UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 001-08038

KEY ENERGY SERVICES, INC.

(Exact name of registrant as specified in its charter)

 

1301 McKinney Street

Suite 1800

Houston, Texas 77010

(Address of principal executive offices, including Zip Code)

 

(713) 651-4300

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer (as defined in Rule 405 of the Securities Act).  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     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 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.  o

 

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

 

(Do not check if a smaller reporting company)

 

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

 

The aggregate market value of the common stock of the registrant held by non-affiliates of the registrant as of June 30, 2008, based on the $19.42 per share closing price for the registrant’s common stock as quoted on the New York Stock Exchange on such date, was $1,727,937,807 (for purposes of calculating these amounts, only directors, officers and beneficial owners of 10% or more of the outstanding capital stock of the registrant have been deemed affiliates).

 

As of February 23, 2009, the number of outstanding shares of common stock of the registrant was 121,210,781.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 with respect to the 2009 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

 

 

KEY ENERGY SERVICES, INC.

 

ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 2008

 

INDEX

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

In addition to statements of historical fact, this report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature or that relate to future events and conditions are, or may be deemed to be, forward-looking statements. These “forward-looking statements” are based on our current expectations, estimates and projections about Key Energy Services, Inc. and its subsidiaries, our industry and management’s beliefs and assumptions concerning future events and financial trends affecting our financial condition and results of operations. In some cases, you can identify these statements by terminology such as “may,” “will,” “predicts,” “projects,” “potential” or “continue” or the negative of such terms and other comparable terminology. These statements are only predictions and are subject to substantial risks and uncertainties. In evaluating those statements, you should carefully consider the information above as well as the risks outlined in “Item 1A. Risk Factors.” Actual performance or results may differ materially and adversely.

 

We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of this report except as required by law. All of our written and oral forward-looking statements are expressly qualified by these cautionary statements and any other cautionary statements that may accompany such forward-looking statements.

 

 

THE COMPANY

 

Key Energy Services, Inc. is a Maryland corporation. References to “Key,” the “Company,” “we,” “us” or “our” are intended to refer to Key Energy Services, Inc., its wholly-owned subsidiaries and its controlled subsidiaries.

 

We provide a complete range of well services to major oil companies, foreign national oil companies and independent oil and natural gas production companies, including rig-based well maintenance, workover, well completion and recompletion services, fluid management services, pressure pumping services, fishing and rental services and ancillary oilfield services.

 

We believe that we are the leading onshore, rig-based well servicing contractor in the world. We operate in most major oil and natural gas producing regions of the United States as well as internationally in Argentina and Mexico. Additionally, we have a technology development group based in Canada. We also have an ownership interest in a drilling and production services company based in Canada, and, during October 2008, acquired a 26% ownership interest in a drilling and workover services and sub-surface engineering and modeling company based in the Russian Federation.

 

Key’s principal executive office is located at 1301 McKinney Street, Suite 1800, Houston, Texas 77010. Our phone number is (713) 651-4300 and website address is www.keyenergy.com. We make available free of charge through our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (the “SEC”). We have filed the required certifications under Section 302 of the Sarbanes-Oxley Act of 2002 as Exhibits 31.1 and 31.2 to this Annual Report on Form 10-K. In 2008, we submitted to the New York Stock Exchange (the “NYSE”) the CEO certification required by Section 303A.12(a) of the NYSE’s Listed Company Manual. Information on our website or any other website is not a part of this report.

 

DESCRIPTION OF BUSINESS SEGMENTS

 

During fiscal year 2008, our business was comprised of three primary business segments: well servicing, pressure pumping services and fishing and rental services. Key operates in various regions in the continental United States and internationally in Argentina and Mexico. The following is a description of these three business segments. For financial information regarding these business segments, see “Note 19. Segment Information,” in “Item 8. Consolidated Financial Statements and Supplementary Data.”

 

In early 2009, we implemented a reorganization of our U.S. operating segments to realign both our management structure and resources along six lines of business. We have undertaken this structural realignment in an effort to better position the Company to utilize our assets efficiently in meeting customer needs and to ensure that all lines of business share the same geographic footprint. The six lines of business will be rig services, fluid management services, pressure pumping services, wireline services, rental services and fishing services.

 

Well Servicing Segment

 

Through our well servicing segment (which accounted for approximately 76.6% of revenues for the year ended December 31, 2008), we provide a broad range of well services, including rig-based services, fluid management services (which includes oilfield transportation and produced-water disposal services), cased-hole electric wireline services and ancillary oilfield services. These services are necessary to complete, stimulate, maintain and workover oil and natural gas producing wells. Our well service rig fleet provides well maintenance, workover, completion, and plugging and abandonment services to our customers. Certain of our larger well service rigs are suitable for and used in certain drilling applications, including horizontal drilling.

Our fluid management fleet provides vacuum truck services, fluid transportation services and disposal services for operators whose wells produce saltwater or other fluids and is also a supplier of frac tanks, which are used for temporary storage of fluids used in conjunction with fluid hauling operations.

 

During 2008, we conducted well servicing operations in virtually every major onshore oil and natural gas producing region of the continental United States, including the Gulf Coast (including South Texas, Central Gulf Coast of Texas and South Louisiana), Permian Basin of West Texas and Eastern New Mexico, Mid-Continent (including the Anadarko, Hugoton and Arkoma Basins and the Ark-La-Tex and North Texas regions), Four Corners (including the San Juan, Piceance, Uinta and Paradox Basins), the Appalachian Basin, Rocky Mountains (including the Denver Julesberg, Powder River, Wind River, Green River and Williston Basins), and California (the San Joaquin Basin), and internationally in Argentina and Mexico. In addition to our onshore operations, we also operate six barge-based rigs that serve customers along the Gulf Coast that can conduct operations in shallow water.

 

Rig-based Services

 

Rig-based services include the maintenance of existing wells, workover of existing wells, completion of newly drilled wells, drilling of horizontal wells, recompletion of existing wells (re-entering a well to complete the well in a new geologic zone or formation) and plugging and abandonment of wells at the end of their useful lives. Our rig fleet consists of 924 active rigs and is diverse, allowing us to work on all types of wells ranging from very shallow wells to wells as deep as 20,000 feet. Over 250 of our well service rigs are outfitted with our proprietary KeyView^® technology, which captures and reports well site operating data. This technology allows our customers and our crews to actively monitor well site operations, to improve efficiency and safety and to add value to the services we offer. Included in our domestic well service fleet are six operational inland barge rigs. Inland barge rigs are mobile, self-contained, drilling and/or workover vessels that are used in the drilling and completion of oil and natural gas wells in shallow marshes, inland lakes, rivers and swamps along the Gulf Coast of the United States. When moved from one location to another, the barge floats; when stationed on the drill or workover site, the barge is submerged to rest on the bottom. Typically, inland barge rigs are used to drill or workover wells in marshes, shallow inland bays and offshore where the water covering the drill site is not too deep. Our barge rigs can operate at depths between three and 17 feet. For our rig-based services, we typically charge by the hour in the United States and Argentina, and by the job in Mexico.

 

Maintenance Services

 

We provide well service rigs, equipment and crews for maintenance services. These services are performed on both oil and natural gas wells, but more frequently on oil wells. While some oil wells in the United States flow oil to the surface without mechanical assistance, most require pumping or some other method of artificial lift. Oil wells that require pumping characteristically require more maintenance than flowing wells due to the operation of the mechanical pumping equipment. Because few natural gas wells have mechanical pumping systems in the wellbore, maintenance work on natural gas wells is less frequent.

 

Maintenance services are required throughout the life of most producing wells to ensure efficient and continuous operation. These services consist of routine mechanical repairs necessary to maintain production from the well, such as repairing inoperable pumping equipment in an oil well or replacing defective tubing in an oil or natural gas well, and removing debris such as sand and paraffin from the well. Other services include pulling the rods, tubing, pumps and other downhole equipment out of the wellbore to identify and repair a production problem.

 

Maintenance services are often performed on a series of wells in close proximity to each other and typically require less than 48 hours per well to complete. In general, demand for maintenance services is closely related to the total number of producing oil and natural gas wells in a geographic market, and maintenance services are generally the most stable type of well service activity.

Workover Services

 

In addition to periodic maintenance, producing oil and natural gas wells occasionally require major repairs or modifications, called “workovers.” Workover services are performed to enhance the production of existing wells. Such services include extensions of existing wells to drain new formations either by deepening wellbores to new zones or by drilling horizontal or lateral wellbores to improve reservoir drainage. In less extensive workovers, our rigs are used to seal off depleted zones in existing wellbores and access previously bypassed productive zones. Our workover rigs are also used to convert former producing wells to injection wells through which water or carbon dioxide is pumped into the formation for enhanced recovery operations. Other workover services include: conducting major subsurface repairs such as casing repair or replacement, recovering tubing and removing foreign objects in the wellbore, repairing downhole equipment failures, plugging back a section of a well to reduce the amount of water being produced with the oil and natural gas, cleaning out and recompleting a well if production has declined and repairing leaks in the tubing and casing. These extensive workover operations are normally performed by a well service rig with a workover package, which may include rotary drilling equipment, mud pumps, mud tanks and blowout preventers, depending upon the particular type of workover operation. Most of our well service rigs are designed to perform complex workover operations.

 

Workover services are more complex and time consuming than routine maintenance operations and consequently may last from a few days to several weeks. These services are almost exclusively performed by well service rigs. Demand for workover services is closely related to capital spending by oil and natural gas producers, which is generally a function of oil and natural gas prices. As commodity prices increase, oil and natural gas producers tend to increase capital spending for workover services in order to increase oil and natural gas production. Conversely, as commodity prices decrease, as they have during the second half of 2008, oil and natural gas producers tend to decrease capital spending for workover services.

 

Completion Services

 

Our completion services prepare a newly drilled oil or natural gas well for production. The completion process may involve selectively perforating the well casing to access producing zones, stimulating and testing these zones and installing downhole equipment. We typically provide a well service rig and may also provide other equipment such as a workover package to assist in the completion process. However, during periods of weak drilling rig demand, some drilling contractors may compete with service rigs for completion work. Also, for some completion work on natural gas wells, coiled tubing units can be used in place of a well service rig.

 

The completion process typically requires a few days to several weeks, depending on the nature and type of the completion, and generally requires additional auxiliary equipment that we provide for an additional fee. The demand for well completion services is directly related to drilling activity levels, which are highly sensitive to expectations relating to, and changes in, oil and natural gas prices. As the number of newly drilled wells decreases, the number of completion jobs correspondingly decreases.

 

Plugging and Abandonment Services

 

Well service rigs and workover equipment are also used in the process of permanently shutting-in oil and natural gas wells at the end of their productive lives. Plugging and abandonment work can be performed with a well service rig along with electric wireline and cementing equipment. Plugging and abandonment services require compliance with state regulatory requirements. The demand for oil and natural gas does not significantly affect the demand for plugging and abandonment services because well operators are required by state regulations to plug wells that are no longer productive. The need for these services is also driven by lease or operator policy requirements.

 

Fluid Management Services

 

We provide fluid management services, including oilfield transportation and produced-water disposal services. Our oilfield transportation and produced-water disposal services include vacuum truck services, fluid transportation services and disposal services for operators whose oil or natural gas wells produce saltwater and

other fluids. In addition, we are a supplier of frac tanks which are used for temporary storage of fluids in conjunction with the fluid hauling operations.

 

Fluid hauling trucks are utilized in connection with drilling and workover projects, which tend to use large amounts of various oilfield fluids. In connection with drilling or maintenance activity at a well site, we transport fresh water to the well site and provide temporary storage and disposal of produced saltwater and drilling or workover fluids. In many oil and natural gas producing regions of the United States, saltwater is produced along with the oil and natural gas. The production of saltwater typically increases as the oil and natural gas production decreases. Our fluid management services will collect, transport and dispose of the saltwater. These fluids are removed from the well site and transported for disposal in a saltwater disposal (“SWD”) well. Key owned or leased 52 active SWD wells at December 31, 2008. In addition, we provide equipment trucks that are used to move large pieces of equipment from one well site to the next, and we operate a fleet of hot oilers which are capable of pumping heated fluids that are used to clear soluable restrictions in a wellbore. Demand and pricing for these services generally correspond to demand for our well service rigs. Fluid hauling and equipment hauling services are typically priced on a per barrel or per hour basis while frac tank rentals are typically billed on a per day basis.

 

Cased-Hole Electric Wireline Services

 

Key provides cased-hole electric wireline services in the Appalachian Basin, Texas and Louisiana. These services are performed at various times throughout the life of the well and includes perforating, completion logging, production logging and casing integrity services. After the wellbore is cased and cemented, we can provide a number of services. Perforating creates the flow path between the reservoir and the wellbore. Production logging can be performed throughout the life of the well to measure temperature, fluid type, flow rate, pressure and other reservoir characteristics. This service helps the operator analyze and monitor well performance and determine when a well may need a workover or further stimulation.

 

In addition, cased-hole services may involve wellbore remediation, which could include the positioning and installation of various plugs and packers to maintain production or repair well problems, and casing inspection for internal or external abnormalities in the casing string. Wireline services are provided from surface logging units, which lower tools and sensors into the wellbore. We owned 27 wireline units as of December 31, 2008. Cased-hole electric wireline services are conducted during the completion of an oil or natural gas well and often times throughout the life of a producing well. Services include: production logging, perforating, pipe recovery, pressure control and setting services. We use advanced wireline instruments to evaluate well integrity and perform cement evaluations and production logging. Demand for our cased-hole electric wireline services is correlated to current and anticipated oil and natural gas prices and the resulting effect on the willingness of our customers to make operating and capital expenditures.

 

Contract Drilling Services

 

We provide limited drilling services to oil and natural gas producers. In Argentina, we operate seven drilling rigs and in the continental United States we operate 151 heavy-duty well service rigs that are capable of providing conventional and/or horizontal drilling services. Our drilling services are primarily provided under standard day rates, and, to a lesser extent, footage contracts. Our drilling rigs vary in size and capability. The rigs located in Argentina are equipped with mechanical power systems and have depth ratings of approximately 10,000 feet, although one rig can drill up to approximately 15,000 feet. Domestically, we recently acquired three new rigs equipped with mechanical power systems and 250 ton hydraulic top drive units. These three new rigs are rated to drill to 12,000 feet. Like workover services, the demand for contract drilling is directly related to expectations about, and changes in, oil and natural gas prices which, in turn, are driven by the supply of and demand for these commodities.

