Creating oil and natural gas is an amazing process; over eons, pressure and heat turn tons of organic matter into a usable fuel. But the process is so slow that every person alive today will be long gone before the earth creates more fossil fuel. The peak oil theory suggests that oil production is now in a state of terminal decline. That notion informs the view of Craig Hodges who manages the Hodges Fund (HDPMX, 866-811-0224) alongside his father, Donald Hodges. A multi-cap fund, Hodges is consistently overweight energy relative to its peer group. We recently spoke with Craig Hodges to discuss why he’s so bullish on the energy sector.

Ben Shepherd: The energy sector has been beaten down recently. Why have you remained overweight to this sector relative to your peers?

Craig Hodges: Under the most optimistic scenario, the world can only produce about 90 million barrels of oil per day because production depletes at a rate of 4 percent to 5 percent every year. On top of that, there are a limited number of rigs available that can actually drill for oil and a limited number of hydraulic fracturing (frack) crews that can actually “frack.”

When the price of oil hit its all-time high, everyone discussed how to develop alternative energy sources. But once oil plummeted to $50 per barrel in 2009, interest in pursuing alternative energy waned and we remain dependent on oil. We expect oil prices will eventually climb much higher after China and India resume their torrid pace of growth.

Ben: How far away are we from the day when energy demand finally exceeds supply?

Craig Hodges: Some people think that a global recession resulting from the problems in Europe could cause energy demand to wane. But there are still roughly 70 million people in China who are about to join the middle class. They will undoubtedly place new demands on that country’s energy infrastructure.

So it’s a foregone conclusion that energy demand will continue to rise, and we expect to encounter problems with supply within the next five years. Even though that will lead to higher energy prices, there are a lot of industries that are going to directly benefit from such an environment.

Ben: Oil prices rebounded by about 30 percent from a year ago, but equities still seem to be pricing in a recession. What accounts for this counterintuitive situation?

Craig Hodges: It’s baffling. In September, shares of Halliburton (NYSE: HAL) traded at about $58 and oil was around $100 per barrel. Then the price of oil dipped just below $80 per barrel for a 20 percent correction, yet Halliburton’s stock plunged to $28. Now crude prices are back in the low $90s, but Halliburton is still off by 40 percent.

When a firm contracts Halliburton or Schlumberger (NYSE: SLB), they’re not using the spot price of oil to set the parameters of the contract; they’re relying on three- to five-year estimates. From our perspective, Halliburton’s prospects in the domestic drilling business are better than ever, but the stock price doesn’t reflect those fundamentals.

Ben: In a fairly recent development for the oil market, West Texas Intermediate (WTI) crude trades at a steep discount to Brent crude. What’s driving that disparity?

Craig Hodges: WTI is more of a local benchmark based on oil stored in Cushing, Oklahoma. That oil is trading at a discount because it’s available in greater supply than the oil on the worldwide market.

Such disconnects are usually short-term inefficiencies in the market. Now that this historically wide discount has garnered such attention, we expect the spread between WTI and Brent to narrow as firms take advantage of the discount.

Ben: Are current oil prices in the low $90s per barrel good for the sector?

Craig Hodges: I think prices between $85 and $95 are a good equilibrium level.

A lot of businesses have actually adapted to higher oil prices. For example, if you had told an airline executive five years ago that he would have to deal with oil at $90 per barrel, he would have said his airline couldn’t be profitable at such a level. But airlines have restructured their businesses in such a way that they can be profitable despite the high price of oil.

In fact, this should be a good year for airline profits due to the changes they’ve made to accommodate the higher price of oil. But if oil trades as high as $120 per barrel, then that will create a whole new problem for that industry.

Of course, companies like Halliburton and Transocean (NYSE: RIG) perform quite well in this environment. But at $120 per barrel, their return on investment would be fantastic. At that threshold, their day rates increase and all of that excess revenue goes directly to their bottom line. Conversely, if oil fell to $60 per barrel it would significantly impair their profits.

Ben: Are there any corners of the energy sector that investors should favor right now?

Craig Hodges: In the energy industry, we focus on those sub-sectors that have high barriers to entry because the leaders in these sectors enjoy pricing power. But overall, the energy business is extremely diverse and I don’t think any one corner of it merits special attention.

For example, one of our favorite stocks is Bristow Group (NYSE: BRS). This undervalued company supplies offshore rigs with helicopters. We performed a study in which we valued Bristow’s entire fleet of helicopters—there’s a bluebook for used helicopters similar to the one for used cars— and subtracted its debt. Our resulting valuation of the stock was more than $50. It’s trading at a significant discount to that right now.

But if I had to single out an energy sub-sector, then we favor deepwater drillers because we expect a hug shortage of rigs worldwide in 2013. Consequently, the day rates for deepwater rigs will increase substantially over the next few years. In this environment, companies such as Atwood Oceanics (NYSE: ATW) and Transocean should do quite well. Deepwater drillers don’t trade at high multiples to earnings, as most are priced at less than 10 times earnings.

