Summary of KEY ENERGY SERVICES INC

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW Key Energy Services, Inc., its wholly-owned subsidiaries and its controlled subsidiaries (collectively, "Key," the "Company," "we," "us," "its," and "our") provide a complete range of services to major oil companies, foreign national oil companies and independent oil and natural gas production companies, including rig-based services, fluid management services, pressure pumping services, fishing and rental services, and cased-hole electric wireline services. We operate in most major oil and natural gas producing regions of the United States as well as internationally in Argentina, Mexico and Russia. We also own a technology development company based in Canada and have an equity interest in a Canadian-based oilfield service company.
The following discussion and analysis should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and related notes as of September 30, 2009 and for the three and nine months ended September 30, 2009 and 2008, respectively, included elsewhere herein, and the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008.
During the three and nine months ended September 30, 2009, we operated in two business segments, Well Servicing and Production Services. We also have a Functional Support segment associated with managing all of our reportable operating segments. For a full description of our segments, see "Note 15. Segment Information" in "Item 1. Financial Statements" above.
PERFORMANCE MEASURES In determining the overall health of the oilfield service industry, we believe 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 correlated well with capital spending by oil and natural gas producers. When commodity prices are strong, capital spending by our customers tends to be high. As the following table indicates, the land drilling rig count has fallen dramatically since the fourth quarter of 2008, prices for natural gas have declined significantly, and prices for crude oil have remained volatile.

                                                                    Average Baker
                                              NYMEX Henry            Hughes U.S.
                      WTI Cushing Oil       Hub Natural Gas       Land Drilling Rigs
                            (1)                   (1)                    (2)

    2009:
    First Quarter    $           43.18     $            4.56                    1,287
    Second Quarter   $           59.69     $            3.71                      885
    Third Quarter    $           71.83     $            4.85                      936

    2008:
    First Quarter    $           97.94     $            8.74                    1,712
    Second Quarter   $          123.95     $           11.47                    1,797
    Third Quarter    $          118.05     $            8.99                    1,910
    Fourth Quarter   $           59.06     $            6.42                    1,836

(1) Represents the average price for the periods presented. Source:
EIA / Bloomberg

(2) Source:
www.bakerhughes.com

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Internally, we measure activity levels in our Well Servicing segment primarily through our rig and trucking hours. As capital spending by our customer base increases, demand for our services generally rises, resulting in increased rig and trucking services and more hours worked. Conversely, when activity levels decline due to lower spending by our customer base, we generally provide fewer services, which results in lower hours worked. The number of rig and trucking hours, as well as pricing, may also be affected by increases in industry capacity. We publicly release our monthly rig and trucking hours. The following table presents our quarterly rig and trucking hours from the first quarter of 2008 through the third quarter of 2009:

                                    Rig Hours       Trucking Hours

                  2009:
                  First Quarter        489,819              499,247
                  Second Quarter       415,520              416,269
                  Third Quarter        416,810              398,027

                  2008:
                  First Quarter        659,462              585,040
                  Second Quarter       701,286              603,632
                  Third Quarter        721,285              620,885
                  Fourth Quarter       634,772              607,004