 

Ancillary Oilfield Services

 

We provide ancillary oilfield services, which include, among others: well site construction (preparation of a well site for drilling activities); roustabout services (provision of manpower to assist with activities on a well

site); and air drilling services (drilling technique using compressed air). Demand and pricing for these services are generally related to demand for our well service operations.

 

Pressure Pumping Services Segment

 

Through our pressure pumping services segment (which accounted for approximately 17.5% of revenues for the year ended December 31, 2008), we provide well stimulation and cementing services to oil and natural gas producers. Well stimulation services include fracturing, nitrogen, coiled tubing and acidizing services. These services (which may be completion or workover services) are provided to oil and natural gas producers and are used to enhance the production of oil and natural gas wells from formations which exhibit restricted flow of oil and natural gas. In the fracturing process, we typically pump fluid and sized sand, or proppants, into a well at high pressure in order to fracture the formation and thereby increase the flow of oil and natural gas. With our cementing services, we pump cement into a well between the casing and the wellbore. Demand for our pressure pumping services is primarily influenced by current and anticipated oil and natural gas prices and the resulting effect on the willingness of our customers to make operating and capital expenditures. Coiled tubing services involve the use of a continuous metal pipe spooled on a large reel for oil and natural gas well applications, such as wellbore clean-outs, nitrogen jet lifts and through tubing fishing and formation stimulations utilizing acid, chemical treatments and sand fracturing. Coiled tubing is also used for a number of horizontal well applications, including “stiff wireline” uses in which a wireline is placed in the coiled tube and then fed into a well to carry the wireline to a desired depth (since gravity will not pull the wireline to the desired depth in a horizontal well).

 

Our pressure pumping services in 2008 were conducted in the Permian Basin and Barnett Shale in Texas, the Marcellus Shale in West Virginia, the Bakken Shale in North Dakota, the Michigan Basin, Illinois Basin and New Albany Shale in the four state area of Michigan, Illinois, Indiana and western Ohio, the San Juan Basin in Colorado and New Mexico and the Oswego, Mississippi and Anadarko Basins in Oklahoma. Our well stimulation services were provided in the Permian Basin and Barnett Shale in Texas and Mississippi and Anadarko Basins in Oklahoma. We provided cementing services in the Permian Basin and Barnett Shale in Texas, Mississippi and Anadarko Basins in Oklahoma and the Bakken Shale in North Dakota. We provided coiled tubing services in the Permian Basin and Barnett Shale in Texas, the Marcellus Shale in West Virginia, the Bakken Shale in North Dakota, the Michigan Basin, Illinois Basin, New Albany Shale in the four state area of Michigan, Illinois, Indiana and western Ohio and Minden, Louisiana. We also provided cementing and coiled tubing services in conjunction with our plugging and abandonment operations in the Elk Hills and Kern River Basins of California.

 

Fishing and Rental Services Segment

 

Through our fishing and rental services segment (which accounted for approximately 5.9% of revenues for the year ended December 31, 2008), we provided fishing and rental services to major and independent oil and natural gas production companies in the Gulf Coast, Mid-Continent and Permian Basin regions, as well as in California. We also provided limited services offshore in the Gulf of Mexico. Fishing services involve recovering lost or stuck equipment in the wellbore utilizing a “fishing tool.” We offer a full line of services and rental equipment designed for use both onshore and offshore for drilling and workover services. Our rental tool inventory consists of drill pipe, tubulars, handling tools (including our patented Hydra-Walk^® pipe-handling units and services), pressure-controlled equipment, power swivels and foam air units. Demand for our fishing and rental services is also closely related to capital spending by oil and natural gas producers, which is generally a function of oil and natural gas prices. Pricing for fishing services is typically on a per job basis, including charges for equipment and tools used during the operation along with charges for equipment operators and consulting services. Prices for rental services typically include a daily charge for equipment and tools in addition to any equipment operators furnished.

EQUIPMENT OVERVIEW

 

Well Service Rigs

 

Our rigs typically are billed to customers on a per hour basis, but in certain cases may be billed on a day rate or by project. We categorize our rigs as active, stacked or inactive. We consider an active rig or piece of equipment to be a unit that is working, on standby, or down for repairs but with work orders assigned to it or that is available for work. A stacked rig or piece of equipment is defined as a unit that is in the remanufacturing process and could not be put to work without significant investment in repairs and additional equipment. A rig or piece of equipment is considered inactive if we intend to salvage the unit for parts, sell the unit or scrap the unit. The definitions of active, stacked and inactive are used for the majority of our equipment.

 

As of December 31, 2008, our fleet of active well service rigs totaled 924 rigs. These rigs are located throughout the United States and internationally in Argentina and Mexico. Our geographic diversification provides us with a balanced mix of oil versus natural gas exposure. We estimate that approximately 68% of our rigs are located in predominantly oil regions, while 32% of our rigs are located in predominantly natural gas regions.

 

As mentioned above, our fleet is diverse and allows us to work on all types of wells, ranging from very shallow wells to wells as deep as 20,000 feet. The following table classifies our active rigs based on size and location. Typically, heavy-duty rigs will be utilized on deep wells while light-duty rigs will be used on shallow wells. In most cases, these rigs can be reassigned to other regions should market conditions warrant the transfer of equipment.

 

Active Well Service Rig Fleet as of December 31, 2008

 

 

 

 

Fluid Management Services — Oilfield Transportation Equipment

 

We have a broad and diverse fleet of oilfield transportation service vehicles. We broadly define an oilfield transportation service vehicle as any heavy-duty, revenue-generating vehicle weighing over one ton. Our transportation fleet includes vacuum trucks, winch trucks, hot oilers and other vehicles, including kill trucks and various hauling and transport trucks.

Transportation Fleet as of December 31, 2008

 

 

Pressure Pumping Equipment

 

Our pressure pumping services segment operates a diverse fleet of equipment, including frac pumps, cementing units, acidizing units, nitrogen units and coiled tubing units.

 

Pressure Pumping Fleet as of December 31, 2008

 

 

SEASONALITY

 

Our operations are impacted by seasonal factors. Historically, our business has been negatively impacted during the winter months due to inclement weather, fewer daylight hours and holidays. Our well service rigs are mobile, and we operate a significant number of oilfield transportation service vehicles. During the summer months, our operations may be impacted by tropical weather systems. During periods of heavy snow, ice or rain, we may not be able to move our equipment between locations, thereby reducing our ability to generate rig or trucking hours. In addition, the majority of our well service rigs work only during daylight hours. In the winter months when days become shorter, this reduces the amount of time that the rigs can work and therefore has a negative impact on total hours worked. Lastly, during the fourth quarter, we historically have experienced significant slowdown during the Thanksgiving and Christmas holiday seasons.

 

PATENTS, TRADE SECRETS, TRADEMARKS AND COPYRIGHTS

 

We own numerous patents, trademarks and proprietary technology that we believe provide us with a competitive advantage in the various markets in which we operate or intend to operate. We have devoted significant resources to developing technological improvements in our well service business and have sought patent protection both inside and outside the United States for products and methods that appear to have commercial significance. In the United States, as of December 31, 2008, we had 34 patents issued and 16 patents pending. As of December 31, 2008, we had 23 patents issued and 182 patents pending in foreign countries. All the issued patents have varying remaining durations and begin expiring between 2013 and 2025. The most notable of our technologies include numerous patents surrounding the KeyView^® system, a field data

acquisition system that captures vital well site operating data from service equipment. We believe this information helps us and our customers improve safety, reduce costs and increase productivity.

 

We own several trademarks that are important to our business both in the United States and in foreign countries. In general, depending upon the jurisdiction, trademarks are valid as long as they are in use or their registrations are properly maintained and they have not been found to become generic. Registrations of trademarks can generally be renewed indefinitely as long as the trademarks are in use. While our patents and trademarks, in the aggregate, are of considerable importance to maintaining our competitive position, no single patent or trademark is considered to be of a critical or essential nature to our business.

 

We also rely on a combination of trade secret laws, copyright and contractual provisions to establish and protect proprietary rights in our products and services. We typically enter into confidentiality agreements with our employees, strategic partners and suppliers and limit access to the distribution of our proprietary information.

 

FOREIGN OPERATIONS

 

During 2008, we operated internationally in Argentina and Mexico, and we have a technology development group based in Canada. We also have ownership interests in a drilling and production services company based in Canada and a drilling and workover services and sub-surface engineering and modeling company based in the Russian Federation.

 

Revenue from our international operations during 2008 totaled $171.9 million, or 8.7% of total revenue. Revenue from international operations for 2007 and 2006 totaled $105.9 million and $78.3 million, respectively. International revenues by country are summarized in the following table:

 

 

In Argentina, we operate 42 well service rigs (of which seven are drilling rigs) and 46 oilfield transportation vehicles, all of which we include in our well servicing segment. Beginning in the third quarter of 2008, we experienced a significant downturn in activity levels in Argentina due, in part, to deteriorating oil prices. At December 31, 2008, approximately 75% of our rigs in Argentina were working. The downturn has been further exacerbated by labor-related issues in this country. We are currently exploring other options for our equipment in Argentina if market conditions there do not improve. For additional information regarding Argentina, see the discussion on “International Expansion” under “Business and Growth Strategies” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

In Mexico, we commenced operations during the second quarter of 2007 after Petróleos Mexicanos, the Mexican national oil company (“PEMEX”), awarded our Mexican subsidiary, Key Energy Services de México S. de R.L. de C.V., a 22-month contract (the “First PEMEX Contract”) valued at approximately $45.8 million to provide field production solutions and well workover services. During the fourth quarter of 2008, we were awarded a second 24-month contract with PEMEX (the “Second PEMEX Contract”) to provide the same type of well services valued at approximately $68.0 million. Also, during the fourth quarter of 2008, our First PEMEX Contract was extended until September 2009 and the value increased approximately $60.0 million, for an aggregate value of approximately $105.8 million. Under the terms of the First PEMEX Contract, we

initially provided three well service rigs outfitted with our proprietary KeyView^® system, and we installed two KeyView^® systems on PEMEX-owned well service rigs. PEMEX has the option to call for additional rigs and KeyView^® systems in the future, and, as of December 31, 2008, we had supplied PEMEX a total of 14 rigs. As of February 23, 2009, we have increased the number of rigs in Mexico to 17 rigs. The projects under both contracts cover PEMEX’s North Region assets and initially focus on oil wells in Burgos, Poza Rica-Altamira and Cerro Azul. We anticipate that we will install units with KeyView^® systems on all PEMEX-owned workover rigs over the next two years, through 2010.

 

On October 31, 2008, we acquired a 26% interest in OOO Geostream Services Group (“Geostream”) for $17.4 million. Geostream is based in the Russian Federation and provides drilling and workover services and sub-surface engineering and modeling in the Russian Federation. We are contractually required to purchase an additional 24% of Geostream no later than March 31, 2009 for approximately €11.3 million (which at February 23, 2009 is equivalent to $14.4 million). For a period not to exceed six years subsequent to October 31, 2008, we will have the option to increase our ownership percentage to 100%. If we have not acquired 100% of Geostream on or before the end of the six-year period, we will be required to arrange an initial public offering for those shares.

 

In 2007, we acquired Advanced Measurements, Inc. (“AMI”), a privately-held Canadian technology company focused on oilfield service equipment controls, data acquisition and digital information work flow. AMI builds Key’s proprietary KeyView^® systems for deployment on our well service rigs, designs and builds control and data acquisition systems for fracturing services and develops additional technologies for Key as well as other service providers. In addition, in connection with the acquisition of AMI, we acquired an ownership interest in Advanced Flow Technologies, Inc. (“AFTI”), a privately-held Canadian technology company focused on low cost wireless gas well production monitoring. As of December 31, 2008, we held a 48.73% interest in AFTI.

 

CUSTOMERS

 

Our customers include major oil companies, independent oil and natural gas production companies, and foreign national oil and natural gas production companies. During the years ended December 31, 2008, 2007 and 2006, no single customer accounted for 10% or more of our consolidated revenues.

 

COMPETITION AND OTHER EXTERNAL FACTORS

 

In the well servicing markets, we believe that, based on available industry data, we are the largest provider of land-based well service rigs in the United States. At December 31, 2008, we had 924 active rigs. Based on the Weatherford-AESC (“AESC”) well service rig count, which is available on Weatherford International’s internet website, there were approximately 2,910 well service rigs in the United States at December 31, 2008. A prior survey suggested that there are more well service rigs in the United States than are reported by the AESC count. While we agree that there are likely more rigs than reported by the AESC, AESC provides the most readily available information concerning the U.S. well service rig count. We believe that the difference between the AESC data and the prior survey is likely attributable to (i) not all U.S. well service providers being members of the AESC, (ii) some U.S. oil and natural gas producers owning well service rigs and not reporting to the AESC and (iii) poor reporting of equipment by certain members of the AESC.

 

The markets in which we operate are highly competitive. Competition is influenced by such factors as price, capacity, availability of work crews, and reputation and experience of the service provider. We believe that an important competitive factor in establishing and maintaining long-term customer relationships is having an experienced, skilled and well-trained work force. In recent years, many of our larger customers have placed increased emphasis on the safety performance and quality of the crews, equipment and services provided by their contractors. We have devoted, and will continue to devote, substantial resources toward employee safety

and training programs. In addition, we believe that the KeyView^® system has provided and will continue to provide important safety enhancements. Although we believe customers consider all of these factors, price is often the primary factor in determining which service provider is awarded the work. However, in numerous instances we secure and maintain work for large customers for which efficiency, safety, technology, size of fleet and availability of other services are of equal importance to price. Due, in part, to dramatic declines in the price of oil and natural gas, pricing for our services has become increasingly competitive since September of 2008. Further, as demand drops for oilfield services, the market is left with excess supply, placing additional pressure on our pricing.