Ben: Could you elaborate on what’s attractive about this deepwater theme?

Craig Hodges: Deepwater drillers are almost like a technology play. We’re discovering oil in places that will require extraordinary efforts to extract it. The technology that enables rigs to extract oil from fields that are 10,000 feet below the surface of the ocean is simply amazing. Of course, the advances in seismic technology that led to these discoveries are also noteworthy.

We recently saw a map that shows deepwater oil field discoveries that span the globe. If our thesis plays out, every single one of these discoveries will be drilled for oil. That should lead to a real shortage of deepwater rigs.

Although there are a bunch of rigs slated for completion in 2014, the industry still has high barriers to entry. That’s largely why we favor this corner of the energy sector. If a firm wants to enter the deepwater drilling sector, it will need five to seven years to build a deepwater rig at a cost of around $700 million. There are only a few companies that have the capital and the expertise to do that.

Ben: Does the price of oil really drive demand in the deepwater space?

Craig Hodges: Deepwater drilling can be problematic when a firm is dealing with the difficulties of extracting oil through 10,000 feet of water and coping with terrible weather off the coasts of politically unfriendly countries. But when oil prices are high enough, some of these gigantic deepwater oil fields can really pay off.

Additionally, technology is allowing oil companies a greater degree of comfort in determining whether these deposits are worth the risk of investing in their extraction. Still, high oil prices are necessary for such efforts to be sustained; it’s not economic for firms to do deepwater drilling with oil at $60 per barrel. But at $100 per barrel, we should see as much drilling as the market can bear.

Ben: Can you tell us about a few more of your favorite energy plays?

Craig Hodges: Halliburton is one of my favorite large-cap names because it’s a play on the domestic drilling business. We’re making some remarkable energy discoveries in the US and the new shale plays in places like South Dakota are tremendous.

Although it’s a controversial method, fracking enables us to extract energy deposits from these shale plays, and Halliburton is the Cadillac of the fracking business. Companies that spend millions of dollars to develop a well won’t waste their time with the lowest-cost bidder. When they want the very best expertise brought to bear, they hire Halliburton.

At the moment, there is so much demand for fracking services, that firms with new drilling prospects are waiting four or five months for a fracking crew. Of course, Halliburton has other aspects to its business beyond fracking, but it is well positioned in the domestic drilling business. And if there’s turnover in the White House, a different administration maybe more amenable to developing our domestic resources.

In the deepwater arena, Transocean is my favorite play. It has 50 percent of the world’s deepwater rigs, and once there’s a shortage of rigs, their day rates should skyrocket. That excess cash should drop directly to the company’s bottom line and drive their earnings growth. Transocean also offers investors a 5.5 percent dividend yield while they wait for the stock to appreciate.

Ben: Do Halliburton and Transocean face any liability from their involvement int the BP oil spill in the Gulf of Mexico?

Craig Hodges: I think there is a discount in the shares of both companies since they still have the taint of association with the BP spill. But lawyers who have expertise in this arena say it’s unlikely that these two firms have any liability for what transpired.

The contracts used in their business are standard for the industry and they basically indemnify anyone but the operator–in this case BP–from any liability. Under those contracts, BP tells Transocean and Halliburton exactly what to do and how and when to do it, so BP bears all the legal risk. And we haven’t seen any of these contracts abrogated for such problems in the past. So this unfair stigma is actually an opportunity for investors.

Ben: Are there any other energy plays you find compelling?

Craig Hodges: Many people are familiar with Chesapeake Energy (NYSE: CHK) and its CEO Aubrey McClendon, who is a bit of a lightning rod. Chesapeake was started by McClendon and Tom Ward. McClendon was the sizzle and Ward was the steak. Ward’s not very high profile, but he’s a very good land man and a very good executive with a lot of credibility. He’s easily one of the best in the business.

SandRidge Energy (NYSE: SD) was founded by Ward in 2007, so it’s similar to Chesapeake. About three years ago, natural gas accounted for roughly 80 percent of the firm’s production. As an example of how effective Ward is as an operator, he realized there was a glut of natural gas that would make it unprofitable for his firm to maintain this production mix. While other companies like Chesapeake maintained their focus on natural gas production, Ward reoriented SandRidge’s production so that it’s now 80 percent oil. Investors haven’t realized that yet.

SandRidge has acquired a huge tract of land in Oklahoma called the Mississippi Lime play and is the leader in that geography with over 1 million acres. The firm is also drilling a lot of shallow wells in the Permian Basin. These are all low risk, inexpensive wells. Ward is borrowing money to drill them, but has earned 80 percent to 90 percent returns on these wells.

From the start, Ward has done everything he’s promised. But there are a lot of people who doubt that he can continue his aggressive drilling because the company has borrowed substantial amounts of money. There’s some merit to that argument because the firm is unable to develop all its plays due to its capital expenditures.

But Ward has mapped out a clear, sensible financing plan for future drilling. We think his strategy will be proven right. So it’s a controversial play, but I think it makes a lot of sense, particularly at current prices.