors formed a special litigation committee to review and inquire about these allegations and recommend our response, if any. Further legal proceedings in these suits were stayed pending completion of the work of the special litigation committee. The lawsuits sought recovery on behalf of and for us and did not seek recovery from us. In November 2006, the parties to all three of the derivative actions reached an agreement to settle the actions. After a preliminary hearing and notice to our stockholders, the state court held a hearing, approved the settlement, which requires the implementation of certain corporate governance measures, and signed a final judgment on December 29, 2006. As contemplated by the settlement agreement, the federal court entered a final judgment on January 10, 2007. Pursuant to the terms of the settlement, we will pay a net amount of $230,000 to the attorneys for the plaintiffs in the suits.
 
We are party to various other legal proceedings arising in the normal course of our business. We do not believe that the outcome of these proceedings, either individually or in the aggregate, will have a material adverse effect on our financial condition.
 
Item 4.   Submission of Matters to a Vote of Security Holders.
 
None.


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PART II
 
Item 5.   Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
  (a)  Market Information
 
Our common stock, par value $0.01 per share, is publicly traded on the Nasdaq National Market and is quoted under the symbol “PTEN.” Our common stock is included in the S&P MidCap 400 Index and several other market indexes. The following table provides high and low sales prices of our common stock for the periods indicated:
 
                 
    High     Low  
 
2006:
               
First quarter
  $ 38.49     $ 25.61  
Second quarter
    35.65       25.24  
Third quarter
    29.11       21.84  
Fourth quarter
    28.21       20.81  
2005:
               
First quarter
  $ 26.66     $ 17.15  
Second quarter
    29.33       22.38  
Third quarter
    36.79       27.79  
Fourth quarter
    36.73       28.45  
 
  (b)  Holders
 
As of February 21, 2007, there were approximately 2,200 holders of record and approximately 79,500 beneficial holders of our common stock.
 
  (c)  Dividends and Buyback Program
 
On April 28, 2004, our Board of Directors authorized a two-for-one stock split in the form of a stock dividend which was distributed on June 30, 2004. At June 30, 2004, an adjustment was made to reclassify an amount from retained earnings to common stock to account for the par value of the common stock issued as a stock dividend. This adjustment had no overall effect on equity. All historical share and per-share information prior to June 30, 2004 has been restated to reflect the impact of the two-for-one stock split.
 
On April 28, 2004, our Board of Directors approved the initiation of a quarterly cash dividend of $0.02 on each share of our common stock which was paid on June 2, 2004, September 1, 2004 and December 1, 2004. Total dividends paid in 2004 were approximately $10 million. In February 2005, our Board of Directors approved an increase in the quarterly cash dividend on our common stock to $0.04 per share from $0.02 per share. Quarterly cash dividends in the amount of $0.04 per share were paid on March 4, 2005, June 1, 2005, September 1, 2005 and December 1, 2005. Total cash dividends in 2005 were approximately $27.3 million. On March 2, 2006, our Board of Directors approved a cash dividend on our common stock in the amount of $0.04 per share which was paid on March 30, 2006. On April 26, 2006, our Board of Directors approved an increase in our quarterly cash dividend from $0.04 to $0.08 on each outstanding share of our common stock. Cash dividends of $0.08 per share were paid on June 30, 2006, September 29, 2006 and December 29, 2006. Total cash dividends in 2006 were approximately $45.8 million. 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 our credit facilities and other factors.


15


 

The table below sets forth the information with respect to purchases of our common stock made by us during the quarter ended December 31, 2006.
 
                                 
                Total number
    Approximate
 
                of shares
    dollar value
 
                (or units)
    of shares
 
                purchased as
    that may yet
 
                part of
    be purchased
 
    Total number
    Average price
    publicly announced
    under the
 
    of shares
    paid per
    plans or
    plans or
 
Period covered
  purchased(1)     share     programs(2)     programs(2)  
 
October 1–31, 2006
    1,025,000     $ 22.20       1,025,000     $ 60,572,000  
November 1–30, 2006
    2,378,542     $ 25.47       2,378,542     $  
December 1–31, 2006
        $           $  
                                 
Total
    3,403,542     $ 24.48       3,403,542     $  
                                 
 
 
(1) All of the reported shares were purchased in open-market transactions.
 
(2) On June 7, 2004, our Board of Directors authorized a stock buyback program for the purchase of up to $30 million of our outstanding common stock. During 2004, we purchased 100,000 shares of our common stock in the open market for approximately $1.5 million. During 2005, we purchased 355,000 shares of our common stock in the open market for approximately $12.2 million. On March 27, 2006, our Board of Directors increased the previously authorized stock buyback program to allow for future purchases of up to $200 million of our outstanding common stock. During the second quarter of 2006, we completed the authorized buyback with the purchase of 6,704,800 shares of our common stock at a cost of approximately $200 million. On August 2, 2006, our Board of Directors again increased the previously authorized stock buyback program to allow for future purchases of up to $250 million of our outstanding common stock. During the remainder of 2006, we purchased an additional 9,940,542 shares of our common stock at a cost of approximately $250 million. Shares purchased under the stock buyback program during 2006 totaled $450 million and have been accounted for as treasury stock.
 
  (d)  Securities Authorized for Issuance Under Equity Compensation Plans
 
Equity compensation to our employees, officers and directors as of December 31, 2006 follows:
 
                         
    Equity Compensation Plan Information  
                Number of
 
                Securities Remaining
 
    Number of
          Available for
 
    Securities to
          Future Issuance
 
    be Issued
    Weighted- Average
    under Equity
 
    upon Exercise
    Exercise Price
    Compensation Plans
 
    of Outstanding
    of Outstanding
    (Excluding Securities
 
    Options, Warrants
    Options, Warrants
    Reflected in
 
Plan Category
  and Rights     and Rights     Column(a))  
    (a)     (b)     (c)  
 
Equity compensation plans approved by security holders(1)
    5,812,537     $ 17.02       4,140,197  
Equity compensation plans not approved by security holders(2)
    762,559     $ 9.84        
                         
Total
    6,575,096     $ 16.18       4,140,197  
                         
 
 
(1) The Patterson-UTI Energy, Inc. 2005 Long-Term Incentive Plan (the “2005 Plan”) provides for awards of incentive stock options, non-incentive stock options, tandem and freestanding stock appreciation rights, restricted stock awards, other stock unit awards, performance share awards, performance unit awards and dividend equivalents to key employees, officers and directors, which are subject to certain vesting and forfeiture provisions. All options are granted with an exercise price equal to or greater than the fair market value of the


16


 

common stock at the time of grant. The vesting schedule and term are set by the Compensation Committee of the Board of Directors. All securities remaining available for future issuance under equity compensation plans approved by security holders in column (c) are available under this plan.
 
(2) The Amended and Restated Patterson-UTI Energy, Inc. 2001 Long-Term Incentive Plan (the “2001 Plan”) was approved by the Board of Directors in July 2001. In connection with the approval of the 2005 Plan, the Board of Directors approved a resolution that no further options, restricted stock or other awards would be granted under any equity compensation plan, other than the 2005 Plan. The terms of the 2001 Plan provided for grants of stock options, stock appreciation rights, shares of restricted stock and performance awards to eligible employees other than officers and directors. No Incentive Stock Options could be awarded under the Plan. All options were granted with an exercise price equal to or greater than the fair market value of the common stock at the time of grant. The vesting schedule and term were set by the Compensation Committee of the Board of Directors.


17


 

Item 6.   Selected Financial Data.
 
Our selected consolidated financial data as of December 31, 2006, 2005, 2004, 2003 and 2002, and for each of the five years then ended should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and related Notes thereto, included as Items 7 and 8, respectively, of this Report. Certain reclassifications have been made to the historical financial data to conform with the 2006 presentation.
                                         
    Years Ended December 31,  
    2006     2005     2004     2003     2002  
    (In thousands, except per share amounts)  
 
Income Statement Data:
                                       
Operating revenues:
                                       
Contract drilling
  $ 2,169,370     $ 1,485,684     $ 809,691     $ 639,694     $ 410,295  
Pressure pumping
    145,671       93,144       66,654       46,083       32,996  
Drilling and completion fluids
    192,358       122,011       90,557       69,230       69,943  
Oil and natural gas
    39,187       39,616       33,867       21,163       14,723  
                                         
Total
    2,546,586       1,740,455       1,000,769       776,170       527,957  
                                         
Operating costs and expenses:
                                       
Contract drilling
    1,002,001       776,313       556,869       475,224       318,201  
Pressure pumping
    77,755       54,956       37,561       26,184       19,802  
Drilling and completion fluids
    150,372       98,530       76,503       61,424       60,762  
Oil and natural gas
    13,374       9,566       7,978       4,808       3,956  
Depreciation, depletion, amortization and impairment
    196,370       156,393       122,800       100,834       92,778  
Selling, general and administrative
    55,065       39,110       31,983       27,685       26,116  
Embezzlement costs, net of recoveries
    3,081       20,043       19,122       17,849       8,574  
Other operating expenses
    9,404       4,248       (514 )     (4,120 )     4,660  
                                         
Total
    1,507,422       1,159,159       852,302       709,888       534,849  
                                         
Operating income (loss)
    1,039,164       581,296       148,467       66,282       (6,892 )
Other income
    4,670       3,463       680       2,694       803  
                                         
Income (loss) before income taxes and cumulative effect of change in accounting principle
    1,043,834       584,759       149,147       68,976       (6,089 )
Income tax expense (benefit)
    371,267       212,019       54,801       25,320       (1,949 )
                                         
Income (loss) before cumulative effect of change in accounting principle
    672,567       372,740       94,346       43,656       (4,140 )
Cumulative effect of change in accounting principle, net of related income tax expense of $398 in 2006 and benefit of $287 in 2003
    687                   (469 )      
                                         
Net income (loss)
  $ 673,254     $ 372,740     $ 94,346     $ 43,187     $ (4,140 )
                                         
Net income (loss) per common share:
                                       
Basic:
                                       
Income (loss) before cumulative effect of change in accounting principle
  $ 4.07     $ 2.19     $ 0.57     $ 0.27     $ (0.03 )
                                         
Cumulative effect of change in accounting principle
  $     $     $     $     $  
                                         
Net income (loss)
  $ 4.08     $ 2.19     $ 0.57     $ 0.27     $ (0.03 )
                                         


18


 

                                         
    Years Ended December 31,  
    2006     2005     2004     2003     2002  
    (In thousands, except per share amounts)  
 
Diluted:
                                       
Income (loss) before cumulative effect of change in accounting principle
  $ 4.02     $ 2.15     $ 0.56     $ 0.27     $ (0.03 )
                                         
Cumulative effect of change in accounting principle
  $     $     $     $     $  
                                         
Net income (loss)
  $ 4.02     $ 2.15     $ 0.56     $ 0.26     $ (0.03 )
                                         
Cash dividends per common share
  $ 0.28     $ 0.16     $ 0.06     $     $  
                                         
Weighted average number of common shares outstanding:
                                       
Basic
    165,159       170,426       166,258       161,272       157,410  
                                         
Diluted
    167,413       173,767       169,211       164,572       157,410  
                                         
Balance Sheet Data:
                                       
Total assets
  $ 2,192,503     $ 1,795,781     $ 1,256,785     $ 1,039,521     $ 919,374  
Borrowings under line of credit
    120,000                          
Stockholders’ equity
    1,562,466       1,367,011       961,501       789,814       724,248  
Working capital
    335,052       382,448       235,480       198,399       166,885  


19


 

 
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
This Item 7 contains forward-looking statements, which are made pursuant to the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995.
 
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 years ended December 31, 2006, our operating revenues consisted of the following (dollars in thousands):
 
                                                 
    2006     2005     2004  
 
Contract drilling
  $ 2,169,370       84 %   $ 1,485,684       86 %   $ 809,691       81 %
Pressure pumping
    145,671       6       93,144       5       66,654       7  
Drilling and completion fluids
    192,358       8       122,011       7       90,557       9  
Oil and natural gas
    39,187       2       39,616       2       33,867       3  
                                                 
    $ 2,546,586       100 %   $ 1,740,455       100 %   $ 1,000,769       100 %
                                                 
 
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, Arkansas, 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 offshore in the Gulf of Mexico and on land in Texas, Southeastern New Mexico, Oklahoma and the Gulf Coast region of Louisiana. Our oil and natural gas operations are primarily focused in West and South Texas, Southeastern New Mexico, Utah and Mississippi.
 
The profitability of our business is most readily assessed by two primary indicators in our contract drilling segment: our average number of rigs operating and our average revenue per operating day. During 2006, our average number of rigs operating increased to 296 from 276 in 2005 and our average revenue per operating day increased to $20,050 from $14,770 in 2005. Primarily due to these improvements, we experienced an increase of approximately $301 million, or 81%, in consolidated net income in 2006.
 
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.
 
We believe that the liquidity shown on our balance sheet as of December 31, 2006, which includes approximately $335 million in working capital (including $13.4 million in cash) and $195 million available under a $375 million line of credit ($120 million in borrowings are outstanding at December 31, 2006 and availability of $60 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, pay cash dividends and survive downturns in our industry.
 
Commitments and Contingencies — We maintain letters of credit in the aggregate amount of approximately $60 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.
 
As of December 31, 2006, we have remaining non-cancelable commitments to purchase approximately $297 million of equipment to be received throughout 2007.
 
In November 2005, we discovered that our former Chief Financial Officer, Jonathan D. Nelson (“Nelson”), had fraudulently diverted approximately $77.5 million of our funds for his own benefit. As a result, the Audit Committee of the Board of Directors commenced an investigation into Nelson’s activities and retained independent counsel and independent forensic accountants to assist with the investigation. Nelson has been sentenced and is


20


 

serving a term of imprisonment arising out of his embezzlement. A receiver has been appointed to take control of and liquidate the assets of Nelson in connection with his embezzlement of our funds. The receiver is in the process of seeking court approval for a plan of distribution of the assets recovered by the receiver and the proceeds thereof, which total approximately $40 million. While we believe we have a claim for at least the full amount of funds embezzled from us, other creditors have asserted or may assert claims with respect to the assets held by the receiver.
 