 

Significant well service providers include Nabors Industries, Basic Energy Services and Complete Production Services. Other public-company competitors include Bronco Drilling, Forbes Energy Services and Pioneer Drilling Company. In addition, though there has been consolidation in the domestic well servicing industry, there are numerous small companies that compete in Key’s well servicing markets. We do not believe that any other competitor has more active well service rigs than Key. In Argentina, our largest competitors are San Antonio International (formerly Pride International), Nabors Industries and Allis-Chalmers Energy. San Antonio International and Forbes Energy Services are our largest competitors in Mexico.

 

The pressure pumping services market is dominated by three major competitors: Schlumberger Ltd., Halliburton Company and BJ Services Company. These three companies have a substantially larger asset base than Key and are believed to operate in all major U.S. oil and natural gas producing basins. Other competitors include Weatherford International Ltd., Superior Well Services, Inc., Basic Energy Services, Inc., Complete Production Services, Inc., Frac-Tech Services, Ltd. and RPC, Inc. The pressure pumping industry is very competitive, and the three major competitors generally lead pricing in any particular region. Our pressure pumping services operate in niche markets and historically have competed effectively with these competitors based on performance and strong customer service. Where feasible, we cross-market our electric wireline services to a number of customers where our pressure pumping crews work in tandem with our wireline crews, thereby offering our customers the ability to minimize vendors, which, we believe, will improve efficiency. We may be able to further pursue other cross-marketing opportunities utilizing capabilities that are unique to Key, because none of the three major pressure pumping contractors own and operate well service rigs in the United States.

 

The U.S. fishing and rental services market is fragmented compared to our other product lines. Companies that provide fishing services generally compete based on the reputation of their fishing tool operators and their relationships with customers. Competition for rental tools is sometimes based on price; however, in most cases, when a customer chooses a specific fishing tool operator for a particular job, then the necessary rental equipment will be part of that job as well. Our primary competitors include Baker Oil Tools, Smith International, Inc., Weatherford International Ltd., Basic Energy Services, Inc., Superior Energy Services Inc., Quail Tools (owned by Parker Drilling Company) and Knight Oil Tools.

 

The need for well servicing, pressure pumping services and fishing and rental services fluctuates, primarily, in relation to the price (or anticipated price) of oil and natural gas, which, in turn, is driven by the supply of and demand for oil and natural gas. Generally, as supply of those commodities decreases and demand increases, service and maintenance requirements increase as oil and natural gas producers attempt to maximize the productivity of their wells in a higher priced environment. However, in a lower oil and natural gas price environment, such as the one we are currently experiencing, demand for service and maintenance decreases as oil and natural gas producers decrease their activity. In particular, the demand for new or existing field drilling and completion work, including electric wireline services, is driven by available investment capital for such work. Because these types of services can be easily “started” and “stopped,” and oil and natural gas producers are less risk tolerant when commodity prices are low or volatile, we may experience a more rapid decline in demand for these types of well maintenance services compared with demand for other types of oilfield services. Further, in this lower-priced environment, fewer well service rigs are needed for completions and there is reduced demand for fishing services because these activities are generally associated with drilling activity.

The level of our revenues, earnings and cash flows are substantially dependent upon, and affected by, the level of domestic and international oil and natural gas exploration and development activity, as well as the equipment capacity in any particular region. For a more detailed discussion, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

EMPLOYEES

 

As of December 31, 2008, we employed approximately 8,411 persons in our domestic operations and approximately 1,710 additional persons in Argentina, Mexico and Canada. Not including the reductions in force that were initiated by the Company in response to market conditions, we experienced an annual domestic employee turnover rate of approximately 42% during 2008, compared to a turnover rate of approximately 41% in 2007. The high turnover rate is caused, in part, by the nature of the work, which is physically demanding and sometimes performed in harsh outdoor conditions. As a result, workers may choose to pursue employment in fields that offer a more desirable work environment at wage rates that are competitive with ours. Alternatively, some employees may leave Key if they can earn a higher wage with a competitor.

 

Our domestic employees are not represented by a labor union and are not covered by collective bargaining agreements. Many of our employees in Argentina are represented by formal unions. Beginning in 2008, we have been experiencing significant labor-related issues in Argentina as a result of not being able to terminate the employment of field and office personnel because of restrictions imposed by local regulatory agencies in that country. In Mexico, during 2008, we entered into a collective bargaining agreement that applies to our workers in Mexico performing work under the PEMEX contracts. Other than with respect to the labor situation in Argentina, we have not experienced any significant work stoppages associated with labor disputes or grievances and consider our relations with our employees to be satisfactory. A discussion of the risks associated with our high turnover is presented under “Business Related Risk Factors” in “Item 1A. Risk Factors.”

 

GOVERNMENTAL REGULATIONS

 

Our operations are subject to various federal, state and local laws and regulations pertaining to health, safety and the environment. We cannot predict the level of enforcement of existing laws or regulations or how such laws and regulations may be interpreted by enforcement agencies or court rulings in the future. We also cannot predict whether additional laws and regulations affecting our business will be adopted, or the effect such changes might have on us, our financial condition or our business. The following is a summary of the more significant existing environmental, health and safety laws and regulations to which our operations are subject and for which compliance may have a material adverse impact on our results of operation or financial position.

 

Environmental Regulations

 

Our operations routinely involve the storage, handling, transport and disposal of bulk waste materials, some of which contain oil, contaminants and regulated substances. Various environmental laws and regulations require prevention, and where necessary, cleanup of spills and leaks of such materials, and some of our operations must obtain permits that limit the discharge of materials. Failure to comply with such environmental requirements or permits may result in fines and penalties, remediation orders and revocation of permits.

 

Laws and regulations protecting the environment have become more stringent over the years, and in certain circumstances may impose “strict liability,” rendering us liable for environmental damage without regard to negligence or fault on our part. Moreover, cleanup costs, penalties and other damages arising as a result of new or changes to existing environmental laws and regulations could be substantial and could have a material adverse effect on our financial condition, results of operations and cash flows. From time to time, claims have been made and litigation has been brought against us under such laws. However, the costs incurred in connection with such claims and other costs of environmental compliance have not had a material adverse effect on our past operations or financial statements. Management believes that Key conducts its

operations in substantial compliance with current federal, state and local requirements related to health, safety and the environment.

 

Hazardous Substances and Waste

 

The Comprehensive Environmental Response, Compensation, and Liability Act, as amended, referred to as “CERCLA” or the “Superfund” law, and comparable state laws impose liability without regard to fault or the legality of the original conduct on certain defined persons, including current and prior owners or operators of a site where a release of hazardous substances occurred and entities that disposed or arranged for the disposal of the hazardous substances found at the site. Under CERCLA, these “responsible persons” may be liable for the costs of cleaning up the hazardous substances, for damages to natural resources and for the costs of certain health studies.

 

In the course of our operations, we do not typically generate materials that are considered “hazardous substances.” One exception, however, would be spills that occur prior to well treatment materials being circulated downhole. For example, if we spill acid on a roadway as a result of a vehicle accident in the course of providing well stimulation services, or if a tank with acid leaks prior to downhole circulation, the spilled material may be considered a “hazardous substance.” In this respect, we are occasionally considered to “generate” materials that are regulated as hazardous substances and, as a result, may incur CERCLA liability for cleanup costs. Also, claims may be filed for personal injury and property damage allegedly caused by the release of hazardous substances or other pollutants.

 

We also generate solid wastes that are subject to the requirements of the Resource Conservation and Recovery Act, as amended, or “RCRA,” and comparable state statutes. Certain materials generated in the exploration, development or production of crude oil and natural gas are excluded from RCRA’s hazardous waste regulation, but these wastes, which include wastes currently generated during our operations, could be designated as “hazardous wastes” in the future and become subject to more rigorous and costly disposal requirements. Any such changes in these laws and regulations could have a material adverse effect on our operating expense.

 

Although we used operating and disposal practices that were standard in the industry at the time, hydrocarbons or other wastes may have been released at properties owned or leased by us now or in the past, or at other locations where these hydrocarbons and wastes were taken for treatment or disposal. Under CERCLA, RCRA and analogous state laws, we could be required to clean up contaminated property (including contaminated groundwater), or to perform remedial activities to prevent future contamination.

 

Air Emissions

 

The Clean Air Act, as amended, or “CAA,” and similar state laws and regulations restrict the emission of air pollutants and also impose various monitoring and reporting requirements. These laws and regulations may require us to obtain approvals or permits for construction, modification or operation of certain projects or facilities and may require use of emission controls. Our failure to comply with CAA requirements and those of similar state laws and regulations could subject us to civil and criminal penalties, injunctions and restrictions on operations.

 

Global Warming and Climate Control

 

Scientific studies suggest that emissions of greenhouse gases (including carbon dioxide and methane) may contribute to warming of the Earth’s atmosphere. In response to such studies, the U.S. Congress is considering legislation to reduce greenhouse gas emissions. In addition, many states have already taken measures to address greenhouse gases through the development of greenhouse gas emission inventories and/or regional greenhouse gas cap and trade programs. As a result of the U.S. Supreme Court’s decision on April 2, 2007 in Massachusetts et al. v. EPA, the Environmental Protection Agency (the “EPA”) may regulate greenhouse gas emissions from mobile sources (e.g. cars and trucks) even if Congress does not adopt new legislation. The Court’s holding in Massachusetts that greenhouse gases are covered pollutants under the CAA may also result in future regulation of greenhouse gas emissions from stationary sources. In addition, some states where we

have operations have become more active in the regulation of emissions that are believed to be contributing to global climate change. For example, California enacted the Global Warming Solutions Act of 2006, which established the first statewide program in the United States to limit greenhouse gas emissions and impose penalties for non-compliance. While we do not believe our operations raise climate control issues different from those generally raised by commercial use of fossil fuels, legislation or regulatory programs that restrict greenhouse gas emissions in areas where we conduct business could increase our costs in order to stay compliant with any new laws.

 

Water Discharges

 

We operate facilities that are subject to requirements of the Clean Water Act, as amended, or “CWA,” and analogous state laws that impose restrictions and controls on the discharge of pollutants into navigable waters. Pursuant to these laws, permits must be obtained to discharge pollutants into state waters or waters of the United States, including to discharge storm water runoff from certain types of facilities. Spill prevention, control and countermeasure requirements under the CWA require implementation of measures to help prevent the contamination of navigable waters in the event of a hydrocarbon spill. Other requirements for the prevention of spills are established under the Oil Pollution Act of 1990, as amended, or “OPA”, which amends the CWA and applies to owners and operators of vessels, including barges, offshore platforms and certain onshore facilities. Under OPA, regulated parties are strictly liable for oil spills and must establish and maintain evidence of financial responsibility sufficient to cover liabilities related to an oil spill for which such parties could be statutorily responsible. The CWA can impose substantial civil and criminal penalties for non-compliance.

 

Employees

 

Occupational Safety and Health Act

 

We are subject to the requirements of the federal Occupational Safety and Health Act, as amended, or “OSHA”, and comparable state laws that regulate the protection of employee health and safety. OSHA’s hazard communication standard requires that information about hazardous materials used or produced in our operations be maintained and provided to employees, state and local government authorities and citizens. We believe that our operations are in substantial compliance with OSHA requirements.

 

Marine Employees

 

Certain of our employees who perform services on our barge rigs or work offshore are covered by the provisions of the Jones Act, the Death on the High Seas Act and general maritime law. These laws operate to make the liability limits established under state workers’ compensation laws inapplicable to these employees. Instead, these employees or their representatives are permitted to pursue actions against us for damages resulting from job related injuries, with generally no limitations on our potential liability.

 

Other Laws and Regulations

 

Saltwater Disposal Wells

 

We operate SWD wells that are subject to the CWA, Safe Drinking Water Act, and state and local laws and regulations, including those established by the EPA’s Underground Injection Control Program which establishes the minimum program requirements. Most of our SWD wells are located in Texas and we also operate SWD wells in Arkansas, Louisiana and New Mexico. Regulations in these states require us to obtain a permit to operate each of our SWD wells. The applicable regulatory agency may suspend or modify one of our permits if our well operation is likely to result in pollution of freshwater, substantial violation of permit conditions or applicable rules, or leaks to the environment. We maintain insurance against some risks associated with our well service activities, but there can be no assurance that this insurance will continue to be commercially available or available at premium levels that justify its purchase by us. The occurrence of a significant event that is not fully insured or indemnified could have a material adverse effect on our financial condition and operations.

Electric Wireline

 

We conduct cased-hole electric wireline logging, which may entail the use of radioactive isotopes along with other nuclear, electrical, acoustic and mechanical devices to evaluate downhole formation. Our activities involving the use of isotopes are regulated by the U.S. Nuclear Regulatory Commission and specified agencies of certain states. Additionally, we may use high explosive charges for perforating casing and formations, and various explosive cutters to assist in wellbore cleanout. Such operations are regulated by the U.S. Department of Justice, Bureau of Alcohol, Tobacco, Firearms, and Explosives and require us to obtain licenses or other approvals for the use of densitometers as well as explosive charges. We have obtained these licenses and approvals when necessary and believe that we are in substantial compliance with these federal requirements.

 

 

In addition to the other information in this report, the following factors should be considered in evaluating us and our business.

 

BUSINESS-RELATED RISK FACTORS

 

Our business is dependent on conditions in the oil and natural gas industry, especially oil and natural gas prices and capital expenditures by oil and natural gas companies, and the recent volatility in oil and natural gas prices, in addition to the deteriorating credit markets and disruptions in the U.S. and global financial systems, may adversely impact our business.