                  Total 2008         2,716,805            2,416,561

MARKET CONDITIONS AND OUTLOOK
Market Conditions - Quarter Ended September 30, 2009 Overall, market conditions during the third quarter of 2009 were relatively unchanged from the conditions that existed at the end of the second quarter of 2009, specifically the month of June. However, in the last month of the third quarter of 2009, we began to see modest activity and pricing improvements in market conditions for all of our lines of business. Our Well Servicing segment experienced an increase in absolute rig hours compared to the previous quarter but a slight decline in rig hours per working day, down approximately 1.3% from the second quarter of 2009, and trucking hours per working day were approximately 5.9% lower than the second quarter of 2009. Our Production Services segment, which is more dependent on natural gas related activity, continued to see depressed activity levels and pricing during the third quarter of 2009.
The average price for West Texas Intermediate crude oil at Cushing, Oklahoma continued to be relatively stable during the third quarter of 2009 compared to the second quarter of 2009. Although average oil prices have remained above $70 per barrel since the end of the second quarter of 2009, we believe that our major customers are continuing to be guarded about their outlook on activity and near-term commodity pricing. The average price per MMBtu for natural gas at the Henry Hub during the third quarter of 2009 was relatively unchanged from the prices at the end of the second quarter of 2009. Natural gas prices have not yet followed the direction of oil prices toward recovery compared to 2008 prices. Based on our assessment of the current and near-term market conditions for the rig-based oilfield services market, we chose to retire a portion of our U.S. rig fleet and associated equipment during the quarter, which resulted in a pre-tax charge of $65.9 million. Included in this retirement were approximately 250 of our older, less efficient rigs, leaving a remaining U.S. well service rig fleet of 743 rigs, consisting of 610 actively marketed rigs and 133 idled rigs. During the quarter, we also determined that continuing market overcapacity, continued and prolonged depression of natural gas prices, lower activity levels from our major customer base related to stimulation work and consecutive quarterly operating losses in our Production Services segment, indicated that the carrying amounts of the asset groups under this segment were potentially not recoverable. We performed an assessment of the fair value of the asset groups in this segment, and the results of this assessment indicated that our pressure pumping equipment was impaired. As a result, we recorded a pre-tax impairment charge of approximately $93.4 during the third quarter of 2009. We also recorded a pre-tax impairment charge of approximately $0.5 million related to goodwill in our Production Services segment during the third quarter of 2009.
Internationally, we were operating 21 of our 24 rigs in Mexico by the end of the third quarter, and these assets continued to generate positive earnings. We expect to place the other three rigs in service by the end of the fourth quarter of 2009. In Argentina, activity levels and pricing remained stable, with a slight increase in revenues; however, labor issues continue to negatively impact earnings. During the second quarter, we began the process of reducing the size of our workforce in Argentina and have reduced headcount by approximately 18%, cumulatively. These headcount reductions have caused disruptions in business activity, including labor strikes, and future disruptions remain possible as we continue our efforts to rationalize the size of our labor force in Argentina relative to the available work opportunities. During the third quarter, we acquired an additional 24% interest in OOO Geostream Services Group ("Geostream") and gained 50% ownership and a controlling interest. Concurrently with our second investment, we agreed to sell to Geostream a customized suite of equipment, including two workover rigs, two drilling rigs, cementing equipment and fishing tools. We are scheduled to begin delivering this equipment during the fourth quarter of 2009.

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Market Outlook for the Remainder of 2009 and 2010 Although current oil price economics might be expected to lead to higher activity levels, we are seeing only modest increases in activity from our major customers for well servicing work. A majority of our customers will begin their planning cycle for 2010 during the fourth quarter of 2009 and we should have a better understanding of their activity plans and the timing of potential spending increases as we finalize our 2010 business plan. We believe that the remainder of 2009 will continue to present challenges and results will likely remain flat compared to the third quarter of 2009. We will continue to focus on the rationalization of our infrastructure, including facility consolidations and continued cost reduction efforts.
In contrast to the recent recovery of oil prices, natural gas prices remain depressed. Our Production Services segment is levered to gas-directed activity, and we expect it to continue to face challenges in the market until the price of natural gas recovers sufficiently for our customers to increase their spending plans. In particular, significant overcapacity exists in the pressure pumping market, and we do not expect activity to increase sufficiently to meaningfully improve asset utilization through at least 2010. We will continue to assess the service footprint of our Production Services segment, which could include facility consolidation and the redeployment of assets to markets where we believe that customer activity provides better opportunities for utilization. Internationally, we expect our opportunities for 2010 will continue to expand. During the third quarter of 2009, we provided an additional three rig packages to expand our fleet in Mexico. In Russia, we expect that the additional equipment we will begin delivering in the fourth quarter of 2009 should provide opportunities for us to expand our market presence in this region during 2010. We are also currently exploring several international expansion opportunities in other markets.