In December 2005, two purported derivative actions were filed in Texas state court in Scurry County, Texas and in May 2006, a derivative action was filed in federal court in Lubbock, Texas, in each case against our directors, alleging that the directors breached their fiduciary duties to us as a result of alleged failure to timely discover the embezzlement of approximately $77.5 million by our former CFO, Jonathan D. Nelson. The Board of Directors formed a special litigation committee to review and inquire about these allegations and recommend our response, if any. Further legal proceedings in these suits were stayed pending completion of the work of the special litigation committee. The lawsuits sought recovery on behalf of and for us and did not seek recovery from us. In November 2006, the parties to all three of the derivative actions reached an agreement to settle the actions. After a preliminary hearing and notice to our stockholders, the state court held a hearing, approved the settlement, which requires the implementation of certain corporate governance measures, and signed a final judgment on December 29, 2006. As contemplated by the settlement agreement, the federal court entered a final judgment on January 10, 2007. Pursuant to the terms of the settlement, we will pay a net amount of $230,000 to the attorneys for the plaintiffs in the suits.
 
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, Arkansas, Louisiana, Mississippi, Colorado, Utah, Wyoming, Montana, North Dakota, South Dakota and Western Canada. As of December 31, 2006, we had 336 currently marketable land-based 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 offshore in the Gulf of Mexico and on land in Texas, Southeastern New Mexico, Oklahoma and the Gulf Coast region of Louisiana. 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.
 
Critical Accounting Policies
 
In addition to established accounting policies, our consolidated financial statements are impacted by certain estimates and assumptions made by management. The following is a discussion of our critical accounting policies pertaining to property and equipment, oil and natural gas properties, goodwill, revenue recognition and the use of estimates.
 
Property and equipment — Property and equipment, including betterments which extend the useful life of the asset, are stated at cost. Maintenance and repairs are charged to expense when incurred. We provide for the depreciation of our property and equipment using the straight-line method over the estimated useful lives. Our method of depreciation does not change when equipment becomes idle; we continue to depreciate idled equipment on a straight-line basis. No provision for salvage value is considered in determining depreciation of our property and equipment. We review our assets for impairment when events or changes in circumstances indicate that the carrying values of certain assets either exceed their respective fair values or may not be recovered over their estimated remaining useful lives. The cyclical nature of our industry has resulted in fluctuations in rig utilization over periods of time. Management believes that the contract drilling industry will continue to be cyclical and rig utilization will fluctuate. Based on management’s expectations of future trends, we estimate future cash flows over the life of the respective assets in our assessment of impairment. These estimates of cash flows are based on historical cyclical trends in the industry as well as management’s expectations regarding the continuation of these trends in the future. Provisions for asset impairment are charged to income when estimated future cash flows, on an undiscounted basis, are less than the asset’s net book value. Impairment charges are recorded based on discounted cash flows. There were no impairment charges to property and equipment during the years 2006, 2005 or 2004.


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Oil and natural gas properties — Oil and natural gas properties are accounted for using the successful efforts method of accounting. Under the successful efforts method of accounting, exploration costs which result in the discovery of oil and natural gas reserves and all development costs are capitalized to the appropriate well. Exploration costs which do not result in discovering oil and natural gas reserves are charged to expense when such determination is made. In accordance with Statement of Financial Accounting Standards No. 19, “Financial Accounting and Reporting by Oil and Gas Producing Companies,” (“SFAS No. 19”) costs of exploratory wells are initially capitalized to wells in progress until the outcome of the drilling is known. We review wells in progress quarterly to determine whether sufficient progress is being made in assessing the reserves and the economic operating viability of the respective projects. If no progress has been made in assessing the reserves and the economic operating viability of a project after one year following the completion of drilling, we consider the costs of the well to be impaired and recognize the costs as expense. Geological and geophysical costs, including seismic costs and costs to carry and retain undeveloped properties, are charged to expense when incurred. The capitalized costs of both developmental and successful exploratory type wells, consisting of lease and well equipment, lease acquisition costs and intangible development costs, are depreciated, depleted and amortized on the units-of-production method, based on engineering estimates of proved oil and natural gas reserves of each respective field. We review our proved oil and natural gas properties for impairment when an event occurs such as downward revisions in reserve estimates or decreases in oil and natural gas prices. Proved properties are grouped by field and undiscounted cash flow estimates are prepared internally and reviewed by an independent petroleum engineer. If the net book value of a field exceeds its undiscounted cash flow estimate, impairment expense is measured and recognized as the difference between its net book value and discounted cash flow. Unproved oil and natural gas properties are reviewed quarterly to determine impairment. Our intent to drill, lease expiration and abandonment of area are considered. Assessment of impairment is made on a lease-by-lease basis. If an unproved property is determined to be impaired, then costs related to that property are expensed. Impairment expense of approximately $5.0 million, $4.4 million and $3.2 million for the years ended December 31, 2006, 2005 and 2004, respectively, is included in depreciation, depletion and impairment in the accompanying financial statements.
 
Goodwill — Goodwill is considered to have an indefinite useful economic life and is not amortized. As such, we assess impairment of our goodwill annually or on an interim basis if events or circumstances indicate that the fair value of the asset has decreased below its carrying value.
 
Revenue recognition — Revenues are recognized when services are performed, except for revenues earned under turnkey contract drilling arrangements which are recognized using the completed contract method of accounting, as described below. We follow the percentage-of-completion method of accounting for footage contract drilling arrangements. Under the percentage-of-completion method, management estimates are relied upon in the determination of the total estimated expenses to be incurred drilling the well. Due to the nature of turnkey contract drilling arrangements and risks therein, we follow the completed contract method of accounting for such arrangements. Under this method, revenues and expenses related to a well in progress are deferred and recognized in the period the well is completed. Provisions for losses on incomplete or in-process wells are made when estimated total expenses are expected to exceed estimated total revenues. We recognize reimbursements received from third parties for out-of-pocket expenses incurred as revenues and account for out-of-pocket expenses as direct costs.
 
Use of estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from such estimates.
 
Key estimates used by management include:
 
  •  allowance for doubtful accounts,
 
  •  total expenses to be incurred on footage and turnkey drilling contracts,
 
  •  depreciation and depletion,
 
  •  asset impairment,
 
  •  reserves for self-insured levels of insurance coverages, and
 
  •  fair values of assets and liabilities assumed in acquisitions.


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For additional information on our accounting policies, see Note 1 of Notes to Consolidated Financial Statements included as a part of Item 8 of this Report.
 
Related Party Transactions
 
We operate certain oil and natural gas properties in which certain of our affiliated persons have participated, either individually or through entities they control. These participations have typically been through working interests in prospects or properties we originated or acquired. At December 31, 2006, affiliated persons were working interest owners in 281 of 330 total wells we operated. We make sales of working interests to reduce our economic risk in the properties. Generally, it is more efficient for us to sell the working interests to these affiliated persons than to market them to unrelated third parties. Sales of working interests to affiliated parties were made at cost, comprised of our costs of acquiring and preparing the working interests for sale plus a promote fee in some cases. These costs were paid by the working interest owners on a pro rata basis based upon their working interest ownership percentage. The price at which working interests were sold to affiliated persons was the same price as that at which working interests were sold to unaffiliated persons, except that in some cases the affiliated persons also paid a promote fee.
 
Production revenues and joint interest costs of each of the affiliated persons during 2006 for all wells operated by us in which the affiliated persons have working interests are presented in the table below. These amounts do not necessarily represent their profits or losses from these interests because the joint interest costs do not include the parties’ related drilling and leasehold acquisition costs incurred prior to January 1, 2006. These activities resulted in a payable to the affiliated persons of approximately $1.5 million and $1.5 million and a receivable from the affiliated persons of approximately $1.6 million and $1.2 million at December 31, 2006 and 2005, respectively.
 
                 
    Year Ended
 
    December 31, 2006  
          Joint Interest
 
Name
  Production Revenues(1)     Costs(2)  
 
Cloyce A. Talbott
  $ 301,445     $ 95,074  
Jana Talbott, Executrix to the Estate of Steve Talbott(3)
    20,621       5,513  
Stan Talbott(3)
    8,597       4,043  
John Evan Talbott Trust(3)
    3,825       875  
Lisa Beck and Stacy Talbott(3)
    1,311,651       893,903  
SSI Oil & Gas, Inc.(4)
    225,360       181,970  
IDC Enterprises, Ltd.(5)
    13,741,205       12,829,963  
                 
Subtotal
    15,612,704       14,011,341  
                 
A. Glenn Patterson(6)
    125,390       40,104  
Robert Patterson(6)
    9,071       4,904  
Thomas M. Patterson(6)
    9,071       4,904  
                 
Subtotal
    143,532       49,912  
                 
Total
  $ 15,756,236     $ 14,061,253  
                 
 
 
(1) Revenues for production of oil and natural gas, net of state severance taxes.
 
(2) Includes leasehold costs, tangible equipment costs, intangible drilling costs and lease operating expense billed during that period. All joint interest costs have been paid on a timely basis.
 
(3) Stan Talbott, Lisa Beck and Stacy Talbott are Mr. Talbott’s adult children. Steve Talbott is the deceased son of Mr. Talbott. John Evan Talbott is Mr. Talbott’s grandson.
 
(4) SSI Oil & Gas, Inc. is beneficially owned 50% by Cloyce A. Talbott and directly owned 50% by A. Glenn Patterson.
 
(5) IDC Enterprises, Ltd. is 50% owned by Cloyce A. Talbott and 50% owned by A. Glenn Patterson.
 
(6) Through April 2006, A. Glenn Patterson was our President and Chief Operating Officer. Robert and Thomas M. Patterson are A. Glenn Patterson’s adult children.


23


 

 
Liquidity and Capital Resources
 
As of December 31, 2006, we had working capital of $335 million including cash and cash equivalents of $13 million. For 2006, our sources of cash flow included:
 
  •  $837 million from operating activities,
 
  •  $120 million in net proceeds from borrowings under our line of credit,
 
  •  $11 million in proceeds from the disposal of property and equipment, and
 
  •  $3 million from the exercise of stock options and related tax benefits.
 
We used $450 million to purchase shares of our common stock in the open market, $46 million to pay dividends on our common stock, and $598 million:
 
  •  to make capital expenditures for the betterment and refurbishment of our drilling rigs,
 
  •  to acquire and procure drilling equipment and facilities to support our drilling operations,
 
  •  to fund capital expenditures for our pressure pumping and drilling and completion fluids divisions, and
 
  •  to fund leasehold acquisition and exploration and development of oil and natural gas properties.
 
On August 2, 2006, we entered into an agreement to amend our $200 million unsecured revolving line of credit (“LOC”). In connection with this amendment, the borrowing capacity under this LOC was increased to $375 million. No significant changes were made to the terms of the LOC, including the interest to be paid on outstanding balances and financial covenants. As of December 31, 2006, we had borrowed $120 million under the LOC and $60 million in letters of credit were outstanding. As a result, we had available borrowing capacity of $195 million at December 31, 2006.
 
On March 2, 2006, our Board of Directors approved a cash dividend on our common stock in the amount of $0.04 per share. The dividend of approximately $6.9 million was paid on March 30, 2006. On April 26, 2006, our Board of Directors approved an increase in our quarterly cash dividend from $0.04 to $0.08 on each outstanding share of our common stock. This dividend of approximately $13.4 million was paid on June 30, 2006 to holders of record on June 15, 2006. On August 2, 2006, our Board of Directors approved a quarterly cash dividend of $0.08 on each outstanding share of our common stock. This dividend of approximately $13.0 million was paid on September 29, 2006 to holders of record as of September 14, 2006. On October 31, 2006, our Board of Directors approved a quarterly cash dividend of $0.08 on each outstanding share of our common stock. This dividend of approximately $12.5 million was paid on December 29, 2006 to holders of record as of December 14, 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 our credit facilities and other factors.
 
On March 27, 2006, our Board of Directors increased our previously authorized stock buyback program to allow for future purchases of up to $200 million of our outstanding common stock. During the second quarter of 2006, we completed the authorized buyback with the purchase of 6,704,800 shares of our common stock at a cost of approximately $200 million. On August 2, 2006, our Board of Directors again increased the previously authorized stock buyback program to allow for future purchases of up to $250 million of our outstanding common stock. During the remainder of 2006, we purchased an additional 9,940,542 shares of our common stock at a cost of approximately $250 million. Shares purchased under the stock buyback program have been accounted for as treasury stock.
 
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.


24


 

Contractual Obligations
 
The following table presents information with respect to our contractual obligations as of December 31, 2006 (dollars in thousands):
 
                                         
    Payments Due by Period  
          Less Than
                More Than
 
    Total     1 Year     1-3 Years     3-5 Years     5 Years  
 
Borrowings under line of credit(1)
  $ 120,000     $     $ 120,000     $        —     $        —  
Commitments to purchase equipment(2)
    296,577       296,577                    
                                         
    $ 416,577     $ 296,577     $ 120,000     $        —     $        —  
                                         
 
 
(1) Our line of credit is a revolving line of credit that matures on December 16, 2009. So long as we are in compliance with our obligations under the credit agreement, no principal repayments are required until maturity.
 
(2) Represents non-cancelable commitments to purchase equipment to be delivered throughout 2007.
 
Off-Balance Sheet Arrangements
 
We had no off-balance sheet arrangements at December 31, 2006.
 