 

Prices for oil and natural gas historically have been extremely volatile and have reacted to changes in the supply of and demand for oil and natural gas. These include changes resulting from, among other things, the ability of the Organization of Petroleum Exporting Countries to support oil prices, domestic and worldwide economic conditions and political instability in oil-producing countries. Weakness in oil and natural gas prices (or the perception by our customers that oil and natural gas prices will continue to decrease) could result in further reduction in the utilization of available well service equipment and result in lower rates. In addition, when oil and natural gas prices are weak, or when our customers expect oil and natural gas prices to decrease, fewer wells are drilled, resulting in less completion and maintenance work for us. Additional factors that affect demand for our services include:

 

 

Financial markets are in an unprecedented economic crisis worldwide, affecting both debt and equity markets. The shortage of liquidity and credit combined with the recent substantial losses in worldwide equity markets have led to an economic recession that could continue for an extended period of time. The slowdown in economic activity caused by the recession has reduced worldwide demand for energy and resulted in lower oil and natural gas prices. This reduction in demand could continue through 2009 and beyond. Demand for our services is primarily influenced by current and anticipated oil and natural gas prices. As a result of recent volatility and significant decreases in oil and natural gas prices and the substantial uncertainty due to the deteriorating credit markets and disruptions in the U.S. and global financial systems, our customers have reduced, and may continue to reduce, their spending on exploration and development drilling. If economic conditions continue to deteriorate or do not improve, it could result in additional reductions of exploration and production expenditures by our customers, causing further declines in the demand for our services and products. The decline in demand for our oil and natural gas services could have a material adverse effect on our revenue and profitability. Further, it is uncertain whether customers, vendors and suppliers will be able to access financing necessary to sustain their previous level of operations, fulfill their commitments and fund future operations and obligations.

Periods of diminished or weakened demand for our services have occurred in the past. We experienced a material decrease in the demand for our services beginning in August 2001 and continuing through September 2002. Although we experienced strong demand for our services following that period through the third quarter of 2008, we believe the overall decrease in demand resulting from the current economic crisis could be more severe than what we experienced during the 2001 — 2002 downturn. The current economic downturn and oil and natural gas price volatility could have a material adverse effect on our financial condition and results of operations. In light of these and other factors relating to the oil and natural gas industry, our historical operating results may not be indicative of future performance.

 

We may be unable to maintain pricing on our core services.

 

During the past three years, we have periodically increased the prices on our services to offset rising costs and to generate higher returns for our shareholders. However, as a result of pressures stemming from deteriorating market conditions and falling commodity prices, it has become increasingly difficult to maintain our prices. We have and will likely continue to face pricing pressure from our competitors. We have made price concessions, and may be compelled to make further price concessions, in order to maintain market share. The inability to maintain our pricing or reduction in our pricing may have a material negative impact on our operating results.

 

Industry capacity may adversely affect our business.

 

Over much of the past three years, new capacity, including new well service rigs, new pressure pumping equipment and new fishing and rental equipment, has entered the market. In some cases, the new capacity is attributable to start-up oilfield service companies and, in other cases, the new capacity has been deployed by existing service providers to increase their service capacity. The new capacity adversely affected our utilization rates in 2008, which is down from prior years. Lower utilization of our fleet has led to reduced pricing for our services. The combination of overcapacity and declining demand has further exacerbated the pricing pressure for our services. Although oilfield service companies are not likely to add significant new capacity under current market conditions, in light of current market conditions and the deteriorating demand for our services, the overcapacity could cause us to experience continued pressure on the pricing of our services and experience lower utilization. This could have a material negative impact on our operating results.

 

Our business involves certain operating risks, which are primarily self-insured, and our insurance may not be adequate to cover all losses or liabilities we might incur in our operations.

 

Our operations are subject to many hazards and risks, including the following:

 

 

If these hazards occur, they could result in suspension of operations, damage to or destruction of our equipment and the property of others, or injury or death to our or a third party’s personnel.

 

We self-insure a significant portion of these liabilities. For losses in excess of our self-insurance limits, we maintain insurance from unaffiliated commercial carriers. However, our insurance may not be adequate to cover all losses or liabilities that we might incur in our operations. Furthermore, our insurance may not adequately protect us against liability from all of the hazards of our business. We also are subject to the risk that we may not be able to maintain or obtain insurance of the type and amount we desire at a reasonable

cost. If we were to incur a significant liability for which we were uninsured or for which we were not fully insured, it could have a material adverse effect on our financial position, results of operations and cash flows.

 

We are subject to the economic, political and social instability risks of doing business in certain foreign countries.

 

We currently have operations in Argentina, Mexico and Canada, as well as investments in a drilling and production services company based in Canada and a drilling and workover services and sub-surface engineering and modeling company based in the Russian Federation. We may expand our operations into other foreign countries as well. As a result, we are exposed to risks of international operations, including:

 

 

The occurrence of one or more of these risks may:

 

 

We historically have experienced a high employee turnover rate. Any difficulty we experience replacing or adding workers could adversely affect our business.

 

We historically have experienced an annual employee turnover rate of almost 50%, although we experienced a lower 42% turnover rate domestically during 2008. We believe that the high turnover rate is attributable to the nature of the work, which is physically demanding and performed outdoors. As a result, workers may choose to pursue employment in fields that offer a more desirable work environment at wage rates that are competitive with ours. We cannot assure that at times of high demand we will be able to retain, recruit and train an adequate number of workers. Potential inability or lack of desire by workers to commute to our facilities and job sites and competition for workers from competitors or other industries are factors that could affect our ability to attract and retain workers. We believe that our wage rates are competitive with the wage rates of our competitors and other potential employers. A significant increase in the wages other employers pay could result in a reduction in our workforce, increases in our wage rates, or both. Either of these events could diminish our profitability and growth potential.

We may not be successful in implementing technology development and technology enhancements.

 

A component of our business strategy is to incorporate our technology into our well service rigs, primarily through the KeyView^® system. The inability to successfully develop and integrate the technology could:

 

 

We may incur significant costs and liabilities as a result of environmental, health and safety laws and regulations that govern our operations.

 

Our operations are subject to U.S. federal, state and local, and foreign laws and regulations that impose limitations on the discharge of pollutants into the environment and establish standards for the handling, storage and disposal of waste materials, including toxic and hazardous wastes. To comply with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various governmental authorities. While the cost of such compliance has not been significant in the past, new laws, regulations or enforcement policies could become more stringent and significantly increase our compliance costs or limit our future business opportunities, which could have a material adverse effect on our operations.

 

Failure to comply with environmental, health and safety laws and regulations could result in the assessment of administrative, civil or criminal penalties, imposition of cleanup and site restoration costs and liens, revocation of permits, and, to a lesser extent, orders to limit or cease certain operations. Certain environmental laws impose strict and/or joint and several liability, which could cause us to become liable for the conduct of others or for consequences of our own actions that were in compliance with all applicable laws at the time of those actions. For additional information, see the discussion under “Governmental Regulations” in “Item 1. Business.”

 

We rely on a limited number of suppliers for certain materials used in providing our pressure pumping services.

 

We rely heavily on three suppliers for sized sand, a principal raw material that is critical for our pressure pumping operations. While the materials are generally available, if we were to have a problem sourcing raw materials or transporting these materials from these suppliers, our ability to provide pressure pumping services could be limited.

 

We may not be successful in identifying, making and integrating our acquisitions.

 

A component of our growth strategy is to make geographic-focused acquisitions that will strengthen our presence in selected regional markets. Pursuit of this strategy may be restricted by the recent deterioration of the credit markets, which may significantly limit the availability of funds for such acquisitions. In addition to restricted funding availability, the success of this strategy will depend on our ability to identify suitable acquisition candidates and to negotiate acceptable financial and other terms. There is no assurance that we will be able to do so. The success of an acquisition depends on our ability to perform adequate diligence before the acquisition and on our ability to integrate the acquisition after it is completed. While we commit significant resources to ensure that we conduct comprehensive due diligence, there can be no assurance that all potential risks and liabilities will be identified in connection with an acquisition. Similarly, while we expect to commit substantial resources, including management time and effort, to integrating acquired businesses into ours, there is no assurance that we will be successful integrating these businesses. In particular, it is important that we be able to retain both key personnel of the acquired business and its customer base. A loss of either key personnel or customers could negatively impact the future operating results of the acquired business.

DEBT-RELATED RISK FACTORS

 

We may not be able to generate sufficient cash flow to meet our debt service obligations.

 

Our ability to make payments on our indebtedness, and to fund planned capital expenditures, will depend on our ability to generate cash in the future. This, to a certain extent, is subject to conditions in the oil and gas industry, general economic and financial conditions, competition in the markets where we operate, the impact of legislative and regulatory actions on how we conduct our business and other factors, all of which are beyond our control. This risk is significantly exacerbated by the current economic downturn and related instability in the global and U.S. credit markets.

 

We cannot assure you that our business will generate sufficient cash flow from operations to service our outstanding indebtedness, or that future borrowings will be available to us in an amount sufficient to enable us to pay our indebtedness or to fund our other capital needs. If our business does not generate sufficient cash flow from operations to service our outstanding indebtedness, we may have to undertake alternative financing plans, such as:

 

 

However, we cannot assure you that we would be able to implement alternative financing plans, if necessary, on commercially reasonable terms or at all, or that implementing any such alternative financing plans would allow us to meet our debt obligations. Our inability to generate sufficient cash flow to satisfy our debt obligations, or to obtain alternative financings, could materially and adversely affect our business, financial condition, results of operations and future prospects for growth.

 

In addition, a downgrade in our credit rating could become more likely if current market conditions continue to worsen. Although such a credit downgrade would not have an effect on our currently outstanding senior debt under our indenture or senior secured credit facility, such a downgrade would make it more difficult for us to raise additional debt financing in the future.

 

The amount of our debt and the covenants in the agreements governing our debt could negatively impact our financial condition, results of operations and business prospects.

 

Our level of indebtedness, and the covenants contained in the agreements governing our debt, could have important consequences for our operations, including:

 

 

 

We may be required to repay all or a portion of our debt on an accelerated basis in certain circumstances. If we fail to comply with the covenants and other restrictions in the agreements governing our debt, it could lead to an event of default and the consequent acceleration of our obligation to repay outstanding debt. Our ability to comply with debt covenants and other restrictions may be affected by events beyond our control, including prevailing economic and financial conditions.

 

In particular, under the terms of our indebtedness, we must comply with certain financial ratios and satisfy certain financial condition tests, several of which become more restrictive over time and could require us to take action to reduce our debt or take some other action in order to comply with them. Our ability to satisfy required financial ratios and tests can be affected by events beyond our control, including prevailing economic, financial and industry conditions, and we cannot assure you that we will continue to meet those ratios and tests in the future. A breach of any of these covenants, ratios or tests could result in a default under our indebtedness. If we default, our credit facility lenders will no longer be obligated to extend credit to us and they, as well as the trustee for our outstanding notes, could elect to declare all amounts outstanding under the indenture or senior secured credit facility, as applicable, together with accrued interest, to be immediately due and payable. The results of such actions would have a significant negative impact on our results of operations, financial condition and cash flows.

 

Our variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.

 

Borrowings under our senior secured credit facility bear interest at variable rates, exposing us to interest rate risk. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash available for servicing our indebtedness would decrease.

 

DELAYED FINANCIAL REPORTING-RELATED RISK FACTORS

 

Taxing authorities may determine that we owe additional taxes from previous years.

 

We restated our financial statements for periods prior to 2004 and experienced delays in our financial reporting for subsequent periods. As result, we have amended previously filed tax returns and reports through 2004. We also intend to amend our 2005 and 2006 federal and state income tax filings during 2009. Where legal, regulatory or administrative rules require or allow us to amend our previous tax filings, we intend to comply with our obligations under applicable law. To the extent that tax authorities do not accept our conclusions about the tax effects of the restatement, liabilities for taxes could differ from those which have been recorded in our consolidated financial statements. If it is determined that we have additional tax liabilities, there could be an adverse effect on our financial condition, results of operations and cash flows.

 

During the past three years, we have identified material weaknesses in our internal control over financial reporting. These material weaknesses, if not corrected, could affect the reliability of our financial statements and have other adverse consequences.

 

Section 404 of the Sarbanes-Oxley Act of 2002 and the related SEC rules require management of public companies to assess the effectiveness of their internal control over financial reporting annually and to include in Annual Reports on Form 10-K a management report on that assessment, together with an attestation report by an independent registered public accounting firm. Under Section 404 and the SEC rules, a company cannot find that its internal control over financial reporting is effective if there exist any “material weaknesses” in its financial controls. A “material weakness” is a control deficiency, or combination of control deficiencies in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected.

We have identified one material weakness in internal control over financial reporting as of December 31, 2008. We have taken actions to remediate the material weakness and improve the effectiveness of our internal control over financial reporting; however, we cannot assure you that material weaknesses will not exist during 2009. Any failure in the effectiveness of internal control over financial reporting, if it results in misstatements in our financial statements, could have a material effect on financial reporting or cause us to fail to meet reporting obligations, and could negatively impact investor perceptions.

 

TAKEOVER PROTECTION-RELATED RISKS

 

Our bylaws contain provisions that may prevent or delay a change in control.

 

Our Amended and Restated Bylaws contain certain provisions designed to enhance the ability of the Board of Directors to respond to unsolicited attempts to acquire control of the Company. These provisions:

 

 

These provisions may have the effect of entrenching management and may deprive investors of the opportunity to sell their shares to potential acquirers at a premium over prevailing prices. This potential inability to obtain a control premium could reduce the price of our common stock.

 

 

None.

 

 

We lease executive office space in both Houston, Texas and Midland, Texas (our principal executive office is in Houston, Texas). We own or lease numerous rig yards, storage yards, truck yards and sales and administrative offices throughout the geographic regions in which we operate. Also, in connection with our fluid management services, we operate a number of SWD facilities. Our leased properties are subject to various lease terms and expirations.

 

We believe all properties that we currently occupy are suitable for their intended uses. We believe that we have sufficient facilities to conduct our operations. However, we continue to evaluate the purchase or lease of additional properties or the consolidation of our properties, as our business requires.

The following table shows our active owned and leased properties, as well as active SWD facilities, categorized by business segment and geographic region:

 

 

Although we have listed some of our SWD facilities as “leased” in the above table, in some of these cases, we actually own the wellbore for the SWD and lease only the land. In other cases, we lease both the wellbore and the land. Lease terms vary among different sites, but with respect to some of the SWD facilities for which we lease the land and own the wellbore, the land owner has an option under the land lease to retain the wellbore at the termination of the lease.

 

Also included in the figures shown in the table above are nine apartments leased in the United States and eight apartments leased in Argentina. These apartments are for Key employees to use for operational support and business purposes only.