                             RESULTS OF OPERATIONS
The following table shows our consolidated results of operations for the three
and nine months ended September 30, 2009 and 2008 (in thousands, except per
share data):

                                              Three Months Ended September 30,              Nine Months Ended September 30,
                                                 2009                   2008                  2009                   2008
                                                                               (unaudited)
REVENUES                                   $         237,671       $       535,620      $        811,118       $      1,494,022

COSTS AND EXPENSES:
Direct operating expenses                            179,901               342,195               580,981                946,324
Depreciation and amortization expense                 44,477                42,676               132,424                124,923
General and administrative expenses                   41,071                62,477               135,172                188,458
Asset retirements and impairments                    159,802                     -               159,802                      -
Interest expense, net of amounts
capitalized                                            9,082                10,475                28,911                 30,594
Loss (gain) on disposal of assets, net                 1,945                (1,683 )               1,284                 (2,309 )
Interest income                                          (42 )                (213 )                (459 )                 (903 )
Other (income) expense, net                             (359 )               2,152                  (789 )                1,240

Total costs and expenses, net                        435,877               458,079             1,037,326              1,288,327


(Loss) income before taxes and
noncontrolling interest                             (198,206 )              77,541              (226,208 )              205,695
Income tax benefit (expense)                          73,189               (29,079 )              83,622                (78,982 )


Net (Loss) Income                                   (125,017 )              48,462              (142,586 )              126,713


Noncontrolling interest                                   75                     -                    75                    245


(LOSS) INCOME ATTRIBUTABLE TO COMMON
STOCKHOLDERS                               $        (124,942 )     $        48,462      $       (142,511 )     $        126,958


(Loss) earnings per share attributable
to common stockholders:
Basic                                      $           (1.03 )     $          0.39      $          (1.18 )     $           1.01
Diluted                                    $           (1.03 )     $          0.39      $          (1.18 )     $           1.00

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A detailed review of our operations, including a review of our segments, for the three and nine months ended September 30, 2009 compared to the same periods in 2008, is provided below.
Consolidated Results of Operations - Three Months Ended September 30, 2009 and 2008
Revenues
Our consolidated revenues for the three months ended September 30, 2009 decreased $297.9 million, or 55.6% to $237.7 million from $535.6 million for the three months ended September 30, 2008. See "Segment Operating Results - Three Months Ended September 30, 2009 and 2008" below for a more detailed discussion of the change in our revenues.
Direct Operating Expenses
Our consolidated direct operating expenses decreased $162.3 million, or 47.4%, to $179.9 million for the three months ended September 30, 2009, compared to $342.2 million for the three months ended September 30, 2008. These costs were 75.7% of revenue during the third quarter of 2009, compared to 63.9% during the same period in 2008. See "Segment Operating Results - Three Months Ended September 30, 2009 and 2008" below for a more detailed discussion of the change in our direct operating expenses.
Depreciation and Amortization Expense
Depreciation and amortization expense increased approximately $1.8 million, or 4.2%, to $44.5 million during the three months ended September 30, 2009, compared to $42.7 million for the same period in 2008. The increase in our depreciation and amortization expense is primarily attributable to our larger average fixed asset base during the current period. However, after giving effect to the rig retirement and asset impairment charges recorded in the third quarter of 2009, we expect depreciation and amortization expense will decrease in the future based on the current carrying value of our fixed assets. General and Administrative Expenses
General and administrative expenses decreased approximately $21.4 million, or 34.3%, to $41.1 million for the three months ended September 30, 2009, compared to $62.5 million for the three months ended September 30, 2008. General and administrative expense was 17.3% of revenue for the third quarter of 2009, compared to 11.7% of revenue for the same period in 2008. Our general and administrative expenses declined primarily as a result of lower employee compensation attributable to headcount, wage rate and benefits reductions that we put in place beginning in late 2008 and that continued into 2009 in response to the downturn in activity levels. Equity-based compensation was also lower in the third quarter of 2009 as a result of our having accelerated the vesting period on the majority of our stock option awards and stock appreciation rights ("SARs") that were "out of the money" during the fourth quarter of 2008. As a result, no expense was recognized on these awards during the three months ended September 30, 2009.
Asset Retirements and Impairments
During the three months ended September 30, 2009, we recognized $159.8 million in pre-tax charges associated with asset retirements and impairments. Included in this pre-tax charge is $65.9 million related to the retirement of certain of our rigs and associated equipment. Additionally, during the third quarter of 2009, we identified events and changes in circumstance indicating that the carrying amounts of certain of our asset groups may not be recoverable. Accordingly, we performed a recoverability assessment by comparing the estimated future cash flows for these asset groups to the asset groups' estimated carrying value. The completion of this test indicated that the carrying value of our pressure pumping equipment was not recoverable and resulted in the recording of a $93.4 million pre-tax impairment charge. We also determined that the goodwill of the fishing and rental services line of business within our Production Services segment was impaired, and as such we recorded a pre-tax impairment charge of approximately $0.5 million during the three months ended September 30, 2009.
Interest Expense, net of amounts capitalized Interest expense decreased approximately $1.4 million for the three months ended September 30, 2009, compared to the same period in 2008. The decrease in interest expense was primarily due to the repayment of $100.0 million of our revolving credit facility in the second quarter of 2009, and lower interest rates on our variable rate debt.