Results of Operations
 
Comparison of the years ended December 31, 2006 and 2005
 
A summary of operations by business segment for the years ended December 31, 2006 and 2005 follows:
 
                         
    Year Ended December 31,  
Contract Drilling
  2006     2005     % Change  
    (Dollars in thousands)  
 
Revenues
  $ 2,169,370     $ 1,485,684       46.0 %
Direct operating costs
  $ 1,002,001     $ 776,313       29.1 %
Selling, general and administrative
  $ 7,313     $ 5,069       44.3 %
Depreciation
  $ 168,607     $ 131,740       28.0 %
Operating income
  $ 991,449     $ 572,562       73.2 %
Operating days
    108,192       100,591       7.6 %
Average revenue per operating day
  $ 20.05     $ 14.77       35.7 %
Average direct operating costs per operating day
  $ 9.26     $ 7.72       19.9 %
Number of rigs operated
    331       307       7.8 %
Average rigs operating
    296       276       7.2 %
Capital expenditures
  $ 531,087     $ 329,073       61.4 %
 
Our average number of rigs operating increased to 296 in 2006 from 276 in 2005. The average market price of natural gas and our average rigs operating for each of the fiscal quarters and full years in 2006 and 2005 follow:
 
                                         
    1st Quarter     2nd Quarter     3rd Quarter     4th Quarter     Year  
 
2006:
                                       
Average natural gas price(1)
  $ 7.93     $ 6.74     $ 6.26     $ 6.87     $ 6.94  
Average rigs operating
    300       295       301       290       296  
2005:
                                       
Average natural gas price(1)
  $ 6.62     $ 7.14     $ 9.82     $ 12.64     $ 8.98  
Average rigs operating
    263       265       283       292       276  
 
 
(1) The average natural gas price above represents the Henry Hub Spot price as reported by the United States Energy Information Administration.


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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 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 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 have been incurred to activate additional drilling rigs, to modify and upgrade our 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. The increase in depreciation expense was a result of the capital expenditures discussed above.
 
                         
    Year Ended December 31,  
Pressure Pumping
  2006     2005     % Change  
    (Dollars in thousands)  
 
Revenues
  $ 145,671     $ 93,144       56.4 %
Direct operating costs
  $ 77,755     $ 54,956       41.5 %
Selling, general and administrative
  $ 13,185     $ 9,430       39.8 %
Depreciation
  $ 9,896     $ 7,094       39.5 %
Operating income
  $ 44,835     $ 21,664       107.0 %
Total jobs
    11,650       9,615       21.2 %
Average revenue per job
  $ 12.50     $ 9.69       29.0 %
Average direct operating costs per job
  $ 6.67     $ 5.72       16.6 %
Capital expenditures
  $ 41,262     $ 25,508       61.8 %
 
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 has been 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 compensation and the cost of materials used in our operations as well as an increase in the number of larger jobs. Selling, general and administrative expense increased as a result of additional expenses to support the expanded operations of the pressure pumping segment. Significant capital expenditures have been incurred to add capacity and modify and upgrade existing equipment. The increase in depreciation expense was a result of the capital expenditures discussed above.
 
                         
    Year Ended December 31,  
Drilling and Completion Fluids
  2006     2005     % Change  
    (Dollars in thousands)  
 
Revenues
  $ 192,358     $ 122,011       57.7 %
Direct operating costs
  $ 150,372     $ 98,530       52.6 %
Selling, general and administrative
  $ 10,521     $ 8,912       18.1 %
Depreciation
  $ 2,706     $ 2,368       14.3 %
Operating income
  $ 28,759     $ 12,201       135.7 %
Total jobs
    2,042       1,980       3.1 %
Average revenue per job
  $ 94.20     $ 61.62       52.9 %
Average direct operating costs per job
  $ 73.64     $ 49.76       48.0 %
Capital expenditures
  $ 4,222     $ 3,042       38.8 %
 
Revenues and direct operating costs increased primarily as a result of increases 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 large jobs in the Gulf of Mexico.
 


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    Year Ended December 31,  
Oil and Natural Gas Production and Exploration
  2006     2005     % Change  
    (Dollars in thousands, except commodity prices)  
 
Revenues
  $ 39,187     $ 39,616       (1.1 )%
Direct operating costs
  $ 13,374     $ 9,566       39.8 %
Selling, general and administrative
  $ 2,785     $ 2,189       27.2 %
Depreciation, depletion and impairment
  $ 14,368     $ 14,456       (0.6 )%
Operating income
  $ 8,660     $ 13,405       (35.4 )%
Capital expenditures
  $ 21,198     $ 17,163       23.5 %
Average net daily oil production (Bbls)
    983       860       14.3 %
Average net daily gas production (Mcf)
    5,143       7,016       (26.7 )%
Average oil sales price (per Bbl)
  $ 63.83     $ 54.30       17.6 %
Average gas sales price (per Mcf)
  $ 6.82     $ 7.64       (10.7 )%
 
Direct operating costs increased primarily due to $4.2 million in costs associated with the abandonment of exploratory wells. Depreciation, depletion and impairment expense includes $5.0 million and $4.4 million incurred during 2006 and 2005, respectively, to reflect the impairment of certain oil and natural gas properties. Average net daily oil production increased due to the completion of new wells in 2006. Average net daily natural gas production decreased as a result of production declines and the sale of certain natural gas properties.
 
                         
    Year Ended December 31,  
Corporate and Other
  2006     2005     % Change  
    (Dollars in thousands)  
 
Selling, general and administrative
  $ 21,261     $ 13,510       57.4 %
Depreciation
  $ 793     $ 735       7.9 %
Other operating expenses
  $ 9,404     $ 4,248       121.4 %
Embezzlement costs, net of recoveries
  $ 3,081     $ 20,043       (84.6 )%
Interest income
  $ 5,925     $ 3,551       66.9 %
Interest expense
  $ 1,602     $ 516       210.5 %
Other income
  $ 347     $ 428       (18.9 )%
Capital expenditures
  $ 150     $ 5,308       (97.2 )%
 
Selling, general and administrative expense increased primarily as a result of an increase of $7.8 million in stock-based compensation expense which was impacted by the adoption of a new accounting standard in 2006 requiring the expensing of stock options. Other operating expenses include bad debt expense of $5.4 million and $1.2 million in 2006 and 2005, respectively. Embezzlement costs, net of recoveries 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, net of insurance proceeds of $2.0 million received in connection with the loss. Interest expense in 2006 increased due to borrowings under our line of credit during 2006.

27


 

Comparison of the years ended December 31, 2005 and 2004
 
A summary of operations by business segment for the years ended December 31, 2005 and 2004 follows:
 
                         
    Year Ended December 31,  
Contract Drilling
  2005     2004     % Change  
    (Dollars in thousands)  
 
Revenues
  $ 1,485,684     $ 809,691       83.5 %
Direct operating costs
  $ 776,313     $ 556,869       39.4 %
Selling, general and administrative
  $ 5,069     $ 4,417       14.8 %
Depreciation
  $ 131,740     $ 101,779       29.4 %
Operating income
  $ 572,562     $ 146,626       290.5 %
Operating days
    100,591       77,355       30.0 %
Average revenue per operating day
  $ 14.77     $ 10.47       41.1 %
Average direct operating costs per operating day
  $ 7.72     $ 7.20       7.2 %
Number of rigs operated
    307       259       18.5 %
Average rigs operating
    276       211       30.8 %
Capital expenditures
  $ 329,073     $ 140,945       133.5 %
 
Our average number of rigs operating increased to 276 in 2005 from 211 in 2004. The average market price of natural gas and our average rigs operating for each of the fiscal quarters and full years in 2005 and 2004 follow:
 
                                         
    1st Quarter     2nd Quarter     3rd Quarter     4th Quarter     Year  
 
2005:
                                       
Average natural gas price(1)
  $ 6.62     $ 7.14     $ 9.82     $ 12.64     $ 8.98  
Average rigs operating
    263       265       283       292       276  
2004:
                                       
Average natural gas price(1)
  $ 5.64     $ 6.13     $ 5.62     $ 6.42     $ 5.95  
Average rigs operating
    197       203       216       229       211  
 
 
(1) The average natural gas price above represents the Henry Hub Spot price as reported by the United States Energy Information Administration.
 
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 as a result of the increased demand for our contract drilling services and the increase in the number of marketable rigs in our fleet due to the acquisition of land drilling assets from Key Energy Services, Inc. in January 2005 and our rig activation program. Average revenue per operating day increased as a result of increased demand and pricing for our drilling services. Significant capital expenditures were incurred during 2005 to activate additional drilling rigs to meet increased demand, to modify and upgrade our drilling rigs and to acquire additional related equipment such as drill pipe, drill collars, engines, fluid circulating systems, rig hoisting systems and safety


28


 

enhancement equipment. The increase in depreciation expense was a result of the capital expenditures discussed above.
 
                         
    Year Ended December 31,  
Pressure Pumping
  2005     2004     % Change  
    (Dollars in thousands)  
 
Revenues
  $ 93,144     $ 66,654       39.7 %
Direct operating costs
  $ 54,956     $ 37,561       46.3 %
Selling, general and administrative
  $ 9,430     $ 7,234       30.4 %
Depreciation
  $ 7,094     $ 5,112       38.8 %
Operating income
  $ 21,664     $ 16,747       29.4 %
Total jobs
    9,615       7,444       29.2 %
Average revenue per job
  $ 9.69     $ 8.95       8.3 %
Average direct operating costs per job
  $ 5.72     $ 5.05       13.3 %
Capital expenditures
  $ 25,508     $ 17,705       44.1 %
 
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 costs per job. The increase in jobs in 2005 was largely due to our expanded operations in the Appalachian regions of Kentucky, Tennessee and West Virginia, as well as increased demand for our services resulting from the improved industry conditions as discussed in “Contract Drilling” above. Increased average revenue per job was due primarily to increased pricing for our services. Selling, general and administrative expenses increased largely as a result of the expanding operations of the pressure pumping segment. Increased depreciation expense during 2005 was largely due to the expansion of the pressure pumping segment from 2003 through 2005 and related expenditures to acquire necessary equipment to facilitate the growth. Capital expenditures increased in 2005 compared to 2004 due to further expansion of services into Tennessee and Wyoming as well as modifications and upgrades to existing equipment and facilities.
 
                         
    Year Ended December 31,  
Drilling and Completion Fluids
  2005     2004     % Change  
    (Dollars in thousands)  
 
Revenues
  $ 122,011     $ 90,557       34.7 %
Direct operating costs
  $ 98,530     $ 76,503       28.8 %
Selling, general and administrative
  $ 8,912     $ 7,696       15.8 %
Depreciation
  $ 2,368     $ 2,156       9.8 %
Operating income
  $ 12,201     $ 4,202       190.4 %
Total jobs
    1,980       2,205       (10.2 )%
Average revenue per job
  $ 61.62     $ 41.07       50.0 %
Average direct operating costs per job
  $ 49.76     $ 34.70       43.4 %
Capital expenditures
  $ 3,042     $ 1,488       104.4 %
 
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


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increase in the size of our offshore jobs. Selling, general and administrative expense increased primarily due to increased incentive compensation resulting from higher profitability levels.
 
                         
    Year Ended December 31,  
Oil and Natural Gas Production and Exploration
  2005     2004     % Change  
    (Dollars in thousands, except for commodity prices)}  
 
Revenues
  $ 39,616     $ 33,867       17.0 %
Direct operating costs
  $ 9,566     $ 7,978       19.9 %
Selling, general and administrative
  $ 2,189     $ 1,816       20.5 %
Depreciation, depletion and impairment
  $ 14,456     $ 13,309       8.6 %
Operating income
  $ 13,405     $ 10,764       24.5 %
Capital expenditures
  $ 17,163     $ 14,451       18.8 %
Average net daily oil production (Bbls)
    860       1,071       (19.7 )%
Average net daily gas production (Mcf)
    7,016       7,429       (5.6 )%
Average oil sales price (per Bbl)
  $ 54.30     $ 39.12       38.8 %
Average gas sales price (per Mcf)
  $ 7.64     $ 5.81       31.5 %
 
Revenues increased due to increased market prices for oil and natural gas. Direct operating costs increased as a result of higher oilfield service cost and production taxes. Average net daily oil production decreased as a result of production declines and the sale of certain oil properties during 2005. Average net daily gas production also decreased as a result of the sale of certain natural gas properties, however, this decrease was partially offset by an increase in production. Depreciation, depletion and impairment expense includes approximately $4.4 million and $3.2 million of expenses incurred during 2005 and 2004, respectively, to impair certain oil and gas properties.
 
                         
    Year Ended December 31,  
Corporate and Other
  2005     2004     % Change  
    (Dollars in thousands)  
 
Selling, general and administrative
  $ 13,510     $ 10,820       24.9 %
Depreciation
  $ 735     $ 444       65.5 %
Other operating expenses
  $ 4,248     $ (514 )     N/A %
Embezzlement costs, net of recoveries
  $ 20,043     $ 19,122       4.8 %
Interest income
  $ 3,551     $ 1,140       211.5 %
Interest expense
  $ 516     $ 695       (25.8 )%
Other income
  $ 428     $ 235       82.1 %
Capital expenditures
  $ 5,308     $       N/A %
 
Selling, general and administrative expenses increased primarily as a result of payroll taxes attributable to the exercise of employee stock options, increased professional fees and additional compensation expense related to the issuance of restricted shares to certain key employees in 2004 and 2005. Embezzlement costs, net of recoveries includes fraudulent 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 professional fees and expenses incurred as a result of the embezzlement. Other operating expenses in 2005 includes a charge of $4.2 million to increase reserves related to the financial failure of a workers’ compensation insurance carrier used previously by the Company.
 
Income Taxes
 
                         
    Year Ended December 31,  
    2006     2005     2004  
    (Dollars in thousands)  
 
Income before income tax
  $ 1,043,834     $ 584,759     $ 149,147  
Income tax expense
    371,267       212,019       54,801  
Effective tax rate
    35.6 %     36.3 %     36.7 %


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The effective tax rate in 2006 is a result of a Federal rate of 35.0% plus an effective state tax rate of 1.4% reduced by permanent differences between taxable income and book income (“permanent differences”). The effective tax rate in 2005 is a result of a Federal rate of 35.0% plus an effective state tax rate of 1.8% reduced by permanent differences. The effective tax rate in 2004 is a result of a Federal rate of 35.0% and an effective state income tax rate of 1.6% increased by permanent differences. The permanent differences to our effective income tax rate in 2006 and 2005 were largely attributable to the Domestic Production Activities Deduction. The deduction was enacted as part of the American Jobs Creation Act of 2004 effective for taxable years after December 31, 2004. The act allows a deduction of 3% in 2005 and 2006, 6% in 2007, 2008 and 2009, and 9% in 2010 and after on the lesser of qualified production activities income or taxable income.
 