 

In addition to various suits and claims that have arisen in the ordinary course of business, we continue to be involved in litigation with some of our former executive officers. We do not believe that the disposition of any of these items, including litigation with former management, will result in a material adverse effect on our consolidated financial position, results of operations or cash flows. For additional information on legal proceedings, see “Note 13. Commitments and Contingencies” in “Item 8. Consolidated Financial Statements and Supplementary Data.”

 

 

None.

 

 

MARKET AND SHARE PRICES

 

During fiscal year 2008, Key’s common stock traded on the NYSE, under the symbol “KEG.” From April 8, 2005 until October 2, 2007, our stock was quoted on the Pink Sheets Electronic Quotation Service (the “Pink Sheets”) under the symbol “KEGS.” As of February 23, 2009, there were 537 registered holders of 121,210,781 issued and outstanding shares of common stock. The following table sets forth the reported high and low sales price of Key’s common stock for the periods indicated:

 

 

 

The following Corporate Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that we specifically incorporate it by reference into such filing.

 

The following performance graph compares the performance of our common stock to the PHLX Oil Service Sector, the Russell 1000 Index, the Russell 2000 Index and to a peer group established by management. During 2008, the Company moved from the Russell 2000 Index to the Russell 1000 Index. For comparative purposes, both the Russell 2000 and the Russell 1000 Indices are reflected in the following performance graph. The peer group is comprised of five other companies with a similar mix of operations and includes Nabors Industries Ltd., Weatherford International Ltd., Basic Energy Services, Inc., Complete Production Services, Inc. and RPC, Inc. The graph below matches the cumulative five-year total return to holders of our common stock with the cumulative total returns of the PHLX Oil Service Sector, the listed Russell Indices and our peer group. The graph assumes that the value of the investment in our common stock

and each index (including reinvestment of dividends) was $100 at December 31, 2003 and tracks the return on the investment through December 31, 2008.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Key Energy Services, Inc., The Russell 1000 Index, The Russell 2000 Index,
The PHLX Oil Service Sector and the Peer Group

 

 

 

DIVIDEND POLICY

 

There were no dividends paid on Key’s common stock for the year ended December 31, 2008. Key must meet certain financial covenants before it may pay dividends under the terms of its current credit facility. Key does not currently intend to pay dividends.

 

STOCK REPURCHASES

 

On October 26, 2007, the Company’s Board of Directors authorized a share repurchase program, in which the Company may spend up to $300.0 million to repurchase shares of its common stock on the open market. The program expires March 31, 2009. At December 31, 2008, the Company had $132.7 million of availability remaining under the share repurchase program to repurchase shares of its common stock on the open market. During 2008, the Company repurchased an aggregate of approximately 11.1 million shares at a total cost of approximately $135.2 million, which represents the fair market value of the shares based on the price of the Company’s stock on the dates of purchase.

 

From the inception of the program in November 2007 through December 31, 2008, the Company has repurchased an aggregate of approximately 13.4 million shares for a total cost of approximately $167.3 million. Under the terms of our Senior Secured Credit Facility (as defined under “Sources of Liquidity and Capital Resources” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation”), we are limited to stock repurchases of $200.0 million if our consolidated debt to capitalization ratio, as defined in the Senior Secured Credit Facility, is in excess of 50%. As of December 31, 2008, our consolidated debt to capitalization ratio was less than 50%.

 

During the fourth quarter of 2008, the Company repurchased an aggregate 2.3 million shares of its common stock. The repurchases were made pursuant to the Company’s $300.0 million share repurchase program and to satisfy tax withholding obligations that arose upon vesting of restricted stock that had been

granted to certain senior executives. As noted above, the share repurchase program expires March 31, 2009. Set forth below is a summary of the share repurchases:

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

 

 

 

EQUITY COMPENSATION PLAN INFORMATION

 

The following table sets forth information as of December 31, 2008 with respect to compensation plans (including individual compensation arrangements) under which our common stock is authorized for issuance:

 

 

 

 

 

The following historical selected financial data for the years ended December 31, 2004 through December 31, 2008 has been derived from the audited financial statements of the Company. The historical selected financial data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the historical consolidated financial statements and related notes thereto included in “Item 8. Consolidated Financial Statements and Supplementary Data.”

 

CONSOLIDATED RESULTS OF OPERATIONS DATA

 

 

SELECTED CONSOLIDATED CASH FLOW DATA

 

SELECTED CONSOLIDATED BALANCE SHEET DATA

 

 

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes thereto in “Item 8. Consolidated Financial Statements and Supplementary Data.” The discussion below contains forward-looking statements that are based upon our current expectations and are subject to uncertainty and changes in circumstances including those identified in “Cautionary Note Regarding Forward-Looking Statements” above. Actual results may differ materially from these expectations due to inaccurate assumptions and known or unknown risks and uncertainties. Such forward-looking statements should be read in conjunction with our disclosures under “Item 1A. Risk Factors.”

 

OVERVIEW

 

We provide a complete range of well services to major oil companies, foreign national oil companies and independent oil and natural gas production companies, including rig-based well maintenance, workover, well completion and recompletion services, fluid management services, pressure pumping services, fishing and rental services and ancillary oilfield services. We believe that we are the leading onshore, rig-based well servicing contractor in the world. We operate in most major oil and natural gas producing regions of the United States as well as internationally in Argentina and Mexico. Additionally, we have a technology development group based in Canada. We also have ownership interests in a drilling and production services company based in Canada and a drilling and workover services and sub-surface engineering and modeling company based in the Russian Federation.

 

During 2008, we operated in three business segments: the well servicing segment, the pressure pumping services segment and the fishing and rental services segment. For further detail regarding these business segments, please see the discussion under “Description of Business Segments” in “Item 1. Business.”

 

BUSINESS AND GROWTH STRATEGIES

 

Our strategy is to improve results through acquisitions, controlling spending, maintenance and growth of our market share in core segments, maintenance of a strong balance sheet and good liquidity, expansion internationally, investments in technology and new service offerings and enhancement of safety and quality.

 

Acquisition Strategy

 

Our strategy contemplates that from time to time we may make acquisitions that strengthen one or more of our service lines, enhance our presence in selected regional markets or expand the service offerings we provide to our customer base. During 2008, we completed the acquisitions of the fishing and rental assets of Tri-Energy Services, LLC (“Tri-Energy”), Western Drilling, LLC (“Western”) and Hydra-Walk, Inc. (“Hydra-

Walk”). In addition, we acquired the U.S.-based assets of Leader Energy Services, Ltd. (“Leader”). Through these acquisitions and purchases, we expanded our well servicing rig fleet in the California market by 22 rigs, increased our presence in the Southeastern Gulf Coast and Gulf of Mexico rental tool market, acquired an automated pipe handling business that we feel is complementary to our rig-based service offerings and increased our presence in the Baaken and Marcellus shale formations through the acquisition of nine coiled tubing units. We believe that these transactions will help us to expand our geographic “footprint” and diversify and improve our service offerings to our customers. For more information on the acquisitions we completed during 2008, see the discussion below under “Acquisitions” in this Item.

 

Our acquisitions in 2008 were made with cash on hand and availability under our Senior Secured Credit Facility, and our objective is to use cash for future acquisitions. Depending on future market conditions, however, we may elect to use equity as a financing tool for acquisitions. See “Liquidity and Capital Resources” under this Item for further discussion of the financing tools available to us.

 

Controlling Spending

 

During the late third quarter of 2008, we saw signs that the market for oilfield services was beginning to weaken. This weakening in the market for our services resulted from the overall turmoil in the credit markets that caused many of our customers to begin to slow down their capital spending, and from significant declines in the prices of oil and natural gas. In response to the pending downturn, we took steps during the later part of the third quarter and in the fourth quarter of 2008 to decrease our spending levels and control costs. These steps included targeted reductions in our workforce, reductions in pay and other reductions in our cost structure. We believe that the actions we have already taken will result in significant cost savings in the near term, and we are continuing to implement other cost saving measures during early 2009, including further reductions in our spending levels and capital expenditures, in order to further improve our cost structure.

 

Maintain and Grow in Core Segments

 

During the past three years, we have significantly increased our capital expenditures, devoting more capital to organic growth. Excluding acquisitions, we have cumulatively spent approximately $627.4 million on capital expenditures since the beginning of 2006, including capital expenditures of $219.0 million in 2008. These expenditures include the purchase of new pressure pumping equipment, new cased-hole electric wireline units and new and remanufactured well service rigs, as well as numerous rental equipment and fishing tools. With the overall downturn in the economy during late 2008 and the projected slowdown for activity in our industry during the near term, we intend to reduce our capital expenditure program in 2009 in order to maintain liquidity and provide flexibility for the use of our capital. Presently, we estimate that we will spend approximately $130.0 million in capital expenditures in 2009, of which we estimate approximately $20.0 million a quarter will be devoted to maintenance of our existing fleet. Our 2009 capital spending could increase if we are awarded additional international work or recognize an opportunity to expand our services in a particular market.

 

Maintain Strong Balance Sheet and Liquidity

 

We believe that our ability to maintain a strong balance sheet and exercise sound capital discipline is critical, and this will position the Company well to sustain itself through the current and projected downturn in the market. We also believe that our ability to maintain ample liquidity and borrowing capacity is important in order to enable us to maintain operational flexibility, as well as to take advantage of other attractive business opportunities, should they develop. As of December 31, 2008, we had $92.7 million in cash and cash equivalents as well as $139.3 million of availability under the revolving portion of our Senior Secured Credit Facility, and we have no maturities under our 8.375% Senior Notes (the “Senior Notes”) until 2014 or required repayments of borrowings on our Senior Secured Credit Facility until 2012. Also, in the fourth quarter of 2009, we are required to make principal payments totaling $14.5 million related to the Moncla Notes (as defined in the discussion below of “Moncla Notes Payable” under “Liquidity and Capital Resources” in this Item). We expect to fund our obligations under the Moncla Notes through cash on hand generated by operating activities or borrowing under our Senior Secured Credit Facility.

International Expansion

 

We presently operate in Argentina and Mexico and have a technology development group based in Canada. We also have an ownership interest in a drilling and production services company based in Canada. During October 2008, we purchased a 26% interest in a drilling, workover and sub-surface engineering and reservoir modeling company operating in the Russian Federation, and we have an obligation to expand that interest in 2009. One of our objectives is to redeploy under-utilized assets to international markets. In addition, we will consider strategic international acquisitions in order to establish a presence in a particular market, if appropriate. We have evaluated a number of international markets, and our near-term priority is expansion in Mexico. During 2008, we increased the number of working rigs we had positioned in Mexico to 14. We intend to further increase our working rigs in Mexico to 21 by the end of the second quarter of 2009. See “Foreign Operations” in “Item 1. Business” for further discussion of our current international operations.

 

Investing in Technology and New Service Offerings

 

We have invested, and will continue to invest, in technology projects that improve operating efficiencies for both ourselves and our customers, improve the safety performance of our well service rigs and fluid hauling vehicles and provide opportunities for additional revenue. In 2003, we began deployment of our proprietary well service technology called KeyView^®. The KeyView^® control and data acquisition system measures certain well-site operating parameters and actively uses this information for safety intervention purposes on the rig, allowing our customers and ourselves to monitor and analyze the information about well servicing to promote improved efficiency and quality. At December 31, 2008, we had more than 250 KeyView^® systems installed. The KeyView^® system increases our and our customers’ visibility into activities at the well site. Through this technology, we have the ability to (i) ensure proper rod and tubing make-up which will result in reduced downhole failures, (ii) improve efficiency, through better logistics and planning, and (iii) improve safety. We believe that this system provides us a competitive advantage as it is a patented technology. For a further discussion of the KeyView^® system, see “Patents, Trade Secrets, Trademarks and Copyrights” and “Foreign Operations” in “Item 1. Business.”

 

Our technology initiative was expanded with the acquisition of AMI in 2007. AMI designs and produces oilfield service data acquisition, control and information systems. AMI’s technology platform and applications facilitate the collection of job performance and related information and digitally distributes the information to customers. AMI contributed to the development of the KeyView^® system and will assist in the advancement of this technology.

 

We also believe that it is important to have a broad, diverse and complementary services offering. For this reason, we have expanded the service offerings of our pressure pumping segment and our fishing and rental segment. We took delivery of five coiled tubing units during the fourth quarter of 2008 that we had previously ordered during 2007, as well as four segments of drill string for our rental tools group. In addition, we took delivery of three drilling rigs and continued to expand our cased-hole wireline business that we entered into during 2006. We believe that some customers prefer to consolidate vendors and we feel that our expanded services offering may provide better opportunities to serve our customers.

 

Safety and Quality

 

We devote significant resources to the training and professional development of our employees, with a special emphasis on safety. We currently own and operate training centers in Texas, California, Wyoming and Louisiana. In addition, in conjunction with local community colleges, we have two cooperative training centers in New Mexico and Oklahoma. The training centers are used to enhance our employees’ understanding of operating and safety procedures. We recognize the historically high turnover rate in the industry in which we operate. We are committed to offering competitive compensation, benefits and incentive programs for our employees in order to ensure we have qualified, safety-conscious personnel who are able to provide quality service to our customers.

PERFORMANCE MEASURES

 

In determining the overall health of the oilfield service industry, we believe that the Baker Hughes U.S. land drilling rig count is the best barometer of capital spending and activity levels, since this data is made publicly available on a weekly basis. Historically, our activity levels have been highly correlated to capital spending by oil and natural gas producers. When commodity prices are strong, capital spending by our customers tends to be high, as illustrated by the Baker Hughes U.S. land drilling rig count. As the following table indicates, the land drilling rig count has increased significantly since 2002 and commodity prices for both oil and natural gas have increased.

 

 

 

 

Internally, we measure activity levels primarily through our rig and trucking hours. Generally, as capital spending by oil and natural gas producers increases, demand for our services also rises, resulting in increased rig and trucking services and more hours worked. Conversely, when activity levels decline due to lower spending by oil and natural gas producers, we generally provide fewer rig and trucking services, which results in lower hours worked. We publicly release our monthly rig and trucking hours and the following table presents our quarterly rig and trucking hours from 2006 through 2008.