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Loss (Gain) on Disposal of Assets, net
During the three months ended September 30, 2009, we recognized a net loss on asset disposals of approximately $1.9 million, compared to a net gain of approximately $1.7 million during the same period in 2008. From time to time we sell assets in the normal course of business consistent with our operational needs. Also included in this line item are disposals of insured assets that are damaged or destroyed and for which we file claims with our insurance carriers. We recognize gains or losses, as appropriate, based on the difference between the proceeds received from the disposal and the carrying value of the asset. Interest Income
Interest income was less than $0.1 million and $0.2 million for the three months ended September 30, 2009 and 2008, respectively. Interest income declined slightly due to lower interest rates, offset by higher average cash and cash equivalents balances during the third quarter of 2009 compared to the same period in 2008.
Other (Income) Expense, net
Other income, net was approximately $0.4 million during the three months ended September 30, 2009, compared to other expense, net of $2.2 million during the three months ended September 30, 2008. Other income and expense, net is primarily attributable to our pro-rata share of the income or loss from our equity-method investments and foreign currency transaction gains and losses from our international operations.
Income Tax Benefit (Expense)
Our income tax benefit was $73.2 million on a pre-tax loss of $198.2 million for the three months ended September 30, 2009, compared to income tax expense of $29.1 million on pre-tax income of $77.5 million for the same period in 2008. Our effective tax rate was 36.9% for the three months ended September 30, 2009 compared to 37.5% for the three months ended September 30, 2008. The difference in our effective tax rates for the three months ended September 30, 2009 and 2008 is due to a more favorable mix of profits subject to varying rates, and the effect of the charges that we took during the third quarter of 2009 related to asset retirements and impairments.
Consolidated Results of Operations - Nine Months Ended September 30, 2009 and 2008
Revenues
Our consolidated revenues for the nine months ended September 30, 2009 decreased $682.9 million, or 45.7%, to $811.1 million from $1.5 billion for the nine months ended September 30, 2008. See "Segment Results of Operations - Nine Months Ended September 30, 2009 and 2008" below for a more detailed discussion of the change in our revenues.
Direct Operating Expenses
Our consolidated direct operating expenses decreased $365.3 million, or 38.6%, to $581.0 million for the nine months ended September 30, 2009, compared to $946.3 million for the nine months ended September 30, 2008. These costs were 71.6% of revenue during the third quarter of 2009, compared to 63.3% during the same period in 2008. See "Segment Results of Operations - Nine Months Ended September 30, 2009 and 2008" below for a more detailed discussion of the change in our direct operating expenses.
Depreciation and Amortization Expense
Depreciation and amortization expense increased approximately $7.5 million, or 6.0%, to $132.4 million during the nine months ended September 30, 2009, compared to $124.9 million for the same period in 2008. The increase in our depreciation and amortization expense is primarily attributable to accelerated depreciation for assets that we removed from service during the first half of 2009 in response to the downturn in market conditions, as well as a larger fixed asset base in 2009 due to our capital spending. However, after giving effect to the rig retirement and asset impairment charges recorded in the third quarter of 2009, we expect depreciation and amortization expense will decrease in the future based on the current carrying value of our fixed assets.