For tax purposes, we have available at December 31, 2006, Federal net operating loss carryforwards of approximately $5 million and $118,000 of alternative minimum tax credit carryforwards. These carryforwards are attributable to the acquisition of TMBR in February 2004.
 
The net operating loss carryforwards, if unused, are scheduled to expire as follows: 2018 — $1 million and 2019 — $4 million. The alternative minimum tax credit may be carried forward indefinitely.
 
We record deferred Federal income taxes based primarily on the relationship between the amount of our unused Federal net operating loss carryforwards and the temporary differences between the book basis and tax basis in our assets. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be settled. As a result of fully recognizing the benefit of our deferred income taxes, we incur deferred income tax expense as these benefits are utilized. We incurred a deferred tax benefit of approximately $4.1 million in 2006 and a deferred income tax expense of approximately $17.1 million and $14.8 million for 2005 and 2004, respectively.
 
Volatility of Oil and Natural Gas Prices
 
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. The average market price of natural gas has improved from $3.36 in 2002 to $6.94 in 2006, resulting in an increase in demand for our drilling services. Our average number of rigs operating increased from 126 in 2002 to 296 in 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 market prices for natural gas would likely 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.
 
Recently Issued Accounting Standards
 
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 and became effective for the Company as of January 1, 2007. The implementation of this standard is not expected to have a material impact in 2007.


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In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. FAS 157 will be effective for the Company in the quarter ending March 31, 2008. The application of FAS 157 is not expected to have a material impact to the Company.
 
In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. Traditionally, there have been two widely-recognized methods for quantifying the effects of financial statement misstatements. The “roll-over” method focuses primarily on the impact of a misstatement on the income statement (including the reversing effect of prior year misstatements) but its use can lead to the accumulation of misstatements in the balance sheet. The “iron-curtain” method, on the other hand, focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior year errors on the income statement. The Company currently uses the iron-curtain method for quantifying identified financial statement misstatements. In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company’s financial statements and the related financial statement disclosures. This model is commonly referred to as a “dual approach” because it requires quantification of errors under both the iron curtain and the roll-over methods. The Company applied the provisions of SAB 108 in the quarter ended December 31, 2006 and there was no impact.
 
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk
 
We currently have exposure to interest rate market risk associated with borrowings under our credit facility. 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. A 5% increase in LIBOR and the prime rate would result in additional interest expense of approximately $415,000 based on borrowings outstanding at December 31, 2006.
 
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.
 
Item 8.   Financial Statements and Supplementary Data.
 
Financial Statements are filed as a part of this Report at the end of Part IV hereof beginning at page F-1, Index to Consolidated Financial Statements, and are incorporated herein by this reference.
 
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
 
None.
 
Item 9A.   Controls and Procedures.
 
Disclosure Controls and Procedures:
 
Under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), we conducted an evaluation of the effectiveness of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities and Exchange Act of 1934, as amended (the Exchange Act), as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our CEO and CFO concluded that, as of December 31, 2006, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time


32


 

periods specified in SEC rules and forms and is accumulated and reported to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.
 
Management’s Report on Internal Control over Financial Reporting:
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our CEO and CFO, we carried out an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2006, based on the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management has concluded that our internal control over financial reporting was effective as of December 31, 2006.
 
Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears under Item 8 of this Annual Report on Form 10-K.
 
Changes in Internal Control over Financial Reporting:
 
As of December 31, 2005, in our assessment of the effectiveness of our internal control over financial reporting, we identified material weaknesses in our internal control over financial reporting relating to:
 
1. Control environment.   We did not maintain a control environment adequate to encourage the prevention or detection of the override of our controls or intentional misconduct, including misappropriation of assets and the preparation of false management reports, accounting records, financial statements and documents together with forged approval signatures. This control environment material weakness contributed to the embezzlement by our former Chief Financial Officer, Jonathan D. Nelson, of our funds for his own benefit, and in turn resulted in the restatement of our consolidated financial statements for the years ended December 31, 2004, 2003 and 2002, each of the quarters of 2004 and 2003, and the first three quarters of 2005.
 
2. Controls over property and equipment.  We did not maintain effective controls over the completeness and accuracy of our accounting for property and equipment including (i) the timely and accurate depreciation of all property and equipment, (ii) the identification and recording of all property and equipment retirements when they occurred, and (iii) that property and equipment transferred between our locations was accurately and completely reflected in our accounting records. This control deficiency resulted in certain inaccuracies in our accounting for property and equipment and in the restatement of our consolidated financial statements for the years ended December 31, 2004, 2003 and 2002; each of the quarters of 2004 and 2003; and the first three quarters of 2005.
 
These material weaknesses are discussed in greater detail in our Annual Report on Form 10-K for the year ended December 31, 2005.
 
During the fourth quarter of 2006, we completed the implementation of the following remediation steps to address the material weakness in our control environment:
 
  •  employees provide formal certifications of information contained in SEC filings related to their areas of responsibility;
 
  •  senior employees and accounting staff submit annual written questionnaires with respect to awareness as to questionable business practices;
 
  •  educational and training programs covering ethics, compliance, financial reporting, good business practices and fraud awareness have been provided to employees;
 
  •  additional guidelines were provided to senior management with respect to their responsibilities for SEC filings, financial reports, budgets and maintenance of controls over assets and expenditures; and,
 
  •  annual reporting to the audit committee with respect to these processes and procedures was added.


33


 

 
Additionally, certain structural changes and processes and procedures were instituted to increase communications between the financial reporting and accounting functions and operations and between financial reporting and accounting functions and senior management. The internal audit reporting structure was also revised to provide for enhanced reporting to the audit committee.
 
During the fourth quarter of 2006, we completed the implementation of the following remediation steps to address the material weakness in our controls over property and equipment:
 
  •  increased coordination between accounting staff and operations to more promptly identify the impairment or retirement of drilling equipment undergoing refurbishment or repair;
 
  •  instituted quarterly physical inventories of our drill pipe and drill collars with comparison of the results of those inventories to our property records;
 
  •  instituted an annual physical inventory of significant drilling equipment with comparison of the results of that inventory to our property records; and,
 
  •  improved procedures to identify property placed in service and to begin depreciation of those assets when placed in service.
 
The changes described above are changes in our internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
Item 9B.   Other Information
 
On February 20, 2007, the Compensation Committee of the Board of Directors of Patterson-UTI Energy, Inc. adopted a bonus compensation program (the “Program”) that would allocate two-thirds of one percent of the Company’s consolidated earnings before interest, income taxes and depreciation, depletion and amortization (“EBITDA”) for fiscal 2007 (the “Allocated Bonus Amount”) among the following four executive officers of the Company if the Company has EBITDA of at least $400 million for fiscal 2007:
 
  •  Mark S. Siegel (Chairman of the Board and Director);
 
  •  Cloyce A. Talbott (President & Chief Executive Officer and Director) (Messrs. Siegel and Talbott, collectively, the “Group A Executive Officers”);
 
  •  Kenneth N. Berns (Senior Vice President and Director); and
 
  •  John E. Vollmer III (Senior Vice President — Corporate Development, Chief Financial Officer and Treasurer) (Messrs. Berns and Vollmer, collectively, the “Group B Executive Officers”).
 
Each Group A Executive Officer would be allocated one-third of the Allocated Bonus Amount and each Group B Executive Officer would be allocated one-sixth of the Allocated Bonus Amount, however, the Compensation Committee expressly retained the ability to reduce the Allocated Bonus Amount at its discretion.


34


 

PART III
 
The information required by Part III is omitted from this Report because we will file a definitive proxy statement pursuant to Regulation 14A of the Securities Exchange Act of 1934 no later than 120 days after the end of the fiscal year covered by this Report and certain information included therein is incorporated herein by reference.
 
Item 10.   Directors, Executive Officers and Corporate Governance.
 
The information required by this Item is incorporated herein by reference to the Proxy Statement.
 
Item 11.   Executive Compensation.
 
The information required by this Item is incorporated herein by reference to the Proxy Statement.
 
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
 
The information required by this Item is incorporated herein by reference to the Proxy Statement.
 
Item 13.   Certain Relationships, Related Transactions and Director Independence.
 
The information required by this Item is incorporated herein by reference to the Proxy Statement.
 
Item 14.   Principal Accountant Fees and Services.
 
The information required by this Item is incorporated herein by reference to the Proxy Statement.


35


 

PART IV
 
Item 15.   Exhibits and Financial Statement Schedule.
 
(a)(1) Financial Statements
 
See Index to Consolidated Financial Statements on page F-1 of this Report.
 
(a)(2) Financial Statement Schedule
 
Schedule II — Valuation and qualifying accounts is filed herewith on page S-1.
 
All other financial statement schedules have been omitted because they are not applicable or the information required therein is included elsewhere in the financial statements or notes thereto.
 
(a)(3) Exhibits
 
The following exhibits are filed herewith or incorporated by reference herein.
 
         
  3 .1   Restated Certificate of Incorporation, as amended (filed August 9, 2004 as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).
  3 .2   Amendment to Restated Certificate of Incorporation, as amended (filed August 9, 2004 as Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).
  3 .3   Amended and Restated Bylaws (filed March 19, 2002 as Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001 and incorporated herein by reference).
  4 .1   Rights Agreement dated January 2, 1997, between Patterson Energy, Inc. and Continental Stock Transfer & Trust Company (filed January 14, 1997 as Exhibit 2 to the Company’s Registration Statement on Form 8-A and incorporated herein by reference).
  4 .2   Amendment to Rights Agreement dated as of October 23, 2001 (filed October 31, 2001 as Exhibit 3.4 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2001 and incorporated herein by reference).
  4 .3   Restated Certificate of Incorporation, as amended (See Exhibits 3.1 and 3.2).
  4 .4   Registration Rights Agreement with Bear, Stearns and Co. Inc., dated March 25, 1994, as assigned by REMY Capital Partners III, L.P.(filed March 19, 2002 as Exhibit 4.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001 and incorporated herein by reference).
  10 .1   For additional material contracts, see Exhibits 4.1, 4.2 and 4.4.
  10 .2   Patterson-UTI Energy, Inc., 1993 Stock Incentive Plan, as amended (filed March 13, 1998 as Exhibit 10.1 to the Company’s Registration Statement on Form S-8 (File No. 333-47917) and incorporated herein by reference).*
  10 .3   Patterson-UTI Energy, Inc. Non-Employee Directors’ Stock Option Plan, as amended (filed November 4, 1997 as Exhibit 10.1 to the Company’s Registration Statement on Form S-8 (File No. 333-39471) and incorporated herein by reference).*
  10 .4   Amended and Restated Patterson-UTI Energy, Inc. 2001 Long-Term Incentive Plan (filed November 27, 2002 as Exhibit 4.4 to Post Effective Amendment No. 1 to the Company’s Registration Statement on Form S-8 (File No. 333-60470) and incorporated herein by reference).*
  10 .5   Patterson-UTI Energy, Inc. Amended and Restated 1997 Long-Term Incentive Plan (filed July 28, 2003 as Exhibit 4.7 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003 and incorporated herein by reference).*
  10 .6   Amendment to the Patterson-UTI Energy, Inc. Amended and Restated 1997 Long-Term Incentive Plan (filed August 9, 2004 as Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).*
  10 .7   Amended and Restated Patterson-UTI Energy, Inc. Non-Employee Director Stock Option Plan(filed July 28, 2003 as Exhibit 4.8 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003 and incorporated herein by reference).*


36


 

         
  10 .8   Amended and Restated Patterson-UTI Energy, Inc. 1996 Employee Stock Option Plan (filed July 25, 2001 as Exhibit 4.4 to Post-Effective Amendment No. 1 to the Company’s Registration Statement on Form S-8 (File No. 333-60466) and incorporated herein by reference).*
  10 .9   Patterson-UTI Energy, Inc. 2005 Long-Term Incentive Plan, including Form of Executive Officer Restricted Stock Award Agreement, Form of Executive Officer Stock Option Agreement, Form of Non-Employee Director Restricted Stock Award Agreement and Form of Non-Employee Director Stock Option Agreement (filed June 15, 2005 as Exhibit 10.1 to the Company’s Current Report on Form 8-K, and incorporated herein by reference).*
  10 .10   Restricted Stock Award Agreement dated April 28, 2004 between Patterson-UTI Energy, Inc. and Mark S. Siegel (filed August 9, 2004 as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).*
  10 .11   Restricted Stock Award Agreement dated April 28, 2004 between Patterson-UTI Energy, Inc. and Cloyce A. Talbott (filed August 9, 2004 as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).*
  10 .12   Restricted Stock Award Agreement dated April 28, 2004 between Patterson-UTI Energy, Inc. and A. Glenn Patterson (filed August 9, 2004 as Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).*
  10 .13   Restricted Stock Award Agreement dated April 28, 2004 between Patterson-UTI Energy, Inc. and Kenneth N. Berns (filed August 9, 2004 as Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).*
  10 .14   Restricted Stock Award Agreement dated April 28, 2004 between Patterson-UTI Energy, Inc. and John E. Vollmer III (filed August 9, 2004 as Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004 and incorporated herein by reference).*
  10 .15   Patterson-UTI Energy, Inc. Change in Control Agreement, effective as of January 29, 2004, by and between Patterson-UTI Energy, Inc. and Mark S. Siegel (filed on February 4, 2004 as Exhibit 10.2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference).*
  10 .16   Employment Agreement, effective as of May 3, 2006 between Patterson-UTI Energy, Inc. and A. Glenn Patterson (filed on May 5, 2006 as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2006 and incorporated herein by reference).*
  10 .17   Patterson-UTI Energy, Inc. Change in Control Agreement, effective as of January 29, 2004, by and between Patterson-UTI Energy, Inc. and Cloyce A. Talbott (filed on February 4, 2004 as Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference).*
  10 .18   Patterson-UTI Energy, Inc. Change in Control Agreement, effective as of January 29, 2004, by and between Patterson-UTI Energy, Inc. and Kenneth N. Berns (filed on February 4, 2004 as Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference).*
  10 .19   Patterson-UTI Energy, Inc. Change in Control Agreement, effective as of January 29, 2004, by and between Patterson-UTI Energy, Inc. and John E. Vollmer III (filed on February 4, 2004 as Exhibit 10.7 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference).*
  10 .20   Form of Letter Agreement regarding termination, effective as of January 29, 2004, entered into by Patterson-UTI Energy, Inc. with each of Mark S. Siegel, Kenneth N. Berns and John E. Vollmer III (filed on February 25, 2005 as Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 and incorporated herein by reference).*
  10 .21   Form of Indemnification Agreement entered into by Patterson-UTI Energy, Inc. with each of Mark S. Siegel, Cloyce A. Talbott, A. Glenn Patterson, Kenneth N. Berns, Robert C. Gist, Curtis W. Huff, Terry H. Hunt, Kenneth R. Peak, Nadine C. Smith and John E. Vollmer III (filed April 28, 2004 as Exhibit 10.11 to the Company’s Annual Report on Form 10-K, as amended, for the year ended December 31, 2003 and incorporated herein by reference).*