 

 

MARKET CONDITIONS AND OUTLOOK

 

Market Conditions — Year Ended December 31, 2008

 

During 2008, the overall industry demand for the services that we provide was high. The average Baker Hughes land rig count in the United States during 2008 was 1,814 rigs, which was an increase of approximately 7% over the 2007 average and approximately 16% over the 2006 average. The increase in the average land rig count was driven primarily by record commodity prices; during 2008 the West Texas Intermediate — Cushing crude oil price averaged almost $100 per barrel and natural gas at the Henry Hub averaged almost $9.00 per Mcf, increases of approximately 38% and 25%, respectively, over 2007 levels.

 

Overall, our activity levels and asset utilization during 2008 were high. For 2008, we had approximately 2.7 million rig hours and 2.4 million trucking hours, which was an increase of approximately 10.9% and 4.7%, respectively, over 2007 activity levels. Acquisitions we made during 2008 contributed approximately 65,509 rig hours during 2008, and the full year effect of acquisitions we completed during 2007 was 242,545 rig hours. Also contributing to the increase in rig hours was our expansion into Mexico during 2008, which contributed an additional 44,736 rig hours. Excluding the effects of acquisitions and expansion in Mexico, our domestic rig and trucking hours per working day increased slightly during 2008.

 

During the first three quarters of 2008, we saw our activity levels steadily increase, due to high demand for our services associated with strong commodity prices. However, throughout 2008, there were signs that the financial markets of the United States were becoming unstable. As the turmoil in the credit markets increased during the summer and fall of 2008, commodity prices peaked at all-time highs. Late in the third quarter of 2008, we began to see demand for our services starting to weaken, as the tightening of the credit markets

made access to capital for spending more difficult for our customers and uncertainty grew around future pricing for oil and natural gas.

 

Conditions continued to deteriorate during the fourth quarter of 2008, driven by rapidly declining commodity prices, tight credit markets and overall uncertainty about market conditions. We responded to these deteriorating market conditions by implementing an aggressive cost control program, implementing pricing changes in selected markets in an effort to maintain asset utilization and cutting our own capital spending plans. Additionally, the steps we were taking towards a new organizational structure to more efficiently manage our under-utilized assets allowed us to identify cost savings.

 

Market Outlook

 

We believe that 2009 will be a challenging year for our business, as public estimates point to an anticipated decline in the land rig count of a magnitude not seen since the 2001 — 2002 timeframe. Because of tighter credit markets and declining borrowing bases, our customers will likely have less access to capital, and because of lower commodity prices, our customers will likely not be inclined to spend capital even if they can access it. These assessments are supported by the fact that the land drilling rig count at January 31, 2009 stood at 1,412, a decline of approximately 22.2% from the 2008 average, and oil and natural gas prices were $41.73 per barrel and $4.42 per MMbtu, respectively, down approximately 58.1% and 50.3%, respectively, from their 2008 averages.

 

Near-term, we anticipate that our service lines whose revenues are more closely tied to new drilling activity will be most severely affected. However, we believe that our core service lines, including rig-based well servicing and our fluids management business, will be more resilient to the market downturn because our customers will still need to maintain their existing wells and transport and dispose of saltwater and other fluids. While we expect prices for our core services will decline during 2009, we do not believe they will fall as much as prices in some other service lines that are more closely connected with new drilling.

 

In light of these challenging conditions, we believe that Key is well equipped for the downturn until production decline rates begin to drive commodity prices higher, causing our customers to spend capital dollars and increasing the demand for our services. Management has focused on maintaining a strong balance sheet, with acceptable leverage ratios and good liquidity, and we do not currently believe that the downturn in 2009 will affect the Company’s compliance with the financial covenants in its debt agreements. We also feel that our geographic diversity will help the Company maintain its margins until the market for all of our services in the United States recovers.

 

Impact of Inflation on Operations

 

We are of the opinion that inflation has not had a significant impact on Key’s business.

 

ACQUISITIONS

 

Acquisitions and equity method investments completed during 2008

 

Tri-Energy Services, LLC.  On January 17, 2008, the Company purchased the fishing and rental assets of Tri-Energy for approximately $1.9 million in cash. These assets were integrated into our fishing and rental segment. The equity interests of Tri-Energy were owned by employees of the Company who joined the Company in October 2007 in connection with the earlier acquisition in 2007 of Moncla Well Service, Inc. and related entities (collectively, “Moncla”).

 

Western Drilling, LLC.  On April 3, 2008, the Company purchased all of the outstanding equity interests of Western, a privately-owned company based in California that operated 22 working well service rigs, three stacked well service rigs and equipment used in the workover and rig relocation process, for total consideration of $51.6 million. We acquired Western to increase our service footprint in the California market. The acquisition was funded from borrowings under the Company’s Senior Secured Credit Facility and cash on hand.

Hydra-Walk, Inc.  On May 30, 2008, the Company purchased all of the outstanding stock of Hydra-Walk for approximately $10.5 million in cash. The Company retained approximately $1.1 million of Hydra-Walk’s net working capital and did not assume any debt of Hydra-Walk. Hydra-Walk is a leading provider of pipe handling solutions for the oil and gas industry and operates over 80 automated pipe handling units in Oklahoma, Texas and Wyoming. We acquired Hydra-Walk to expand the level of integrated services we are able to provide customers. The assets and results of operations for Hydra-Walk were integrated into our fishing and rental segment.

 

Leader Energy Services Ltd.  On July 22, 2008, the Company acquired all of the United States-based assets of Leader, a Canadian company, for consideration of $34.6 million in cash. The acquired assets include nine coiled tubing units, seven nitrogen trucks, twelve pumping trucks and other ancillary equipment. Additionally, the Company paid approximately $0.7 million for supplies and inventory used in pressure pumping operations. The Leader assets were integrated into our pressure pumping segment.

 

OOO Geostream Services Group.  On October 31, 2008, we acquired a 26% interest in Geostream for $17.4 million. We incurred direct transaction costs of approximately $1.9 million associated with the transaction. Geostream is based in the Russian Federation and provides drilling and workover services and sub-surface engineering and modeling in the Russian Federation. In connection with our initial investment in Geostream, three officers of the Company became board members of Geostream, representing 50% of the board membership. We are contractually required to purchase an additional 24% of Geostream no later than March 31, 2009 for approximately €11.3 million (which at December 31, 2008 was equivalent to $15.9 million). For a period not to exceed six years subsequent to October 31, 2008, we will have the option to increase our ownership percentage of Geostream to 100%. If we have not acquired 100% of Geostream on or before the end of the six-year period, we will be required to arrange an initial public offering for those shares.

 

Acquisitions completed during 2007

 

AMI.  On September 5, 2007, the Company acquired AMI, which operates in Canada and is a technology company focused on oilfield service equipment controls, data acquisition and digital information flow. The purchase price was $6.6 million in cash and $2.9 million in assumed debt.

 

Moncla.  On October 25, 2007, the Company acquired Moncla, which operated well service rigs, barges and ancillary equipment in the southeastern United States for total consideration of $146.0 million, consisting of cash, notes payable and assumed debt. The acquisition was made to expand our presence in the southeastern United States market, and was incorporated into our well servicing segment.

 

Kings Oil Tools.  On December 7, 2007, the Company acquired the well service assets and related equipment of Kings Oil Tools, Inc. (“Kings”), a California-based well service company, for approximately $45.1 million in cash to increase our presence in the California market. The assets of Kings were incorporated into our well servicing segment.

 

Acquisitions completed during 2006

 

We made no acquisitions during 2006.

RESULTS OF OPERATIONS

 

Consolidated Results of Operations

 

The following table shows our consolidated results of operations for the years ended December 31, 2008, 2007 and 2006:

 

 

Year Ended December 31, 2008 and 2007

 

For the year ended December 31, 2008, our net income was $84.1 million, which represents a 50.3% decrease from net income of $169.3 million for the year ended December 31, 2007. Our earnings per fully diluted share for the year were $0.67 per share compared to $1.27 per share for the same period in 2007. Items contributing to the decline in net income and diluted earnings per share during 2008 included an impairment of the Company’s goodwill pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets (“SFAS 142”) (approximately $69.8 million before tax, or $0.54 per fully diluted share); a charge associated with the acceleration of the vesting of certain of the Company’s equity awards (approximately $10.9 million before tax, or $0.05 per fully diluted share); an impairment of the Company’s investment in IROC Energy Services Corp. (“IROC”) (approximately $5.4 million before tax, or $0.03 per fully diluted share); severance charges associated with a reduction in the Company’s domestic and international workforce (approximately $2.6 million before tax, or $0.01 per fully diluted share); and the impact of hurricanes and their after-effects in the Gulf Coast during the third quarter of 2008 (estimated to have decreased our pre-tax earnings by $8.4 million, or $0.04 per fully diluted share). Partially offsetting these items were price increases implemented during the second and third quarters of 2008, incremental net income from acquisitions the Company completed during 2008, the integration of acquisitions completed during 2007 for a full year of operations, and expansion of the Company’s cased-hole wireline operations and operations in Mexico.

 

Revenues

 

Our consolidated revenue for the year ended December 31, 2008 was $2.0 billion, an increase of $310.1 million, or 18.7%, from $1.7 billion for the year ended December 31, 2007. The increase in revenue is

primarily attributable to price increases implemented during the second and third quarters of 2008, expansion of the Company’s cased-hole wireline operations and international operations in Mexico, acquisitions completed during 2008 and the integration of the acquisitions the Company made during 2007 for a full year of operations. Please refer to “Segment Operating Results” below for further discussion of the changes in revenues from 2007. Changes in revenues for each of our reportable segments were (in millions):

 

 

Weather, including hurricanes Ike and Gustav, impacted our land-based operations during the third quarter of 2008 in parts of Texas, Louisiana and Oklahoma. The inclement weather also significantly impacted our fishing operations in the Gulf of Mexico. The Company estimates that inclement weather during the third quarter of 2008 reduced well servicing segment revenues by approximately $7.0 million and fishing and rental segment revenues by approximately $1.4 million.

 

Direct operating expenses

 

Our consolidated direct operating expenses increased approximately $264.7 million, or 26.9%, to $1.3 billion for the year ended December 31, 2008 compared to $985.6 million for the year ended December 31, 2007. Excluding depreciation and amortization, these costs were 63.4% of consolidated revenues during 2008, compared to 59.3% of consolidated revenues for 2007. The change in consolidated direct operating expenses was the result of (in millions):

 

 

Direct employee compensation, which includes salaries, cash bonuses, health insurance, 401(k) costs and payroll taxes, increased approximately $125.5 million, or 23.4%, for 2008 compared to the same period in 2007. Acquisitions completed by the Company during 2008 contributed approximately $18.6 million to the increase over 2007, and the incorporation of acquisitions completed during 2007 for a full year of operations in 2008 contributed approximately $57.4 million to the increase. The Company’s expansion of its operations in Mexico contributed approximately $7.4 million to the increase. Excluding these items, direct employee compensation increased approximately 7.9% for 2008 compared to the same period last year. This increase is primarily attributable to organic direct headcount growth over the course of 2008 to support our ongoing operations, as well as pay rate increases that were implemented over the course of the year in order to retain a high quality workforce. In response to deteriorating market conditions during the fourth quarter of 2008, the Company’s management implemented a cost control program, which included freezing pay rates and reductions in the Company’s workforce in certain areas.

 

Equipment, supplies and maintenance costs increased approximately $58.0 million for 2008 compared to the same period in 2007. Acquisitions completed during 2008 contributed approximately $5.7 million to the year-over-year increase in these costs, and the full year effect of acquisitions the Company completed during 2007 was approximately $24.5 million. The expansion of our operations in Mexico contributed approximately $23.0 million to the increase. Absent these items, these costs increased approximately 0.3% during 2008. The increase in these costs is related to higher prices from the Company’s vendors, and increased requirements for

repairs and maintenance related to the preparation of our assets for increased utilization and expansion of our operations.

 

Fuel costs increased approximately $33.4 million, or 44.9%, for the year ended December 31, 2008 compared to the same period in 2007. Acquisitions completed during 2008 contributed approximately $2.1 million to the increase in fuel costs, while the incorporation of acquisitions the Company completed during 2007 for a full year of operations during 2008 contributed approximately $3.6 million to the increase. The Company estimates that on average, the per-gallon cost of diesel fuel increased approximately 27.5% during 2008 compared to 2007. This, combined with the overall higher usage of fuel because of higher activity levels, led to the remaining increase in fuel costs.

 

Frac sand and chemical costs, which also includes the cost of transporting those supplies, increased approximately $29.4 million, or 34.0%, during 2008 compared to the same period in 2007. Acquisitions by the Company during 2008 contributed approximately $1.2 million to the increase in these costs and the full year effect of acquisitions completed during 2007 contributed approximately $0.6 million to the increase in 2008. Overall demand for frac sand and chemicals increased during 2008 because of the overall increase in pressure pumping activity. As a result, prices increased for all users of these products. This also had a direct impact on the cost to transport our frac sand; these costs increased approximately 36.1% during 2008. Additionally, during 2008 the Company began using coated sand as a proppant for certain high pressure frac jobs in the Barnett Shale formation. Coated sand is more expensive than normal types of frac sand, which contributed to the overall increase in these costs. Our pressure pumping operations are able to charge higher rates for frac jobs that require coated sand.

 

The Company’s costs associated with self-insurance increased approximately $4.7 million during 2008 compared to 2007. The Company is largely self-insured against loss and uses actuarial information, as well as actual claims history, in order to calculate the required reserves. The primary cause for the increase in self-insurance costs was the increase in the number of employees covered, as we added headcount through acquisitions during 2007 and 2008.

 

Depreciation and amortization expense

 

Depreciation and amortization expense increased $41.2 million, or 31.7%, to $170.8 million for the twelve months ended December 31, 2008 compared to $129.6 million for the same period in 2007. Acquisitions the Company completed during 2008 contributed approximately $6.6 million to the increase and the integration of acquisitions made during 2007 for a full year of operations during 2008 contributed approximately $24.1 million. The remaining $10.5 million increase can be attributed to the Company’s capital expenditures and its larger fixed asset base, which resulted from the Company’s capital expenditures.