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General and Administrative Expenses
General and administrative expenses decreased approximately $53.3 million, or 28.3%, to $135.2 million for the nine months ended September 30, 2009, compared to $188.5 million for the nine months ended September 30, 2008. General and administrative expense was 16.7% of revenue during the nine months ended September 30, 2009, compared to 12.6% of revenue for the same period in 2008. Our general and administrative expenses declined as a result of cost cutting measures that we put in place beginning in late 2008 and that continued into 2009 related to reductions in headcount, employee wage rate and benefits reductions, and controlled spending in overhead costs. Equity-based compensation was also lower during the nine months ended September 30, 2009 as a result of our having accelerated the vesting period on the majority of our stock option and SAR awards that were "out of the money" during the fourth quarter of 2008. As a result, no expense was recognized on these awards during the nine months ended September 30, 2009.
Asset Retirements and Impairments
During the third quarter of 2009, we recognized $159.8 million in pre-tax charges associated with asset retirements and impairments. Included in this pre-tax charge is $65.9 million related to the retirement of certain of our rigs and associated equipment. Additionally, during the third quarter of 2009, we identified events and changes in circumstance indicating that the carrying amounts of certain of our asset groups may not be recoverable. Accordingly, we performed a recoverability assessment by comparing the estimated future cash flows for these asset groups to the asset groups' estimated carrying value. The completion of this test indicated that the carrying value of our pressure pumping equipment was not recoverable and resulted in the recording of a $93.4 million pre-tax impairment charge. We also determined that the goodwill of the fishing and rental services line of business within our Production Services segment was impaired, and as such we recorded a pre-tax impairment charge of approximately $0.5 million during the third quarter of 2009. Interest Expense, net of amounts capitalized Interest expense decreased approximately $1.7 million for the nine months ended September 30, 2009, compared to the same period in 2008. The decline in interest expense is primarily attributable to lower interest rates on our variable-rate debt instruments, and the repayment of $100.0 million of our revolving credit facility during the second quarter of 2009. Loss (Gain) on Disposal of Assets, net
During the nine months ended September 30, 2009, we recognized a net loss on asset disposals of approximately $1.3 million, compared to a net gain of approximately $2.3 million during the same period in 2008. From time to time we sell assets in the normal course of business consistent with our operational needs. Also included in this line item are disposals of insured assets that are damaged or destroyed and for which we file claims with our insurance carriers. We recognize gains or losses, as appropriate, based on the difference between the proceeds received from the disposal and the carrying value of the asset. Interest Income
Interest income decreased approximately $0.4 million to $0.5 million for the nine months ended September 30, 2009, compared to $0.9 million for the same period in 2008. The decrease in interest income is primarily attributable to declines in interest rates, partially offset by our higher average cash and cash equivalents balances during the period.
Other (Income) Expense, net
Other income, net was approximately $0.8 million during the nine months ended September 30, 2009 compared to other expense, net of approximately $1.2 million during the same period of 2008. Other income and expense, net is primarily attributable to our pro-rata share of the income or loss from our equity-method investments and foreign currency transaction gains and losses from our international operations.
Income Tax Benefit (Expense)
Our income tax benefit was $83.6 million on a pre-tax loss of $226.2 million for the nine months ended September 30, 2009, compared to income tax expense of $79.0 million on pre-tax income of $205.7 million for the same period in 2008. Our effective tax rate was 37.0% for the nine months ended September 30, 2009 compared to 38.4% for the nine months ended September 30, 2008. Our effective tax rate declined for the nine months ended September 30, 2009 due to a favorable mix of profit subject to tax at varying rates, coupled with an activity-related reduction in permanent tax differences.

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Segment Operating Results - Three Months Ended September 30, 2009 and 2008 The following table shows operating results for each of our segments, net of intersegment eliminations, for the three month periods ended September 30, 2009 and 2008, respectively (in thousands, except for percentages):
For the three months ended September 30, 2009:

. . .