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  10 .22   Credit Agreement dated as of December 17, 2004 among Patterson-UTI Energy, Inc., as the Borrower, Bank of America, N.A., as administrative agent, L/C Issuer and a Lender and the other lenders and agents party thereto (filed on December 23, 2004 as Exhibit 10.1 to the Company’s Current Report on Form 8-K and incorporated herein by reference).
  10 .23   Commitment Increase and Joinder Agreement, dated as of August 2, 2006, by and among Patterson-UTI Energy, Inc., the guarantors party thereto, the lenders party thereto, and Bank of America, N.A. as Administrative Agent, L/C Issuer and Lender (filed August 21, 2006 as Exhibit 10.1 to the Company’s Current Report on Form 8-K and incorporated herein by reference).
  10 .24   Letter Agreement dated February 6, 2006 between Patterson-UTI Energy, Inc. and John E. Vollmer III (filed May 1, 2006 as Exhibit 10.25 to the Company’s Annual Report on Form 10-K, as amended, and incorporated herein by reference).*
  14 .1   Patterson-UTI Energy, Inc. Code of Business Conduct and Ethics for Senior Financial Executives (filed on February 4, 2004 as Exhibit 14.1 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference).
  21 .1   Subsidiaries of the Registrant.
  23 .1   Consent of Independent Registered Public Accounting Firm.
  31 .1   Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended.
  31 .2   Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended.
  32 .1   Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 USC Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
* Management Contract or Compensatory Plan identified as required by Item 15(a)(3) of Form 10-K.
 

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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
         
    Page
 
    F-2  
Consolidated Financial Statements:
       
    F-4  
    F-5  
    F-6  
    F-7  
    F-8  
    S-1  


F-1


 

 
Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Shareholders of
Patterson-UTI Energy, Inc.:
 
We have completed integrated audits of Patterson-UTI Energy, Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
 
Consolidated financial statements and financial statement schedule
 
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Patterson-UTI Energy, Inc. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
Internal control over financial reporting
 
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable


F-2


 

assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
PricewaterhouseCoopers LLP
Houston, Texas
February 26, 2007


F-3


 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
 
                 
    December 31,  
    2006     2005  
    (In thousands,
 
    except share data)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 13,385     $ 136,398  
Accounts receivable, net of allowance for doubtful accounts of $7,484 and $2,199 at December 31, 2006 and 2005, respectively
    484,106       422,002  
Accrued Federal and state income taxes receivable
    5,448        
Inventory
    43,947       27,907  
Deferred tax assets, net
    48,868       26,382  
Deposit on equipment purchase contract
    24,746        
Other
    32,170       25,168  
                 
Total current assets
    652,670       637,857  
Property and equipment, at cost, net
    1,435,804       1,053,845  
Goodwill
    99,056       99,056  
Other
    4,973       5,023  
                 
Total assets
  $ 2,192,503     $ 1,795,781  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
Accounts payable:
               
Trade
  $ 138,372     $ 113,226  
Accrued revenue distributions
    15,359       13,379  
Other
    18,424       5,294  
Accrued Federal and state income taxes payable
          11,034  
Accrued expenses
    145,463       112,476  
                 
Total current liabilities
    317,618       255,409  
Borrowings under line of credit
    120,000        
Deferred tax liabilities, net
    187,960       169,188  
Other
    4,459       4,173  
                 
Total liabilities
    630,037       428,770  
                 
Commitments and contingencies
           
Stockholders’ equity:
               
Preferred stock, par value $.01; authorized 1,000,000 shares, no shares issued
           
Common stock, par value $.01; authorized 300,000,000 shares with 176,656,401 and 175,909,274 issued and 156,542,512 and 172,441,178 outstanding at December 31, 2006 and 2005, respectively
    1,766       1,759  
Additional paid-in capital
    681,069       672,151  
Deferred compensation
          (9,287 )
Retained earnings
    1,346,542       719,113  
Accumulated other comprehensive income, net of tax
    8,390       8,565  
Treasury stock, at cost, 20,113,889 shares and 3,468,096 shares at December 31, 2006 and 2005, respectively
    (475,301 )     (25,290 )
                 
Total stockholders’ equity
    1,562,466       1,367,011  
                 
Total liabilities and stockholders’ equity
  $ 2,192,503     $ 1,795,781  
                 
 
The accompanying notes are an integral part of these consolidated financial statements.


F-4


 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF INCOME
 
                         
    Years Ended December 31,  
    2006     2005     2004  
    (In thousands, except per share data)  
 
Operating revenues:
                       
Contract drilling
  $ 2,169,370     $ 1,485,684     $ 809,691  
Pressure pumping
    145,671       93,144       66,654  
Drilling and completion fluids
    192,358       122,011       90,557  
Oil and natural gas
    39,187       39,616       33,867  
                         
      2,546,586       1,740,455       1,000,769  
                         
Operating costs and expenses:
                       
Contract drilling
    1,002,001       776,313       556,869  
Pressure pumping
    77,755       54,956       37,561  
Drilling and completion fluids
    150,372       98,530       76,503  
Oil and natural gas
    13,374       9,566       7,978  
Depreciation, depletion and impairment
    196,370       156,393       122,800  
Selling, general and administrative
    55,065       39,110       31,983  
Embezzlement costs, net of recoveries
    3,081       20,043       19,122  
Other operating expenses
    9,404       4,248       (514 )
                         
      1,507,422       1,159,159       852,302  
                         
Operating income
    1,039,164       581,296       148,467  
                         
Other income (expense):
                       
Interest income
    5,925       3,551       1,140  
Interest expense
    (1,602 )     (516 )     (695 )
Other
    347       428       235  
                         
      4,670       3,463       680  
                         
Income before income taxes and cumulative effect of change in accounting principle
    1,043,834       584,759       149,147  
                         
Income tax expense (benefit):
                       
Current
    375,373       194,918       39,952  
Deferred
    (4,106 )     17,101       14,849  
                         
      371,267       212,019       54,801  
                         
Income before cumulative effect of change in accounting principle
    672,567       372,740       94,346  
Cumulative effect of change in accounting principle, net of related income tax expense of $398
    687              
                         
Net income
  $ 673,254     $ 372,740     $ 94,346  
                         
Net income per common share:
                       
Basic:
                       
Income before cumulative effect of change in accounting principle
  $ 4.07     $ 2.19     $ 0.57  
                         
Cumulative effect of change in accounting principle
  $     $     $  
                         
Net income
  $ 4.08     $ 2.19     $ 0.57  
                         
Diluted:
                       
Income before cumulative effect of change in accounting principle
  $ 4.02     $ 2.15     $ 0.56  
                         
Cumulative effect of change in accounting principle
  $     $     $  
                         
Net income
  $ 4.02     $ 2.15     $ 0.56  
                         
Weighted average number of common shares outstanding:
                       
Basic
    165,159       170,426       166,258  
                         
Diluted
    167,413       173,767       169,211  
                         
 
The accompanying notes are an integral part of these consolidated financial statements.


F-5


 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 
                                                                 
                                  Accumulated
             
    Common Stock     Additional
                Other
             
    Number of
          Paid-In
    Deferred
    Retained
    Comprehensive
    Treasury
       
    Shares     Amount     Capital     Compensation     Earnings     Income     Stock     Total  
    (In thousands)  
 
Balance, December 31, 2003
    82,483     $ 825     $ 506,018     $     $ 290,237     $ 4,389     $ (11,655 )   $ 789,814  
Issuance of common stock for acquisition
    1,388       14       49,462                               49,476  
Issuance of restricted stock
    189       2       6,640       (6,642 )                        
Amortization of deferred compensation expense
                      1,222                         1,222  
Exercise of stock options and warrants
    2,580       25       24,494                               24,519  
Tax benefit related to exercise of stock options
                10,666                               10,666  
Foreign currency translation adjustment (net of tax of $1,716)
                                  2,961             2,961  
Purchase of treasury stock
                                        (1,482 )     (1,482 )
Payment of cash dividend (see Note 10)
                            (10,021 )                 (10,021 )
Effect of two-for-one stock split (see Note 10)
    84,986       850                   (850 )                  
Net income
                            94,346                   94,346  
                                                                 
Balance, December 31, 2004
    171,626       1,716       597,280       (5,420 )     373,712       7,350       (13,137 )     961,501  
Issuance of restricted stock
    305       3       8,040       (8,043 )                        
Amortization of deferred compensation expense
                      2,825                         2,825  
Forfeitures of restricted shares
    (65 )           (1,351 )     1,351                          
Exercise of stock options
    4,043       40       43,434                               43,474  
Tax benefit related to exercise of stock options
                24,748                               24,748  
Foreign currency translation adjustment (net of tax of $705)
                                  1,215             1,215  
Purchase of treasury stock
                                        (12,153 )     (12,153 )
Payment of cash dividend (see Note 10)
                            (27,339 )                 (27,339 )
Net income
                            372,740                   372,740  
                                                                 
Balance, December 31, 2005
    175,909       1,759       672,151       (9,287 )     719,113       8,565       (25,290 )     1,367,011  
Elimination of deferred compensation due to change in accounting principle
                (9,287 )     9,287                          
Issuance of restricted stock
    613       6       (6 )                              
Forfeitures of restricted shares
    (47 )     (1 )     1                                
Exercise of stock options
    181       2       1,944                               1,946  
Tax benefit related to exercise of stock options
                1,087                               1,087  
Stock based compensation, net of cumulative effect of change in accounting principle
                15,179                               15,179  
Foreign currency translation adjustment, (net of tax of $6)
                                  (175 )           (175 )
Payment of cash dividend (see Note 10)
                            (45,825 )                 (45,825 )
Purchase of treasury stock
                                        (450,011 )     (450,011 )
Net income
                            673,254                   673,254  
                                                                 
Balance, December 31, 2006
    176,656     $ 1,766     $ 681,069     $     $ 1,346,542     $ 8,390     $ (475,301 )   $ 1,562,466  
                                                                 
 
The accompanying notes are an integral part of these consolidated financial statements.


F-6


 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CHANGES IN CASH FLOWS
 
                         
    Years Ended December 31,  
    2006     2005     2004  
    (In thousands)  
 
Cash flows from operating activities:
                       
Net income
  $ 673,254     $ 372,740     $ 94,346  
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Depreciation, depletion and impairment
    196,370       156,393       122,800  
Provision for bad debts
    5,400       1,231       897  
Dry holes and abandonments
    4,338              
Deferred income tax expense (benefit)
    (3,708 )     17,101       14,849  
Tax benefit related to exercise of stock options
          24,748       10,666  
Stock based compensation expense
    15,179       2,825       1,222  
(Gain) loss on disposal of assets
    3,819       (1,253 )     (1,411 )
Changes in operating assets and liabilities, net of business acquired:
                       
Accounts receivable
    (67,417 )     (208,248 )     (50,682 )
Federal income taxes receivable/payable
    (16,231 )     7,068       15,734  
Inventory and other current assets
    (47,406 )     (9,402 )     (13,556 )
Accounts payable
    27,184       60,860       12,861  
Accrued expenses
    32,972       32,514       1,555  
Other liabilities
    13,416       3,902       (6,090 )
                         
Net cash provided by operating activities
    837,170       460,479       203,191  
                         
Cash flows from investing activities:
                       
Acquisitions, net of cash acquired
          (73,577 )     (30,387 )
Purchases of property and equipment
    (597,919 )     (380,094 )     (174,589 )
Proceeds from disposal of property and equipment
    10,934       12,674       3,303  
Change in other assets
          1,766       (1,766 )
                         
Net cash used in investing activities
    (586,985 )     (439,231 )     (203,439 )
                         
Cash flows from financing activities:
                       
Purchase of treasury stock
    (450,011 )     (12,153 )     (1,482 )
Dividends paid
    (45,825 )     (27,339 )     (10,021 )
Tax benefit related to exercise of stock options
    1,087              
Proceeds from borrowings under line of credit
    274,000              
Repayments on line of credit
    (154,000 )            
Line of credit issuance costs
    (342 )           (780 )
Proceeds from exercise of stock options and warrants
    1,946       43,474       24,519  
                         
Net cash provided by (used in) financing activities
    (373,145 )     3,982       12,236  
                         
Effect of foreign exchange rate changes on cash
    (53 )     (1,203 )     (100 )
                         
Net increase (decrease) in cash and cash equivalents
    (123,013 )     24,027       11,888  
Cash and cash equivalents at beginning of year
    136,398       112,371       100,483  
                         
Cash and cash equivalents at end of year
  $ 13,385     $ 136,398     $ 112,371  
                         
Supplemental disclosure of cash flow information:
                       
Net cash paid during the year for:
                       
Interest expense
  $ (1,278 )   $ (418 )   $ (245 )
Income taxes
    (377,847 )     (156,709 )     (12,500 )
 
The accompanying notes are an integral part of these consolidated financial statements.


