In Down Mexico Way, a Flash Alert issued on October 19, I recommended Seahawk Drilling (NSDQ: HAWK) as a trade on a rally in natural gas prices into 2010 and a gradual recovery in conditions in the shallow-water Gulf of Mexico jackup market. I added the stock to the aggressive Gushers Portfolio.

As I stated when I initially recommended the stock, this pick was a short-term trade, not a long-term investment. Further, given the volatility in the stock, I set a stop-loss order to protect our downside and recommended that investors take out a smaller position. On Friday Seahawk traded through that recommended stop.

Although I am never pleased to see a stock stopped out of the portfolio for a loss, stops are a useful and necessary risk management tool. I will occasionally recommend large-capitalization stocks in the portfolio without stops, but I always set these orders on smaller-cap names to protect downside. I have found that stops often protect us from even greater downside.

There is no real fundamental basis for the high volume selloff that hit Seahawk’s stock on Friday. The company reported earnings more than a week ago and the report met expectations. Management’s comments supported my thesis that the shallow-water drilling market in the Gulf of Mexico remains depressed but is showing early signs of recovery.

In particular, Seahawk noted that it had extended contracts on some of its rigs at day-rates in the $35,000 a day range. That’s not a great rate but it’s above breakeven and does not suggest that there has been any downside in the rates jackup operators charge in the Gulf. 

There are four potential catalysts for Friday’s selloff. First, most energy-levered stocks sold off in the final two days of the week due to a minor correction in crude back to the mid-$70s a barrel and spillover from some weaker-than-expected US economic data. The 6.5 percent correction for the Philadelphia Oil Services Index in the second half of the week looks like a normal pullback for an index that’s up 20 percent since mid-year. As I noted in the past two issues of The Energy Strategist, I continue to regard such corrections as buying opportunities.

Second, Baker Hughes reported a minor dip in gas-focused rigs counts, suggesting a slowdown in US gas-drilling activity. That’s not entirely surprising: Gas prices, though well off their lows, remain depressed. If history is any guide, the rig count will trade sideways for a few months; rig counts will likely remain volatile from week to week. The important point is that the rig count has bottomed.

Third, the Mexican national oil company (NOC) Pemex is still finalizing its budget for 2010–including how many jackup rigs it will need next year. Because Pemex is a key customer for Seahawk, traders are nervous about the budget. This might also explain the weakness in shares of Weatherford International (NYSE: WFT) over the past week–as I noted in the most recent issue of TES, investors remain overly pessimistic about the prospects for Weatherford’s Chicontepec contract in Mexico.

Finally, Seahawk was spun-off from Pride International (NYSE: PDE) in August, which means that many institutional investors holding Pride got shares in Seahawk and might have looked to monetize that stake. Some undoubtedly bought Pride as a play on deepwater drilling and may have sold Seahawk to invest in a deepwater focused driller such as Seadrill (OTC: SDRLF), Transocean (NYSE: RIG) or Noble Corp (NYSE: NE). Some institutional selling is likely behind the volume spike on Friday.

My bullish thesis in the stock looks to be intact but given the extreme volume and activity in Seahawk Friday, I recommend standing aside from this trade for now. As a rule, when stopped out of a stock for a loss I like to wait a few days to consider any changes in fundamentals before reentering. Stay out of Seahawk, I will issue another Flash Alert or discuss the stock at length in a future issue when I believe it’s prudent to buy the stock again.

Also, please note that I recommended selling out of Hess (NYSE: HES) and taking profits in Dril-Quip (NYSE: DRQ) in last week’s issue. If you haven’t done so already, please consider selling these two positions to book significant gains and investing the proceeds in the other TES recommendations.