 

Impairment of goodwill and equity method investment

 

As discussed in “Critical Accounting Policies — Valuation of Tangible and Intangible Assets,” we test goodwill for impairment on an annual basis, or more often if circumstances indicate our goodwill might be impaired. Our tests for 2006 and 2007 resulted in no indications of impairment. However, upon completion of our test in 2008, there were indicators that the goodwill of our pressure pumping and fishing and rental segments might be impaired. As required by SFAS 142, we calculated the implied fair value of the goodwill for the pressure pumping and fishing and rental segments and determined that the implied fair value was less than the carrying value of the goodwill, meaning that the goodwill was impaired. As a result, during the fourth quarter of 2008 we recorded a pre-tax charge of approximately $69.8 million to write off the goodwill balances for both the pressure pumping and fishing and rental segments. Management of the Company believes that the goodwill of these segments was impaired because of the overall economic downturn and deterioration in the global credit markets and specifically the downturn in the oilfield services sector, which has resulted in a decline in the Company’s stock price and market valuation. All of the goodwill written off from our pressure pumping segment and approximately $18.9 million of the goodwill written off from our fishing and rental segment arose from our acquisition of Q Services, Inc. during 2002.

In 2007, the fair value of the Company’s investment in IROC, based on publicly available stock prices, declined below its book value. At that time, management of the Company believed that steps being taken by IROC’s management as well as economic trends in the Canadian markets indicated that the impairment of the investment was temporary and would be recovered. In the fourth quarter of 2008, management of the Company determined that, based on IROC’s continued depressed stock price and the overall negative outlook for the general economy and oilfield services sector, the impairment was other than temporary and as a result we recorded a pre-tax charge of $5.4 million in order to write the carrying value of our investment in IROC down to fair value.

 

General and administrative expenses

 

General and administrative expenses were approximately $257.7 million for the year ended December 31, 2008, which represents an increase of $27.3 million, or 11.9%, over approximately $230.4 million for the same period in 2007. General and administrative expenses were 13.1% of revenue during 2008, compared to 13.9% of revenue during 2007. The change in general and administrative expense was the result of (in millions):

 

 

Non-equity employee compensation costs increased $27.1 million, or 30.6%, for the year ended December 31, 2008 compared to the same period in 2007. Acquisitions made during 2008 contributed approximately $0.9 million to this increase, and the integration of acquisitions made during 2007 for a full year during 2008 contributed approximately $5.2 million to the increase. Other increases in non-equity compensation during 2008 were the result of pay rate increases given over the course of 2008, the expansion of our operations in Mexico, and the expansion of our business development group through the transfer of existing personnel who previously held positions classified as direct labor. During the fourth quarter of 2008, due to declining industry conditions, the Company’s management initiated a cost control program, which included efforts to curtail all nonessential spending and, in some cases, reductions in the Company’s workforce. Severance charges associated with these workforce reductions resulted in a pre-tax charge totaling approximately $1.8 million recorded in general and administrative expenses.

 

Equity-based compensation increased $11.3 million for the year ended December 31, 2008 compared to the same period in 2007. Because of declines in the Company’s stock price, during the fourth quarter of 2008 we accelerated the vesting period on certain of the Company’s outstanding unvested stock option awards and stock appreciation rights. As a result of the acceleration the Company recorded a pre-tax charge of approximately $10.9 million in general and administrative expenses. Absent this item, equity-based compensation was approximately $12.5 million during 2008, which represents an increase of approximately $0.4 million from 2007. The increase was primarily due to new awards granted during 2008, partially offset be declines in the fair value of certain awards classified as liabilities whose value is based on the Company’s stock price.

 

Legal fees and reserves decreased $2.2 million for the year ended December 31, 2008 compared to the same period in 2007. The Company records loss contingencies related to lawsuits, claims, and proceedings in the normal course of our business. These loss contingencies are reviewed routinely to ensure that appropriate liabilities are recorded and are adjusted as appropriate.

 

Professional fees declined approximately $12.3 million, or 27.2%, during 2008 compared to 2007. Professional fees declined primarily as a result of the Company emerging from its delayed financial reporting process and becoming current with its SEC filings and re-listed on a national stock exchange during 2007.

Loss on early extinguishment of debt

 

For the year ended December 31, 2007, we incurred a loss of $9.6 million associated with the termination of our prior senior credit agreement, dated July 29, 2005 (the “Prior Credit Facility”). During 2007, we issued the $425.0 million of Senior Notes and used the proceeds to retire the term loans then outstanding under the Prior Credit Facility. Concurrently, we entered into the Senior Secured Credit Facility and terminated the Prior Credit Facility. The loss represents the write-off of debt issue costs we incurred when we entered into the Prior Credit Facility.

 

Interest expense, net of amounts capitalized

 

The Company’s interest expense increased approximately $5.0 million, or 13.9%, to $41.2 million for the twelve months ended December 31, 2008 compared to $36.2 million for the same period in 2007. Higher overall debt levels led to the increase in interest expense.

 

Gain on sale of assets, net

 

The Company recorded a net gain of approximately $0.6 million in connection with the sale of various assets during 2008, compared with a loss of approximately $1.8 million during 2007. From time to time and in the normal course of business, the Company sells assets that are either in scrap condition or no longer being used by the Company.

 

Interest income

 

Interest income recognized by the Company during 2008 was approximately $1.2 million. This represents a decline of approximately $5.4 million from the amounts recognized during 2007. The primary reason for the decline in interest income was the decline in the Company’s short-term investment balances since 2007. During the fourth quarter of 2007, the Company liquidated its short-term interest-bearing investments to complete the acquisition of Moncla.

 

Other expense, net

 

Other expense, net for the twelve months ended December 31, 2008 was approximately $4.7 million, compared to other income, net of approximately $0.4 million for the year ended December 31, 2007. Other expense, net for 2008 primarily relates to foreign currency transaction losses associated with the Company’s foreign operations in Mexico, Argentina, and Canada of approximately $3.5 million. Partially offsetting these losses was equity in earnings from the Company’s investment in IROC.

 

Income tax expense

 

Our income tax expense was $90.2 million for the year ended December 31, 2008, compared to $106.8 million for the year ended December 31, 2007. Our effective tax rate was 51.8% in 2008, compared to 38.7% in 2007. The decrease in income tax expense is primarily attributable to lower pretax income in 2008. The increase in our effective tax rate is primarily attributable to the impairment of $63.4 million of goodwill that was non-deductible for income tax purposes and $6.4 million of goodwill that was deductible for income tax purposes in 2008. The 2008 effective tax rate exclusive of the goodwill impairment would be 38.0%. Other differences in the effective tax rate and the statutory rate of 35.0% result primarily from the effect of state and certain foreign income taxes and permanent items attributable to book-tax differences.

 

Year Ended December 31, 2007 and 2006

 

For the year ended December 31, 2007, the Company’s net income was $169.3 million, which represented a decline of approximately $1.7 million, or 1%, from the Company’s net income of $171.0 million for the year ended December 31, 2006. Fully diluted earnings per share for the year ended December 31, 2007 were $1.27 per share, a decline of $0.01 per share from fully diluted earnings per share for the year ended December 31, 2006 of $1.28 per share. Items contributing to the decline in net income and diluted earnings per share were

costs associated with the refinancing of indebtedness during the fourth quarter of 2007. In connection with that refinancing, the Company recorded a pre-tax loss of approximately $9.6 million, or $0.04 per fully diluted share, associated with the write-off of existing unamortized debt issuance costs, and the termination of two interest rate swaps, which led to a pre-tax charge of approximately $2.3 million, or $0.01 per fully diluted share. Offsetting these one-time charges were increased revenues and net income associated with acquisitions the Company made during the third and fourth quarters of 2007 as well as the effect of higher pricing and increased activity during 2007, and expansion of our cased-hole wireline business and international operations in Mexico.

 

Revenues

 

Consolidated revenue for the year ended December 31, 2007 was approximately $1.7 billion, which represented an increase of $115.8 million, or 7.5%, from $1.6 billion for the year ended December 31, 2006. Please refer to “Segment Operating Results” below for further discussion of the changes in revenues from 2006. Changes in revenue for each of our reportable segments were (in millions):

 

 

Contributing to the increase in revenues in 2007 were acquisitions the Company made during the third and fourth quarters, the startup of our operations in Mexico during the second quarter, and the expansion of our cased-hole wireline business, as well as price increases and increased activity levels.

 

Direct operating expenses

 

Consolidated direct operating expenses increased approximately $65.0 million, or 7.1%, to $985.6 million for the year ended December 31, 2007, compared to $920.6 million for the year ended December 31, 2006. The increase in direct operating expenses was the result of (in millions):

 

 

Our employee compensation costs, which include salaries, bonuses and related expenses, increased $25.4 million primarily as the result of increased incentive compensation and increased headcount, exclusive of the impact of acquisitions. Wage and bonus increases during the year were necessary, as the market for our labor was extremely competitive. Because new competitors entered the market and existing competitors added equipment capacity, we were forced to increase wage rates in order to maintain our high levels of quality personnel. Supplies and equipment for our pressure pumping segment increased $41.6 million, primarily as a result of increases in the size of our pressure pumping fleet and increases in the costs to purchase and transport materials used in providing services to our customers. Acquisitions in our well services segment added $16.0 million to our direct operating expenses in 2007. Our self-insurance costs, comprised of costs associated with workers compensation, vehicular liability exposure, and insurance premiums declined significantly in 2007 as compared to 2006.

Depreciation and amortization expense

 

Depreciation and amortization expense increased $3.6 million, or 2.9%, to $129.6 million for the year ended December 31, 2007, compared to $126.0 million for the year ended December 31, 2006. Contributing to the increase in depreciation and amortization expense was depreciation expense associated with our acquisitions during 2007, which totaled approximately $4.8 million, and increased depreciation of approximately $7.7 million related to management’s reassessment of the useful lives of certain assets. Excluding the depreciation and amortization expense associated with acquisitions and reassessment of useful lives, our depreciation expense would have declined approximately $8.9 million because the assets we added through various acquisitions during the 1994 to 2002 time period were reaching the end of their depreciable lives. Depreciation and amortization expense as a percentage of revenue for the year ended December 31, 2007 totaled 7.8%, compared to 8.1% for the year ended December 31, 2006.

 

General and administrative expenses

 

General and administrative expense increased $34.9 million, or 17.8%, to $230.4 million for the year ended December 31, 2007, compared to $195.5 million for the year ended December 31, 2006. The $34.9 million increase was primarily the result of (in millions):

 

 

Employee compensation, exclusive of the impact of acquisitions, which includes salaries, bonuses, equity-based compensation and payroll taxes, increased primarily due to higher equity-based compensation and, to a lesser extent, increased salaries. Equity-based compensation expense during 2007, excluding grants made to our outside directors, totaled $12.0 million, compared to $5.6 million during 2006. The $6.4 million increase is primarily attributable to awards granted under our Phantom Share Plan at the end of 2006, as well as incremental stock options, restricted stock and stock appreciation rights awarded during 2007 under our 1997 Incentive Plan. General and administrative expenses added through acquisitions made during 2007 contributed $3.0 million to the increase in costs when compared to 2006.

 

General and administrative expenses also increased in 2007 because 2006 general and administrative expenses included a $7.5 million benefit from a legal settlement in 2006 that was not repeated during 2007. Professional fees increased approximately $9.6 million during 2007, primarily due to our delayed financial reporting process. Also contributing to the increase was an additional $1.8 million in bad debt expense and $5.5 million in other general and administrative costs. General and administrative expense as a percentage of revenue for the year ended December 31, 2007 totaled 13.9% compared to 12.6% for the year ended December 31, 2006.

 

Interest expense, net of amounts capitalized

 

Interest expense decreased $2.7 million, or 7.0%, to $36.2 million for the year ended December 31, 2007, compared to $38.9 million for the year ended December 31, 2006. The decrease was primarily the result of the impact of higher capitalized interest as a result of higher capital expenditures. This decrease was partially offset by a one-time $2.3 million cost associated with the settlement of two interest rate swaps that were terminated in connection with the termination of our Prior Credit Facility in 2007. Interest expense as a percentage of revenue for the year ended December 31, 2007 totaled 2.2%, compared to 2.5% for the year ended December 31, 2006.

Loss on early extinguishment of debt

 

For the year ended December 31, 2007, we incurred a loss of $9.6 million associated with the termination of our Prior Credit Facility. During 2007, we issued the $425.0 million of Senior Notes and used the proceeds to retire the term loans then outstanding under the Prior Credit Facility. Concurrently, we entered into the Senior Secured Credit Facility and terminated the Prior Credit Facility. The loss represents the write-off of debt issue costs we incurred when we entered into the Prior Credit Facility.

 

Loss on sale of assets, net

 

For the year ended December 31, 2007, we incurred a net loss on the disposal of assets of approximately $1.8 million, compared to a net gain of approximately $4.3 million in 2006. From time to time and in the ordinary course of business the Company sells assets that are in scrap condition or are no longer being used by the Company, and recognizes gains or losses as a result of these sales.

 

Interest Income

 

Interest income was approximately $6.6 million during 2007, compared to approximately $5.6 million during 2006. The increase in interest income is primarily associated with the Company’s investments of excess cash and cash equivalents. These investments were liquidated during the fourth quarter of 2007 to partially fund our purchase of Moncla.

 

Other income, net

 

Other income, net was approximately $0.4 million during 2007 compared to other expense, net of approximately $0.5 million in 2006. The increase in other income, net was primarily attributable to our equity in earnings from our investment in IROC and foreign currency transaction gains.

 

Income tax expense

 

Our income tax expense was $106.8 million for the year ended December 31, 2007, as compared to income tax expense of $103.4 million for the year ended December 31, 2006. Our effective tax rate in 2007 was 38.7%, as compared to 37.7% in 2006. The increase in income tax and our effective tax rate was primarily attributable to the revised Texas Franchise Tax. In general, differences between the effective tax rates and the statutory rate of 35% result primarily from the effect of certain foreign and state income taxes and permanent items attributable to book-tax differences.