F-7


 

PATTERSON-UTI ENERGY, INC. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.   Description of Business and Summary of Significant Accounting Policies
 
   A description of the business and basis of presentation follows:
 
Description of business — Patterson-UTI Energy, Inc., together with its wholly-owned subsidiaries, (collectively referred to herein as “Patterson-UTI” or the “Company”) is a leading provider of onshore contract drilling services to major and independent oil and natural gas operators in Texas, New Mexico, Oklahoma, Arkansas, Louisiana, Mississippi, Colorado, Utah, Wyoming, Montana, North Dakota, South Dakota and Western Canada. The Company provides pressure pumping services to oil and natural gas operators primarily in the Appalachian Basin. The Company provides drilling fluids, completion fluids and related services to oil and natural gas operators offshore in the Gulf of Mexico and on land in Texas, Southeastern New Mexico, Oklahoma and the Gulf Coast region of Louisiana. The Company is also engaged in the development, exploration, acquisition and production of oil and natural gas. The Company’s oil and natural gas business operates primarily in producing regions of West and South Texas, Southeastern New Mexico, Utah and Mississippi.
 
Basis of presentation — The consolidated financial statements include the accounts of Patterson-UTI and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. The Company has no controlling financial interests in any entity that is not a wholly-owned subsidiary which would require consolidation.
 
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.
 
On April 28, 2004, the Company’s Board of Directors authorized a two-for-one stock split in the form of a stock dividend which was distributed on June 30, 2004 to holders of record on June 14, 2004. At June 30, 2004, an adjustment was made to reclassify an amount from retained earnings to common stock to account for the par value of the common stock issued as a stock dividend. This adjustment had no overall effect on equity. Historical net income per common share amounts included in the Statements of Income and elsewhere in these financial statements have been presented as if the two-for-one stock split had occurred on January 1, 2004.
 
   A summary of the significant accounting policies follows:
 
Management estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from such estimates.
 
Revenue recognition — Revenues are recognized when services are performed, except for revenues earned under turnkey contract drilling arrangements which are recognized using the completed contract method of accounting, as described below. The Company follows the percentage-of-completion method of accounting for footage and daywork contract drilling arrangements. Under the percentage-of-completion method, management estimates are relied upon in the determination of the total estimated expenses to be incurred drilling the well. Due to the nature of turnkey contract drilling arrangements and risks therein, the Company follows the completed contract method of accounting for such arrangements. Under this method, all drilling revenues and expenses related to a well in progress are deferred and recognized in the period the well is completed. Provisions for losses on incomplete or in-process wells are made when estimated total expenses are expected to exceed estimated total revenues. The Company recognizes reimbursements received from third parties for out-of-pocket expenses incurred as revenues and accounts for these out-of-pocket expenses as direct costs.
 
Accounts receivable — Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts represents the Company’s estimate of the amount of probable credit losses


F-8


 

existing in the Company’s accounts receivable. The Company reviews the adequacy of its allowance for doubtful accounts monthly. Significant individual accounts receivable balances and balances which have been outstanding greater than 90 days are reviewed individually for collectibility. Account balances, when determined to be uncollectible, are charged against the allowance.
 
Inventories — Inventories consist primarily of chemical products to be used in conjunction with the Company’s drilling and completion fluids and pressure pumping activities. The inventories are stated at the lower of cost or market, determined by the first-in, first-out method.
 
Property and equipment — Property and equipment is carried at cost less accumulated depreciation. Depreciation is provided on the straight-line method over the estimated useful lives. The method of depreciation does not change when equipment becomes idle. The estimated useful lives, in years, are defined below.
 
         
    Useful Lives  
 
Drilling rigs and related equipment
    2-15  
Office furniture
    3-10  
Buildings
    15-20  
Automotive equipment
    3-7  
Other
    3-12  
 
Oil and natural gas properties — Oil and natural gas properties are accounted for using the successful efforts method of accounting. Under the successful efforts method of accounting, exploration costs which result in the discovery of oil and natural gas reserves and all development costs are capitalized to the appropriate well. Exploration costs which do not result in discovering oil and natural gas reserves are charged to expense when such determination is made. Costs of exploratory wells are initially capitalized to wells in progress until the outcome of the drilling is known. The Company reviews wells in progress quarterly to determine whether sufficient progress is being made in assessing the reserves and the economic operating viability of the respective projects. If no progress has been made in assessing the reserves and the economic operating viability of a project after one year following the completion of drilling, the Company considers the costs of the well to be impaired and recognizes the costs as expense. Geological and geophysical costs, including seismic costs, and costs to carry and retain undeveloped properties are charged to expense when incurred. The capitalized costs of both developmental and successful exploratory type wells, consisting of lease and well equipment, lease acquisition costs and intangible development costs, are depreciated, depleted and amortized on the units-of-production method, based on engineering estimates of proved oil and natural gas reserves of each respective field. The Company reviews its proved oil and natural gas properties for impairment when an event occurs such as downward revisions in reserve estimates or decreases in oil and natural gas prices. Proved properties are grouped by field and undiscounted cash flow estimates are provided by an independent petroleum engineer. If the net book value of a field exceeds its undiscounted cash flow estimate, impairment expense is measured and recognized as the difference between its net book value and discounted cash flow. Unproved oil and natural gas properties are reviewed quarterly to determine impairment. The Company’s intent to drill, lease expiration and abandonment of area are considered. Assessment of impairment is made on a lease-by-lease basis. If an unproved property is determined to be impaired, costs related to that property are expensed.
 
Goodwill — Goodwill is considered to have an indefinite useful economic life and is not amortized. As such, the Company assesses impairment of its goodwill annually or on an interim basis if events or circumstances indicate that the fair value of the asset has decreased below its carrying value.


F-9


 

 
Depreciation, depletion and impairment — The following table summarizes depreciation, depletion and impairment expense for 2006, 2005 and 2004 (in millions):
 
                         
    2006     2005     2004  
 
Depreciation expense
  $ 181.6     $ 141.7     $ 109.4  
Depletion expense
    9.8       10.3       10.1  
Amortization expense
                0.1  
Impairment of oil and natural gas properties
    5.0       4.4       3.2  
                         
Total
  $ 196.4     $ 156.4     $ 122.8  
                         
 
Maintenance and repairs — Maintenance and repairs are charged to expense when incurred. Renewals and betterments which extend the life or improve existing property and equipment are capitalized.
 
Retirements — Upon disposition or retirement of property and equipment, the cost and related accumulated depreciation are removed and any resulting gain or loss is credited or charged to operations.
 
Net income per common share — The Company provides a dual presentation of its net income per common share; Basic net income per common share (“Basic EPS”) and Diluted net income per common share (“Diluted EPS”). Basic EPS excludes dilution and is computed by dividing net income by the weighted average number of unrestricted common shares outstanding during the year. Diluted EPS is based on the weighted average number of common shares outstanding plus the impact of dilutive instruments, including stock options, warrants and restricted shares using the treasury stock method. The following table presents information necessary to calculate net income per share for the years ended December 31, 2006, 2005 and 2004 as well as cash dividends per share paid and potentially dilutive securities excluded from the weighted average number of diluted common shares outstanding as their inclusion would have been anti-dilutive (in thousands, except per share amounts):
 
                         
    2006     2005     2004  
 
Net income
  $ 673,254     $ 372,740     $ 94,346  
Weighted average number of unrestricted common shares outstanding
    165,159       170,426       166,258  
                         
Basic net income per common share
  $ 4.08     $ 2.19     $ 0.57  
                         
Weighted average number of unrestricted common shares outstanding
    165,159       170,426       166,258  
Dilutive effect of stock options and restricted shares
    2,254       3,341       2,953  
                         
Weighted average number of diluted common shares outstanding
    167,413       173,767       169,211  
                         
Diluted net income per common share
  $ 4.02     $ 2.15     $ 0.56  
                         
Cash dividends per common share
  $ 0.28     $ 0.16     $ 0.06  
                         
Potentially dilutive securities excluded as anti-dilutive
    800             640  
                         
 
Income taxes — The asset and liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for operating loss and tax credit carryforwards and for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. If applicable, a valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not that such assets will be realized.
 
Stock based compensation — Prior to January 1, 2006, the Company accounted for stock based compensation related to employee stock options and shares of restricted stock using the recognition and measurement principles of


F-10


 

APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations. Under the provisions of APB 25, expense associated with stock option grants was measured based on the intrinsic value of the option at the date of grant and expense associated with restricted stock grants was measured based on the fair value of the shares at the date of grant. Reductions in compensation expense associated with awards that were forfeited prior to vesting were recognized as those grants were forfeited. Effective January 1, 2006, the Company adopted the provisions of Financial Accounting Standards Board Statement No. 123(R), Accounting for Stock-Based Compensation (“SFAS 123(R)”). SFAS 123(R) requires the recognition of expense associated with the grant of both stock options and restricted stock based on the estimated fair value of the options or restricted stock at the date of grant, net of estimated forfeitures.
 
Statement of cash flows — For purposes of reporting cash flows, cash and cash equivalents include cash on deposit, money market funds and investment grade municipal and commercial bonds with original maturities of 90 days or less.
 
Recently Issued Accounting Standards — In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 and became effective for the Company as of January 1, 2007. The implementation of this standard is not expected to have a material impact in 2007.
 
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. FAS 157 will be effective for the Company in the quarter ending March 31, 2008. The application of FAS 157 is not expected to have a material impact to the Company.
 
In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. Traditionally, there have been two widely-recognized methods for quantifying the effects of financial statement misstatements. The “roll-over” method focuses primarily on the impact of a misstatement on the income statement (including the reversing effect of prior year misstatements) but its use can lead to the accumulation of misstatements in the balance sheet. The “iron-curtain” method, on the other hand, focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior year errors on the income statement. The Company currently uses the iron-curtain method for quantifying identified financial statement misstatements. In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company’s financial statements and the related financial statement disclosures. This model is commonly referred to as a “dual approach” because it requires quantification of errors under both the iron curtain and the roll-over methods. The Company applied the provisions of SAB 108 in the quarter ended December 31, 2006 and there was no impact.
 
Reclassifications — Certain reclassifications have been made to the 2005 and 2004 consolidated financial statements in order for them to conform with the 2006 presentation.
 
2.   Acquisitions
 
   2005 Acquisitions
 
Key Energy Services, Inc. — On January 15, 2005, the Company purchased land drilling assets from Key Energy Services, Inc. for $61.8 million. The assets included 25 active and 10 stacked land-based drilling rigs, related drilling equipment, yard facilities and a rig moving fleet consisting of approximately 45 trucks and 100 trailers. The transaction was accounted for as an acquisition of assets and the purchase price was allocated among the assets acquired based on their estimated fair market values.


F-11


 

 
Other — On June 17, 2005, the Company acquired one land-based drilling rig for $3.6 million and on September 29, 2005, the Company acquired five land-based drilling rigs and related drilling equipment for $8.2 million. The transactions were accounted for as acquisitions of assets and the purchase price was allocated among the assets acquired based on their estimated fair market values.
 
   2004 Acquisition
 
TMBR/Sharp Drilling, Inc. — On February 11, 2004, the Company completed its acquisition of TMBR, a Texas corporation, in which one of its wholly-owned subsidiaries acquired 100% of the outstanding shares of TMBR. Operations of TMBR subsequent to February 11, 2004, are included in the Company’s consolidated financial statements. The transaction was accounted for as a business combination and the purchase price was allocated among the assets acquired and liabilities assumed based on their estimated fair market values. The assets of TMBR included 18 land-based drilling rigs and related equipment, shop facilities, equipment yards and oil and natural gas properties.
 
The purchase price was calculated as follows (in thousands, except per share data and exchange ratio):
 
         
Cash of $9.09 per share for the 4,447 TMBR shares outstanding at February 11, 2004, excluding the 1,059 TMBR shares owned by Patterson-UTI
  $ 40,423  
Patterson-UTI shares issued at $17.82 per share (4,447 TMBR shares X .624332 exchange ratio X $17.82)
    49,476  
1,059 TMBR shares previously acquired by the Company
    19,771  
Acquisition costs
    10,511  
Less: Cash acquired
    (7,909 )
         
Total purchase price
  $ 112,272  
         
 
The purchase price was allocated among assets acquired and liabilities assumed based on their estimated fair market values as follows (in thousands):
 
         
Current assets
  $ 7,181  
Property and equipment
    60,784  
Other long term assets
    172  
Deferred tax assets
    13,080  
Goodwill
    48,020  
Current liabilities
    (7,080 )
Other long term liabilities
    (1,090 )
Deferred tax liability
    (8,795 )
         
Total purchase allocation
  $ 112,272  
         
 
The Company acquired TMBR to increase its productive asset base in the Permian Basin, which is one of the most active land drilling regions in the U.S. TMBR was well established in the contract drilling industry and maintained favorable customer relationships. Goodwill was recognized in the transaction as a result of these factors.


F-12


 

 
The following represents pro-forma unaudited financial information as if the acquisition had been completed on January 1, 2004 (in thousands, except per share amounts):
 
                 
    2004        
 
Revenue
  $ 1,005,357          
Income before cumulative effect of change in accounting principle
    94,047          
Net income
    94,047          
Earnings per share:
               
Basic
  $ 0.57          
                 
Diluted
  $ 0.56          
                 
 
3.   Comprehensive Income
 
The following table illustrates the Company’s comprehensive income including the effects of foreign currency translation adjustments for the years ended December 31, 2006, 2005 and 2004 (in thousands):
 
                         
    2006     2005     2004  
 
Net income
  $ 673,254     $ 372,740     $ 94,346  
Other comprehensive income:
                       
Foreign currency translation adjustment related to Canadian operations, net of tax
    (175 )     1,215       2,961  
                         
Comprehensive income
  $ 673,079     $ 373,955     $ 97,307  
                         
 
4.   Property and Equipment
 
Property and equipment consisted of the following at December 31, 2006 and 2005 (in thousands):
 
                 
    2006     2005  
 
Equipment
  $ 2,135,567     $ 1,633,911  
Oil and natural gas properties
    85,143       79,079  
Buildings
    30,987       22,490  
Land
    7,507       5,611  
                 
      2,259,204       1,741,091  
Less accumulated depreciation and depletion
    (823,400 )     (687,246 )
                 
    $ 1,435,804     $ 1,053,845  
                 
 
5.   Goodwill
 
Goodwill is evaluated annually to determine if the fair value of the asset has decreased below its carrying value. At December 31, 2006 the Company performed its annual goodwill evaluation and determined that no adjustment to impair goodwill was necessary. Goodwill as of December 31, 2006 and 2005 included $89,092 in the contract drilling segment and $9,964 in the drilling and completion fluids segment. For purposes of impairment testing, goodwill is evaluated at the reporting unit level. The Company’s reporting units for impairment testing have been determined to be its operating segments. There were no changes to goodwill during the years ended December 31, 2006 and 2005.


F-13


 

 
6.   Accrued Expenses
 
Accrued expenses consisted of the following at December 31, 2006 and 2005 (in thousands):
 
                 
    2006     2005  
 
Salaries, wages, payroll taxes and benefits
  $ 42,751     $ 33,816  
Workers’ compensation liability
    67,615       47,107  
Sales, use and other taxes
    11,043       9,484  
Insurance, other than workers’ compensation
    13,328       11,365  
Other
    10,726       10,704  
                 
    $ 145,463     $ 112,476  
                 
 
7.   Asset Retirement Obligation
 
Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations, (“SFAS 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 the Company’s asset retirement obligations during 2006 and 2005 (in thousands):
 
                 
    2006     2005  
 
Balance at beginning of year
  $ 1,725     $ 2,358  
Liabilities incurred
    154       101  
Liabilities settled
    (104 )     (808 )
Accretion expense
    54       74  
                 
Asset retirement obligation at end of year
  $ 1,829     $ 1,725  
                 
 
8.   Borrowings Under Line of Credit
 
The Company entered into a five-year, $200 million unsecured revolving line of credit (“LOC”) in December 2004. Interest is to be paid on outstanding LOC balances at a floating rate ranging from LIBOR plus 0.625% to 1.0% or the prime rate. Any outstanding borrowings must be repaid at maturity on December 16, 2009. This arrangement includes various fees, including a commitment fee on the average daily unused amount (0.15% at December 31, 2006). There are customary restrictions and covenants associated with the LOC. Financial covenants provide for a maximum debt to capitalization ratio and a minimum interest coverage ratio. The Company does not expect that the restrictions and covenants will restrict its ability to operate or react to opportunities that might arise. On August 2, 2006, the Company entered into an agreement to amend the LOC. In connection with this amendment, the borrowing capacity under this LOC was increased to $375 million. No significant changes were made to the terms of the LOC including the interest to be paid on outstanding balances and financial covenants. As of December 31, 2006, the Company had borrowed $120 million under the LOC and $60 million in letters of credit were outstanding. As a result, the Company had available borrowing capacity of $195 million at December 31, 2006. The weighted average interest rate on borrowings outstanding at December 31, 2006 was 6.92%.
 
9.   Commitments, Contingencies and Other Matters
 
Commitments — The Company maintains letters of credit in the aggregate amount of approximately $60 million for the benefit of various insurance companies as collateral for retrospective premiums and retained losses which may become payable under the terms of the underlying insurance contracts. These letters of credit are typically renewed annually. No amounts have been drawn under the letters of credit.
 
As of December 31, 2006, the Company has signed non-cancelable commitments to purchase approximately $297 million of equipment to be received throughout 2007. This amount excludes a $24.7 million deposit that was paid during 2006 pursuant to an agreement that was entered into to purchase rig components to be used in the


F-14


 

construction of 15 new land drilling rigs. This payment is presented as a deposit on equipment purchase contract in the consolidated balance sheet at December 31, 2006.
 
Contingencies — The Company’s contract services and oil and natural gas exploration and production operations are subject to inherent risks, including blowouts, cratering, fire and explosions which could result in personal injury or death, suspended drilling operations, damage to, or destruction of equipment, damage to producing formations and pollution or other environmental hazards.
 
As a protection against these hazards, the Company maintains general liability insurance coverage of $2.0 million per occurrence with $4.0 million of aggregate coverage and excess liability and umbrella coverages up to $100 million per occurrence and in the aggregate. The Company maintains a $1.0 million per occurrence deductible on its workers’ compensation insurance and its general liability insurance coverages.
 
The Company believes it is adequately insured for public liability and property damage to others with respect to its operations. However, such insurance may not be sufficient to protect the Company against liability for all consequences of well disasters, extensive fire damage, or damage to the environment. The Company also carries insurance to cover physical damage to, or loss of, its rigs. However, it does not cover the full replacement cost of the rigs and the Company does not carry insurance against loss of earnings resulting from such damage or loss.
 
Net income for the year ended December 31, 2005 includes a charge of $4.2 million related to the financial failure of a workers’ compensation insurance carrier that had provided coverage for the Company in prior years.
 
In November 2005, the Company discovered that its former Chief Financial Officer, Jonathan D. Nelson (“Nelson”), had fraudulently diverted approximately $77.5 million in Company funds for his own benefit. As a result, the Audit Committee of the Board of Directors commenced an investigation into Nelson’s activities and retained independent counsel and independent forensic accountants to assist with the investigation. Nelson has been sentenced and is serving a term of imprisonment arising out of his embezzlement. A receiver has been appointed to take control of and liquidate the assets of Nelson in connection with his embezzlement of Company funds. The receiver is in the process of seeking court approval for a plan of distribution of the assets recovered by the receiver and the proceeds thereof, which total approximately $40 million. 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.
 
In December 2005, two purported derivative actions were filed in Texas state court in Scurry County, Texas and in May 2006, a derivative action was filed in federal court in Lubbock, Texas, in each case, against the Company’s directors, alleging that the directors breached their fiduciary duties to the Company as a result of alleged failure to timely discover the embezzlement of approximately $77.5 million by its former CFO, Jonathan D. Nelson. 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 were stayed pending completion of the work of the special litigation committee. The lawsuits sought recovery on behalf of and for the Company and did not seek recovery from the Company. In November 2006, the parties to all three of the derivative actions reached an agreement to settle the actions. After a preliminary hearing and notice to the Company’s stockholders, the state court held a hearing, approved the settlement, which required the implementation of certain corporate governance measures, and signed a final judgment on December 29, 2006. As contemplated by the settlement agreement, the federal court entered a final judgment on January 10, 2007. Pursuant to the terms of the settlement, the Company will pay a net amount of $230,000 to the attorneys for the plaintiffs in the suits.
 
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.
 
Other Matters — The Company has Change in Control Agreements with its Chairman of the Board, Chief Executive Officer and two Senior Vice Presidents (the “Key Employees”). Each Change in Control Agreement generally has a three-year term with automatic twelve month renewals unless the Company notifies the Key Employee at least ninety days before the end of such renewal period that the term will not be extended. If a change in control of the Company occurs during the term of the agreement and the Key Employee’s employment is terminated


F-15


 

(i) by the Company other than for cause or other than automatically as a result of death, disability or retirement or (ii) by the Key Employee for good reason (as those terms are defined in the Change in Control Agreements), then the Key Employee shall be entitled to, among other things,
 
  •  bonus payment equal to the greater of the highest bonus paid after the Change in Control Agreement was entered into and the average of the two annual bonuses earned in the two fiscal years immediately preceding a change in control (such bonus payment prorated for the portion of the fiscal year preceding the termination date);
 
  •  a payment equal to 2.5 times (in the case of the Chairman of the Board and Chief Executive Officer) or 1.5 times (in the case of the Senior Vice Presidents) of the sum of (i) the highest annual salary in effect for such Key Employee and (ii) the average of the three annual bonuses earned by the Key Employee for the three fiscal years preceding the termination date; and
 
  •  continued coverage under the Company’s welfare plans for up to three years (in the case of the Chairman of the Board and Chief Executive Officer) or two years (in the case of the Senior Vice Presidents).
 
Each Change in Control Agreement provides the Key Employee with a full gross-up payment for any excise taxes imposed on payments and benefits received under the Change in Control Agreements or otherwise, including other taxes that may be imposed as a result of the gross-up payment.
 
10.   Stockholders’ Equity
 
The Company has granted restricted shares of the Company’s common stock (“Restricted Shares”) to certain key employees under the Patterson-UTI Energy, Inc. 1997 Long-Term Incentive Plan, as amended, and the Patterson-UTI Energy, Inc. 2005 Long-Term Incentive Plan. As required by SFAS 123(R), the Restricted Shares were valued based upon the market price of the Company’s common stock on the date of the grant. The restrictions on these shares lapse at various dates through 2010.
 
On June 7, 2004, the Company’s Board of Directors authorized a stock buyback program for the purchase of up to $30 million of the Company’s outstanding common stock. During 2004, the Company purchased 100,000 shares of its common stock under this program in the open market for approximately $1.5 million. During 2005, the Company purchased 355,000 shares of its common stock under this program in the open market for approximately $12.2 million. On March 27, 2006, the Company’s Board of Directors increased the stock buyback program to allow for future purchases of up to $200 million of the Company’s outstanding common stock. During the second quarter of 2006, the Company completed the purchase of 6,704,800 shares of its common stock under this program in the open market at a cost of approximately $200 million. On August 2, 2006, the Company’s Board of Directors again increased the stock buyback program to allow for future purchases of up to $250 million of the Company’s outstanding common stock. During the remainder of 2006, the Company purchased an additional 9,940,542 shares of its common stock under this program in the open market at a cost of approximately $250 million. Shares purchased under the stock buyback program have been accounted for as treasury stock.
 
On April 28, 2004, the Company’s Board of Directors authorized a two-for-one stock split in the form of a stock dividend which was distributed on June 30, 2004 to holders of record on June 14, 2004. In connection with the two-for-one stock split, an adjustment was made to reclassify an amount from retained earnings to common stock to account for the par value of the common stock issued as a stock dividend. This adjustment had no overall effect on equity. Historical net income per common share amounts included in the Consolidated Statements of Income and elsewhere in these financial statements have been presented as if the two-for-one stock split had occurred on January 1, 2004.
 
On April 28, 2004, the Company’s Board of Directors approved the initiation of a quarterly cash dividend of $0.02 on each share of its common stock which was paid on June 2, 2004, September 1, 2004 and December 1, 2004. Total dividends paid in 2004 were approximately $10.0 million. In February 2005, the Company’s Board of Directors approved an increase in the quarterly cash dividend on the Company’s common stock to $0.04 per share. Quarterly cash dividends in the amount of $0.04 per share were paid on March 4, 2005, June 1, 2005, September 1, 2005 and December 1, 2005. Total cash dividends in 2005 were approximately $27.3 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


F-16


 

which was paid on March 30, 2006. 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. Cash dividends of $0.08 per share were paid on June 30, 2006, September 29, 2006 and December 29, 2006. Total cash dividends in 2006 were approximately $45.8 million. 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.
 
In February 2004, the Company completed its acquisition of TMBR in which one of its wholly-owned subsidiaries acquired 100% of the outstanding shares of TMBR for a net cash payment of $32.5 million ($40.4 million paid to TMBR shareholders less $7.9 million in cash acquired in the transaction) and the issuance of 2.78 million shares of the Company’s common stock valued at $17.82 per share (adjusted to reflect the two-for-one stock split on June 30, 2004). The assets of TMBR included 18 land-based drilling rigs and related equipment, shop facilities, equipment yards and their oil and natural gas properties. The transaction was accounted for as a business combination and the purchase price was allocated among the assets acquired and liabilities assumed based on their estimated fair market values (see Note 2).
 
11.   Stock-based Compensation
 
The Company adopted FASB 123(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 equity instruments in the form of stock options or restricted stock awards and include only service conditions. The Company issues shares of common stock when vested stock option awards are exercised and when restricted stock awards are granted. For the year ended December 31, 2006, the Company recognized $16.3 million in stock-based compensation expense and a related income tax benefit of approximately $5.8 million and recognized a benefit in the form of a cumulative effect of change in accounting principle associated with the adoption of FAS 123(R) of $1.1 million, with a related tax expense of $398,000. As a result of the adoption of FAS 123(R) in 2006, operating income and income before income taxes was reduced by $8.4 million. Net income was reduced by $4.7 million. Basic EPS and Diluted EPS were reduced by $0.03 per share as a result of the adoption of FAS 123(R).
 
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 be made under any of the Company’s other previously existing plans. The Company’s share-based compensation plans at December 31, 2006 follow:
 
                         
          Options &
       
    Shares
    Restricted
    Shares
 
    Authorized
    Shares
    Available
 
Plan Name
  for Grant     Outstanding     for Grant  
 
Patterson-UTI Energy, Inc. 2005 Long-Term Incentive Plan
    6,250,000       1,540,252       4,140,197  
Patterson-UTI Energy, Inc. Amended and Restated 1997 Long-Term Incentive Plan, as amended (“1997 Plan”)
          5,090,885        
Amended and Restated Patterson-UTI Energy, Inc. 2001 Long-Term Incentive Plan (“2001 Plan”)
          762,559        
Amended and Restated Non-Employee Director Stock Option Plan of Patterson-UTI Energy, Inc. (“Non-Employee Director Plan”)
          150,000        
Amended and Restated Patterson-UTI Energy, Inc. 1996 Employee Stock Option Plan (“1996 Plan”)
          95,800        
Patterson-UTI Energy, Inc., 1993 Incentive Stock Plan, as amended (“1993 Plan”)
          123,800        


F-17


 

A summary of the 2005 Plan follows:
 
  •  The Compensation Committee of the Board of Directors administers the plan.
 
  •  All employees including officers and directors are eligible for awards.
 
  •  The Compensation Committee determines the vesting schedule for awards. Awards typically vest over 1 year for non-employee directors and 3 to 4 years for employees.
 
  •  The Compensation Committee sets the term of awards and no option term can exceed 10 years.
 
  •  All options granted under the plan are granted with an exercise price equal to or greater than the fair market value of the Company’s common stock at the time the option is granted.
 
  •  The plan provides for awards of incentive stock options, non-incentive stock options, tandem and freestanding stock appreciation rights, restricted stock awards, other stock unit awards, performance share awards, performance unit awards and dividend equivalents. As of December 31, 2006, only non-incentive stock options and restricted stock awards had been granted under the plan.
 
Options granted under the 1997 Plan typically vest over three or five years as dictated by the Compensation Committee. These options have terms of no more than ten years. All options were granted with an exercise price equal to the fair market value of the related common stock at the time of grant. Restricted Stock Awards granted under the 1997 Plan typically vest over four years.
 
Options granted under the 2001 Plan typically vest over five years as dictated by the Compensation Committee. These options have terms of no more than 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.
 
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 related common stock at the time of grant.
 
Options granted under the 1996 plan typically vest over one, four or five years as dictated by the Compensation Committee. These options have terms of no more than 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.
 
Options granted under the 1993 Plan typically typically vest over five years as dictated by the Compensation Committee. These options have terms of no more than 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.
 
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 they had no intrinsic value when granted as 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:
 
  •  Previously reported amounts and disclosures are not affected.
 
  •  Compensation cost, net of estimated forfeitures for the unvested portion of awards outstanding at January 1, 2006, is recognized under the fair-value-based method as the awards vest. Compensation cost is based on the grant-date estimated fair value of stock options as calculated for the Company’s previously reported pro forma disclosures under FASB Statement No. 123, Accounting for Stock-Based Compensation (“FAS 123”).
 
  •  The fair-value based method is applied to new awards and to any awards outstanding at January 1, 2006 that are modified, repurchased or cancelled after that date.


F-18


 

 
The Company estimates grant date fair values of stock options using the Black-Scholes-Merton valuation model (“Black-Scholes”), except for stock options granted prior to 1996 that are not subject to FAS 123(R) and were not subject to FAS 123 pro forma disclosures. Volatility assumptions are based on the historic volatility of the Company’s common stock over the most recent period equal to the expected term of the options as of the date the options were granted. The expected term assumptions are based on the Company’s experience with respect to employee stock option activity. Dividend yield assumptions are based on the expected dividends at the time the options were granted. The risk-free interest rate assumptions are determined by reference to United States Treasury yields. Weighted-average assumptions used to estimate grant date fair values for stock options granted in the years ended December 31, 2006, 2005 and 2004 follow:
 
                         
    2006     2005     2004  
 
Volatility
    33.18 %     26.95 %     36.84 %
Expected term (in years)
    4.00       4.00       3.84  
Dividend yield
    1.09 %     0.65 %     0.06 %
Risk-free interest rate
    4.87 %     3.84 %     3.22 %
 
Stock option activity for the year ended December 31, 2006 follows:
 
                 
          Weighted
 
          Average
 
          Exercise
 
    Shares     Price  
 
Outstanding at beginning of year
    6,338,044     $ 14.37  
Granted
    800,000     $ 28.54  
Exercised
    (180,726 )   $ 10.77  
Forfeited
    (17,000 )   $ 10.94  
Expired
    (4,389 )   $ 9.28  
Cancelled(a)
    (360,833 )   $ 14.83  
                 
Outstanding at end of year
    6,575,096     $ 16.18  
                 
Exercisable at end of year
    5,392,263     $ 13.92  
                 
 
 
(a) Represents vested stock options held by the former CFO which were cancelled by the Company’s Board of Directors.
 
Options outstanding at December 31, 2006 have an aggregate intrinsic value of approximately $51.4 million and have a weighted-average remaining contractual term of 6.21 years. Options exercisable at December 31, 2006 have an aggregate intrinsic value of approximately $50.6 million and have a weighted-average remaining contractual term of 5.60 years. Additional information with respect to options granted and exercised during the years ended December 31, 2006, 2005 and 2004 follows:
 
                         
    2006     2005     2004  
 
Weighted-average grant-date fair value of stock options granted (per share)
  $ 8.62     $ 6.33     $ 6.25  
Aggregate intrinsic value of stock options exercised (in thousands)
  $ 3,377     $ 73,467     $ 41,171  


F-19


 

 
As of December 31, 2006, options to purchase 1,182,833 shares were outstanding and not vested. Substantially all of these non-vested options are expected to ultimately vest. Additional information as of December 31, 2006 with respect to these options that are expected to vest follows:
 
         
Aggregate intrinsic value
  $ 766,000  
Weighted-average remaining contractual term
    8.98 years  
Weighted-average remaining expected term
    2.99 years  
Weighted-average remaining vesting period
    1.99 years  
Unrecognized compensation cost
  $ 8.2 million  
 
Restricted Stock — Under all restricted stock awards to date, shares were issued when granted, nonvested shares are subject to forfeiture for failure to fulfill service conditions and nonforfeitable dividends are paid on nonvested 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 FAS 123(R) did not change the accounting for the Company’s nonvested stock awards, except as follows:
 
  •  Prior to January 1, 2006, forfeitures were recognized as they occurred;
 
  •  From January 1, 2006 forward, forfeitures are estimated in the determination of periodic compensation cost;
 
  •  Contra equity deferred compensation was reversed against paid-in-capital at January 1, 2006; and
 
  •  Compensation expense is recognized as attributed to each period.
 
The Company uses the “graded-vesting” attribution method to determine periodic compensation cost from restricted stock awards.
 
Restricted stock activity for the year ended December 31, 2006 follows:
 
                 
          Weighted-
 
          Average Grant
 
    Shares     Date Fair Value  
 
Outstanding at beginning of year
    623,150     $ 21.44  
Granted
    613,400     $ 30.46  
Vested
    (1,351 )   $ 14.73  
Forfeited
    (46,999 )   $ 26.00  
                 
Outstanding at end of year
    1,188,200     $ 25.92  
                 
 
As of December 31, 2006, approximately 1,059,000 shares of nonvested restricted stock outstanding are expected to vest. Additional information as of December 31, 2006 with respect to these shares that are expected to vest follows:
 
         
Aggregate intrinsic value
  $ 24.6 million  
Weighted-average remaining vesting period
    2.51 years  
Unrecognized compensation cost
  $ 16.0 million  
 
Dividends on Equity Awards — Nonforfeitable dividends paid on equity awards are recognized as follows:
 
  •  Dividends are recognized as reductions of retained earnings for the portion of equity awards expected to vest.
 
  •  Dividends are recognized as additional compensation cost for the portion of equity awards that are not expected to vest or that ultimately do not vest.
 
Vesting expectations, in regard to these dividend payments, correspond with forfeiture assumptions used to recognize compensation cost.


F-20


 

 
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 earnings prior to January 1, 2006 since the exercise price was equal to the grant-date market value of the underlying common stock for all stock options granted prior to that date. The effect of share-based compensation, as if the Company had applied the fair-value-based method proscribed by FAS 123, on net income and earnings per share for the yeas ended December 31, 2005 and 2004 (in thousands, except per share amounts):
 
                 
    2005     2004  
 
Net income, as reported
  $ 372,740     $ 94,346  
Add back: Share-based employee compensation cost, net of related tax effects, included in net income as reported
    1,795       773  
Deduct: Share-based employee compensation cost, net of related tax effects, that would have been included in net income if the fair-value-based method had been applied to all awards
    (11,119 )     (12,304 )
                 
Pro-forma net income
  $ 363,416     $ 82,815  
                 
Net income per common share:
               
Basic, as reported
  $ 2.19     $ 0.57  
                 
Basic, pro-forma
  $ 2.13     $ 0.50  
                 
Diluted, as reported
  $ 2.15     $ 0.56  
                 
Diluted, pro-forma
  $ 2.11     $ 0.49  
                 
 
12.   Leases
 
The Company incurred rent expense of $31.8 million, $22.5 million and $17.8 million, for the years 2006, 2005 and 2004, respectively. The Company’s obligations under non-cancelable operating lease agreements are not material to the Company’s operations.


F-21


 

 
13.   Income Taxes
 
Components of the income tax provision applicable for Federal, state and foreign income taxes for the years ended December 31, 2006, 2005 and 2004 are as follows (in thousands):
 
                         
    2006     2005     2004  
 
Federal income tax expense (benefit):
                       
Current
  $ 344,395     $ 174,635     $ 32,686  
Deferred
    (5,851 )     14,182       12,366  
                         
      338,544       188,817       45,052  
                         
State income tax expense:
                       
Current
    21,371       13,045       2,031  
Deferred
    1,392       1,431       1,555  
                         
      22,763       14,476       3,586  
                         
Foreign income tax expense:
                       
Current
    9,607       7,238       5,235  
Deferred
    353       1,488       928  
                         
      9,960       8,726       6,163  
                         
Total:
                       
Current
    375,373       194,918       39,952  
Deferred
    (4,106 )     17,101       14,849  
                         
Total income tax expense
  $ 371,267     $ 212,019     $ 54,801  
                         
 
The difference between the statutory Federal income tax rate and the effective income tax rate for the years ended December 31, 2006, 2005 and 2004 is summarized as follows:
 
                         
    2006     2005     2004  
 
Statutory tax rate
    35.0 %     35.0 %     35.0 %
State income taxes
    1.4       1.8       1.6  
Permanent differences
    (0.8 )     (0.6 )     0.4  
Other, net
    0.0       0.1       (0.3 )
                         
Effective tax rate
    35.6 %     36.3 %     36.7 %
                         
 
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. The Company expects the deferred tax assets at December 31, 2006 to be realized as a result of the reversal during the carryforward period of existing taxable temporary differences giving rise to deferred tax liabilities and the generation of taxable income in the carryforward period; therefore, no valuation allowance is necessary.


F-22


 

 
The tax effect of significant temporary differences representing deferred tax assets and liabilities and changes therein were as follows (in thousands):
 
                                                         
    December
          December
          December
          January
 
    31,
    Net
    31,
    Net
    31,
    Net
    1,
 
    2006     Change     2005     Change     2004     Change     2004  
 
Deferred tax assets:
                                                       
Current:
                                                       
Federal net operating loss carryforwards
  $ 1,870     $     $ 1,870     $     $ 1,870     $ 1,870     $  
Workers’ compensation allowance
    26,363       6,902       19,461       4,584       14,877       1,545       13,332  
Embezzlement costs
    14,294       14,294                                
AMT credit
                                  (602 )     602  
Other
    14,501       3,137       11,364       4,386       6,978       1,238       5,740  
                                                         
      57,028       24,333       32,695       8,970       23,725       4,051       19,674  
                                                         
Non-current:
                                                       
Federal net operating loss carryforwards
    374       (1,871 )     2,245       (1,870 )     4,115       4,115        
AMT credit
    118             118             118       118        
Federal benefit of foreign deferred tax liabilities
    8,549       353       8,196       1,488       6,708       933       5,775  
Federal benefit of state deferred tax liabilities
    4,692       460       4,232       717       3,515       421       3,094  
Embezzlement costs
                      (22,178 )     22,178       7,193       14,985  
Other
    7,109       6,172       937       174       763       763        
                                                         
      20,842       5,114       15,728       (21,669 )     37,397       13,543       23,854  
                                                         
Total deferred tax assets
    77,870       29,447       48,423       (12,699 )     61,122       17,594       43,528  
                                                         
Deferred tax liabilities:
                                                       
Current:
                                                       
Other
    (8,161 )     (1,848 )     (6,313 )     1,421       (7,734 )     (4,509 )     (3,225 )
                                                         
Non-current:
                                                       
Property and equipment basis difference
    (203,500 )     (23,775 )     (179,725 )     (6,381 )     (173,344 )     (25,534 )     (147,810 )
Other
    (5,301 )     (110 )     (5,191 )     (663 )     (4,528 )     167       (4,695 )
                                                         
      (208,801 )     (23,885 )     (184,916 )     (7,044 )     (177,872 )     (25,367 )     (152,505 )
                                                         
Total deferred tax liabilities
    (216,962 )     (25,733 )     (191,229 )     (5,623 )     (185,606 )     (29,876 )     (155,730 )
                                                         
Net deferred tax liability
  $ (139,092 )   $ 3,714     $ (142,806 )   $ (18,322 )   $ (124,484 )   $ (12,282 )   $ (112,202 )
                                                         
 
Management deducted accumulated net embezzlement losses in the Company’s 2005 tax returns, which corresponds with the period in which the embezzlement was detected.
 
Other deferred tax assets consist primarily of various allowance accounts and tax deferred expenses expected to generate future tax benefit of approximately $22 million. Other deferred tax liabilities consist primarily of receivables from insurance companies and tax deferred income not yet recognized for tax purposes.
 
For tax purposes, the Company has available at December 31, 2006, Federal net operating loss carryforwards of approximately $5 million and $118,000 of alternative minimum tax credit carryforwards. These carryforwards are attributable to the acquisition of TMBR in February 2004.
 
The net operating loss carryforwards, if unused, are scheduled to expire as follows: 2018 — $1 million and 2019 — $4 million. The alternative minimum tax credit may be carried forward indefinitely.


F-23


 

 
14.   Employee Benefits
 
The Company maintains a 401(k) plan for all eligible employees. The Company’s operating results include expenses of approximately $3.1 million in 2006, $2.7 million in 2005 and $2.2 million in 2004 for the Company’s discretionary contributions to the plan.
 
15.   Business Segments
 
The Company conducts its business through four distinct operating segments: (1) contract drilling of oil and natural gas wells, (2) pressure pumping services, (3) drilling and completion fluids services to operators in the oil and natural gas industry, and (4) 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.
 
Contract Drilling — The Company markets its contract drilling services to major and independent oil and natural gas operators. As of December 31, 2006, the Company had 336 currently marketable land-based drilling rigs, of which 107 of the drilling rigs were based in the Permian Basin region, 50 in South Texas, 44 in the Ark-La-Tex region and Mississippi, 67 in the Mid-Continent region, 48 in the Rocky Mountain region and 20 in Western Canada.
 
Pressure Pumping — The Company provides pressure pumping services primarily in the Appalachian Basin. Pressure pumping services consist primarily of well stimulation and cementing for the completion of new wells and remedial work on existing wells. Well stimulation involves processes inside a well designed to enhance the flow of oil, natural gas, or other desired substances from the well. Cementing is the process of inserting material between the hole and the pipe to center and stabilize the pipe in the hole.
 
Drilling and Completion Fluids — The Company provides drilling fluids, completion fluids and related services to oil and natural gas operators offshore in the Gulf of Mexico and on land in Texas, Southeastern New Mexico, Oklahoma and the Gulf Coast region of Louisiana. 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.
 
Oil and Natural Gas — The Company is engaged in the development, exploration, acquisition and production of oil and natural gas.
 
The following ta