Segment Operating Results

 

Year Ended December 31, 2008 and 2007

 

The following table shows operating results for each of our reportable segments for the twelve month periods ended December 31, 2008 and 2007:

 

 

Well servicing segment

 

Revenues for the well servicing segment increased $245.0 million, or 19.4%, to $1.5 billion for the year ended December 31, 2008 compared to $1.3 billion for the same period in 2007. Acquisitions the Company completed during 2008 that were incorporated into the well servicing segment contributed $34.7 million to the increase, and the full year impact of the acquisitions the Company completed during 2007 was approximately $134.9 million. Also leading to higher revenues during 2008 was the expansion of our cased-hole wireline business (approximately $14.3 million) and the continuing expansion of our operations for PEMEX in Mexico (approximately $38.2 million). Additionally, the Company implemented price increases during the second and third quarters of 2008 across most of the markets in which the Company operates, leading to higher revenues. Partially offsetting these increases in revenues for the well servicing segment during 2008 were the effects of hurricanes Ike and Gustav during the third quarter, which restricted the Company’s well servicing operations in Texas, Louisiana, and Oklahoma. The Company estimates that this negatively impacted well servicing segment revenue by approximately $7.0 million during 2008.

 

Direct operating expenses, excluding depreciation and amortization expense, for the well servicing segment were $939.9 million during 2008, which was an increase of $201.2 million, or 27.2%, from the same period in 2007. These costs were 62.3% of revenue during 2008, up from 58.4% during 2007. The increase in direct costs for the well servicing segment resulted from (in millions):

 

 

Employee compensation for the well servicing segment, which includes salaries, cash bonuses, health insurance, 401(k) fees and payroll taxes, increased $110.9 million during 2008 compared to the same period in 2007. Acquisitions made by the Company during 2008 that were incorporated into the well servicing segment

contributed approximately $13.9 million to the increase, and the incorporation of acquisitions made during 2007 for a full year of operations during 2008 contributed approximately $57.4 million to the increase. Also contributing to the increase in employee compensation for the well servicing segment was the expansion of our cased-hole wireline business (approximately $3.6 million) and the Company’s international operations in Mexico (approximately $7.4 million). Additionally, during the third quarter of 2008 the Company incurred approximately $2 million in retroactive union wage increases in Argentina that it will likely be unable to recover from our customers. Excluding these items, direct employee compensation increased approximately 5.7% during 2008, mainly due to organic growth and wage rate increases made throughout the course of the year in order to maintain a quality workforce.

 

Supplies, equipment and maintenance costs for the well servicing segment were approximately $222.5 million for the year ended December 31, 2008, which was an increase of approximately $48.9 million, or 28.2%, compared to the same period in 2007. Acquisitions the Company made during 2008 contributed approximately $4.0 million to the increase and the incorporation of acquisitions the Company made during 2007 for a full twelve months of operations in 2008 contributed approximately $24.5 million to the increase. Absent these items, these costs increased approximately $20.4 million, or 11.8%, from 2007. This increase was due primarily to higher prices being charged by vendors, especially for certain chemicals used in the well servicing process.

 

Fuel costs for the well servicing segment increased approximately $24.6 million, or 43.7%, to $80.7 million for the year ended December 31, 2008 compared to the year ended December 31, 2007. Acquisitions the Company made during 2008 contributed approximately $1.3 million to the increase in fuel costs and the incorporation of acquisitions made during 2007 for a full twelve months during 2008 contributed approximately $3.6 million to the increase. Absent acquisitions, fuel costs have increased primarily as a result of higher usage due to increased utilization and the per gallon price of fuel. The Company estimates that on average, the per-gallon price of diesel increased approximately 27.5% during 2008 compared to 2007.

 

Self-insurance costs for the well servicing segment increased approximately $3.1 million, or 15.8%, during 2008 compared to the same period in 2007. Acquisitions the Company made during 2008 and the incorporation of acquisitions the Company made during 2007 for a full year of operations during 2008 contributed to the increase, primarily due to the costs of insuring increased headcount. These increases were offset by better safety performance resulting in a lower number of incidents.

 

Pressure pumping segment

 

Revenues for the Company’s pressure pumping segment were approximately $345.0 million for the year ended December 31, 2008, which represents an increase of $45.6 million, or 15.2%, from revenues of $299.3 million for the same period in 2007. The acquisition of the Leader assets during the third quarter of 2008 contributed approximately $9.6 million to the increase in pressure pumping segment revenues. Excluding the effects of acquisitions, revenues for the pressure pumping segment increased approximately $36.1 million, or 12.0%, during 2008. This increase was driven primarily by the incremental equipment added by the Company over the course of the year, as well as price increases implemented during the second quarter of 2008. However, during the fourth quarter of 2008, the Company’s pressure pumping segment began to experience significant pricing pressure and began to increase the discounts offered to customers in order to preserve market share. Revenues during 2008 were also negatively impacted by a decline in the number of cementing and acid jobs performed, but these declines were partially offset by an increase in the number of coiled tubing jobs as a result of several coiled tubing units being placed in service during late 2008 in addition to the coiled tubing units acquired from Leader.

 

Direct operating expenses, excluding depreciation and amortization expense, for the pressure pumping segment were approximately $239.9 million during 2008, which represents an increase of $50.2 million, or 26.5%, from the same period in 2007. Excluding depreciation and amortization, direct operating expenses of the pressure pumping segment were 69.5% of revenue during 2008 and 63.4% of revenue during 2007. The increase in the pressure pumping segment’s direct operating expenses as a percentage of revenue was primarily attributable to pricing pressures during the second half of 2008 combined with increasing supply costs during

2008 for fuel and proppants. The increase in direct operating expenses for the pressure pumping segment resulted from (in millions):

 

 

Frac sand and chemical costs for the pressure pumping segment increased approximately $29.5 million, or 34.0%, to $115.9 million during 2008 compared to $86.4 million during 2007. The acquisition of the Leader assets during the third quarter of 2008 contributed approximately $0.7 million to the increase in these costs during 2008. Absent the effect from the Leader asset purchase, costs for frac sand and chemicals increased during 2008 primarily due to higher commodity prices, as well as higher prices being charged by shippers to transport the sand. In addition, during 2008 the pressure pumping segment began using coated sand as a proppant in certain high-pressure frac jobs in the Barnett Shale formation. Using coated sand is more costly than normal sand, but allows the pressure pumping segment to charge a higher rate to its customers to cover the additional cost.

 

Employee compensation for the pressure pumping segment, which is comprised of salaries, cash bonuses, health insurance, 401(k) fees and payroll taxes, increased approximately $8.1 million during 2008 compared to the same period in 2007. The Leader asset purchase during the third quarter of 2008 contributed approximately $2.4 million to the increase in direct employee compensation for the pressure pumping segment. Absent the effects of the Leader asset purchase, direct employee compensation for the pressure pumping segment increased $5.6 million, or 14.1%, during 2008. This increase was the result of the addition of several frac and coiled tubing crews during the year in order to meet customer demand, and wage rate increases given throughout the course of the year in order to maintain a high quality workforce.

 

Fuel costs for the pressure pumping segment increased approximately $7.2 million or 48.9% during 2008 to $22.0 million compared to $14.8 million for the same period in 2007. The acquisition of the Leader assets during the third quarter of 2008 contributed approximately $0.5 million to the increase. Absent the effects of the Leader asset purchase, the primary driver in the increase in fuel is the per gallon price of diesel; the Company estimates that on average the price of diesel rose approximately 27.5% during 2008. Other factors driving the increase in fuel costs are higher activity levels during 2008.

 

Supplies, equipment and maintenance costs for our pressure pumping segment increased $3.6 million, or 9.5%, during 2008 compared to 2007. The increase in these costs is attributable to the acquisition of the Leader fixed assets during 2008, higher prices from the Company’s vendors, and increased requirements for repairs and maintenance associated with the overall increase in utilization of our pressure pumping assets during 2008.

 

Fishing and rental segment

 

Revenues for the Company’s fishing and rental segment were approximately $117.3 million for the year ended December 31, 2008, which represented an increase of $19.4 million, or 19.8%, from revenues of $97.9 million for the same period in 2007. The acquisition of Hydra-Walk during the second quarter of 2008 contributed approximately $6.9 million to the increase in revenues. Excluding the effects of the acquisition, fishing and rental segment revenues increased $12.5 million, or 12.8%, from the same period in 2007. The increase in revenues is attributable to price increases implemented during the second quarter of 2008 as well as a higher number of reverse unit and fishing jobs during 2008 compared to 2007. Partially offsetting these increased revenues were the effects of hurricanes in the Gulf Coast region during the second and third quarters of 2008, which significantly restricted the segment’s operations in the Gulf of Mexico.

 

Direct operating expenses, excluding depreciation and amortization expense, for the fishing and rental segment were $70.6 million during 2008, which was an increase of $13.3 million, or 23.3%, from 2007. The acquisition of Hydra-Walk during 2008 contributed approximately $3.2 million to the increase in direct

operating expenses. Excluding depreciation and amortization expense, direct operating expenses for the fishing and rental segment were 60.2% of revenue during 2008 and 58.5% of revenue during 2007. The increase in direct operating expenses resulted from (in millions):

 

 

Employee compensation expenses, which include salaries, bonuses, insurance, 401(k) fees and payroll taxes, increased approximately $6.5 million during 2008 compared to the same period in 2007. The acquisition of Hydra-Walk during 2008 contributed approximately $2.2 million to the increase in employee compensation. Absent the effects of the acquisition, employee compensation increased as the segment added personnel to keep pace with increased demand, and also resulted from wage rate increases given throughout the course of the year in order to maintain a quality workforce.

 

Supplies, equipment and maintenance for the fishing and rental segment were approximately $24.0 million during 2008, which represents an increase of approximately $5.5 million, or 29.6% from 2007. The acquisition of Hydra-Walk during 2008 contributed approximately $1.0 million to the increase in these costs. Other increases in these costs were attributable to a larger asset fleet and higher activity levels.

 

Fuel for the fishing and rental segment increased approximately $1.6 million, or 47.9%, during 2008 compared to the same period in 2007. The acquisition of Hydra-Walk contributed approximately $0.3 million to the increase in fuel costs during 2008. The remainder of the increase is attributable to increased activity levels and an increase in the per-gallon price of diesel. The Company estimates that on average, the per-gallon price of diesel increased approximately 27.5% during 2008.

 

Year Ended December 31, 2007 and 2006

 

The following table shows the results of operations for each of the Company’s reportable segments for the years ended December 31, 2007 and 2006:

 

 

Well servicing segment

 

Well servicing segment revenue increased $63.5 million, or 5.3%, to $1.26 billion for the year ended December 31, 2007, compared to revenue of $1.20 billion for the year ended December 31, 2006. The increase

in revenue is largely attributable to the impact of the acquisition of Moncla, which contributed $23.6 million, $9.0 million from our contract with PEMEX in Mexico and $13.7 million in higher revenue from our cased-hole electric wireline operations. The remainder of the increase is a result of the full-year impact of pricing increases implemented during the second half of 2006, though revenues were affected by declines in activity levels and reductions from overall peak pricing in the second half of 2007. During the year ended December 31, 2007, our rig hours decreased 7.9% compared to the year ended December 31, 2006 and our trucking hours decreased 2.9% during the comparable period. The decrease in both rig and trucking hours was due primarily to lost market share to new market entrants.

 

Well servicing direct operating expenses increased $13.7 million, or 2.0%, to $738.7 million for the year ended December 31, 2007, compared to $725.0 million for the year ended December 31, 2006. Acquisitions made during 2007 contributed approximately $16.0 million to the increase in direct operating expenses. Excluding the effect of acquisitions, well servicing direct operating expenses increased as a result of higher employee compensation costs of $17.2 million. Compensation-related expenses increased due to the need to retain our workforce. As a result of new equipment capacity in the marketplace, the demand for labor was strong and we implemented programs to retain our personnel, including higher wage rates. Partially offsetting the increased compensation costs was a $22.8 million decrease in costs associated with our self-insurance programs. These costs, which include workers’ compensation, vehicular liability exposure and insurance premiums declined primarily as a result of improved safety performance and fewer and less severe incidents in 2007 compared to 2006. Other well servicing direct expenses increased approximately $3.3 million.

 

Pressure pumping segment

 

Pressure pumping segment revenue increased $51.9 million, or 21.0%, to $299.3 million for the year ended December 31, 2007, compared to revenue of $247.5 million for the year ended December 31, 2006. The increase in revenue is attributable to the purchase of incremental pressure pumping equipment and higher activity levels, but was offset somewhat by lower pricing in 2007. Over the course of 2006 and 2007 we purchased additional new pressure pumping equipment to service and satisfy our customers’ needs, increasing the size of our fleet. The new equipment resulted in additional services performed, which resulted in higher revenue during 2007. During 2007, we completed 2,152 fracturing jobs and 2,074 cementing jobs as compared to 1,585 and 1,958, respectively, in 2006. Fracturing and cementing jobs accounted for the substantial majority of the segment revenue.

 

Direct operating expenses increased $51.3 million, or 37.0%, to $189.6 million for the year ended December 31, 2007, compared to $138.4 million for the year ended December 31, 2006. The increase in direct operating expenses is largely attributable to costs associated with increased demand for pressure pumping services and the increased size of our pressure pumping fleet. During 2007, costs related to employee compensation for the pressure pumping segment increased $8.8 million due primarily to expansion of our pressure pumping fleet through the introduction of new equipment, which required us to hire additional personnel and increased wage rates for our crews. Our equipment costs increased $13.2 million from 2006 primarily due to the expansion of our pressure pumping fleet. Additionally, sand, chemical and associated freight costs increased approximately $29.3 million during 2007. These costs relate to the purchase of sand and chemicals used in our operations from our various suppliers and the shipment to our pressure pumping facilities and job locations. As activity levels in our pressure pumping segment increased in 2007, we used greater amounts of sand and chemicals. Additionally, as overall activity in the pressure pumping sector increased during 2007, the costs for the materials and their transportation increased.

 

Fishing and rental segment

 

Fishing and rental segment revenue totaled $97.9 million for the year ended December 31, 2007, compared to revenue of $97.5 million for the year ended December 31, 2006. Although the segment benefited from additional rental equipment in 2007, these equipment additions were offset somewhat by lower overall pricing. Fishing and rental segment direct operating expenses were flat at $57.3 million for the year ended December 31, 2007, compared to $57.2 million for the year ended December 31, 2006.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Current Financial Condition and Liquidity

 

The following table summarizes our cash flows for the years ended December 31, 2008 and 2007: