Editor’s Note: Because there are five Wednesdays in December, the next installment of The Energy Strategist will come out December 23. But energy markets move fast and don’t wait for our production breaks. Here’s Elliott’s take on Exxon Mobil’s (NYSE: XOM) proposed purchase of XTO Energy (NYSE: XTO) and his outlook for future acquisition activity in the energy patch.

In This Alert

The Stories

A single deal often catalyzes a wave of mergers and acquisitions (M&A). Exxon Mobil’s (NYSE: XOM) proposed purchase of XTO Energy (NYSE: XTO) will likely spur an uptick in M&A activity. See Opening the Floodgates.

This acceleration in M&A activity won’t be limited to the natural gas industry. See Beyond Gas.

Here are my top ten picks to take advantage of the coming wave in M&A activity. See The Picks.

The Stocks

Petrohawk Energy (NYSE: HK)
EOG Resources (NYSE: EOG)
Range Resources (NYSE: RRC)
Chesapeake Energy (NYSE: CHK)
Chesapeake Series D Convertible Preferred (NYSE: CHK D, CUSIP: 165167842)
EnCana Corp (NYSE: ECA)
Southwestern Energy (NYSE: SWN)
Devon Energy (NYSE: DVN)
Smith International (NYSE: SII)
Weatherford International (NYSE: WFT)
Macarthur Coal (Australia: MCC; OTC: MACDF)

In December 1998 Exxon, the largest oil company in the world, announced plans to take over Mobil, the world’s No. 2, in an all-stock deal worth $81 billion.

Investors predictably cringed: Integrating two companies of that size presents myriad complications, and the US and EU authorities were certain to raise concerns about the deal’s impact on competition. Financial history is littered with tales of mega-mergers that ended up destroying value for shareholders.

But the deal that created Exxon Mobil (NYSE: XOM) offered a multi-billion dollar windfall for shareholders of both the acquiring and target firms. Predictably, shareholders in the target firm benefited first; Mobil shareholders scored a more than 20 percent return the day Exxon announced the proposed transaction.

However, Exxon shareholders benefited as well. Although Exxon divested 2,400 gasoline service stations to satisfy antitrust concerns, issued shares to fund the deal and assumed more than $5 billion in debt, the combined firm has been a profit powerhouse ever since. In the decade after the deal was announced, ExxonMobil generated an annualized return of 10.5 percent, trouncing the S&P 500’s 1.4 percent annualized loss and the S&P 500 Energy Index’s 9.9 percent gain over the same time period. 

Chevron’s (NYSE: CVX) acquisition of Texaco in a $45 billion all-stock deal in October 2001 is another massive deal that’s generated solid returns. The deal handed Texaco shareholders a quick 25 percent windfall and Chevron holders a near 11 percent annualized gain since it closed–significantly better than the S&P 500’s 2.4 percent gain over the same timeframe. 

The energy industry has long been a hotbed of merger and acquisition (M&A) activity. And unlike deals in most other sectors, energy M&A has often created value for shareholders, even when deals are complex and involve mega-cap multinational firms. Bigger is quite often better in the energy industry, and the dreaded buyer’s curse isn’t a foregone conclusion.

Better still are deals between large energy firms and smaller competitors; energy behemoths are willing to pay hefty premiums to purchase valuable reserves or key oilfield technologies.

Case in point: BG Group’s (UK: BG; OTC: BRGYY) acquisition of Australia’s Queensland Gas Company in October 2008 amid a global financial crisis. Queensland Gas Company produces coal-bed methane (CBM) gas from Australian coal seams. BG bought the firm with the intention of exporting the gas in the form of liquefied natural gas (LNG) and paid a nearly 70-percent premium to acquire the Queensland Gas Company.

Though it’s by no means a comprehensive list, here’s a table showing some notable deals involving energy firms over the past 18 months.


Source: Bloomberg

One point to note about this table is that the announced premium column vastly understates true profits from M&A activity; rumors often circulate that a firm is “in play” long before a takeover is actually announced. Stocks that are thought to be likely targets routinely run up significantly in price long before the deal is formally announced. This was the case with both TEPPCO Partners, acquired by Enterprise Products Partners (NYSE: EPD), and Felix Resources, acquired by Yanzhou Coal (NYSE: YZC) this year.

Of course, the financial crisis of 2008 hit M&A activity across all market sectors; with credit markets on life support, potential acquirers couldn’t obtain the financing to make bids. And falling commodity prices focused most energy firms on maintaining profit margins rather than expanding their businesses.

But in 2009 merger mania kicked off in earnest in the energy patch. Credit markets have reopened, and companies with solid credit ratings are able to borrow money at even lower rates than was possible before Lehman Brothers collapsed in September 2008.

And the rapid fall in oil, natural gas, coal and uranium prices after mid-2008 has temporarily lowered valuations for firms involved in a wide variety of energy-related businesses. That means potential acquirers have a once-in-a-decade opportunity to snap up the sector’s best-placed firms at a fraction of what they would have cost at the cycle’s top.  

Opening the Floodgates

M&A activity often comes in waves with a single deal acting as a catalyst and blueprint for similar transactions. In 1999 Exxon’s takeover of Mobil was undoubtedly one factor behind Chevron’s takeover of Texaco and the merger of Conoco and Phillips Petroleum in 2001. After all, no energy executive wants to get left out while their competitors take advantage of bargains and expand into new markets.

A series of recent deals across a wide swathe of energy-focused sectors are setting up 2010 as another big year for M&A activity. Once again, ExxonMobil is a primary instigator.

On Dec. 14, 2009, Exxon Mobil offered 0.7098 of its common shares for each share of long-time The Energy Strategist Portfolio recommendation XTO Energy (NYSE: XTO). The all-stock deal valued XTO at more than $31 billion, and Exxon is assuming $10 billion of XTO’s debt.

XTO Energy is a US-based producer that focuses on natural gas. XTO’s core competence is in the production of so-called unconventional natural gas fields, the key source of growth in US gas production. Broadly speaking, the term unconventional–or nonconventional–refers to any field that can’t be produced economically using traditional well technologies.

Two techniques have revolutionized unconventional field production: horizontal drilling and fracturing. By drilling horizontally through unconventional rock formations, producers can expose more of their well to productive zones.

And increasingly effective fracturing techniques allow producers to vastly improve the permeability of unconventional fields, which makes it easier for gas in a reservoir to flow into a well. Most of my favorite plays on natural gas are either directly or indirectly related to unconventional reserves in the US.

For the past few years I’ve written about the importance of the US unconventional natural gas plays such as the Barnett Shale of Texas, the Marcellus in Appalachia and the Haynesville Shale in Louisiana. The buyout of XTO validates the value of these plays; Exxon Mobil is not known to waste money and clearly views US unconventional gas as an important and strategic growth business.

The deal also suggests that Exxon is bullish on the longer-term prospects for natural gas. Clean burning natural gas is a quick and relatively inexpensive way to reduce emissions of carbon dioxide and several other pollutants. Moreover, unlike oil, the US boasts an abundance of natural gas; even if the US ramps up gas-fired electricity generation and starts using gas as a transportation fuel, there’s plenty of gas in North America to supply those needs. 

The deal effectively increases the value of all US-focused natural gas companies with exposure to unconventional fields. I also suspect that other integrated oil companies–notably BP (NYSE: BP)–have been on the hunt for acquisition targets; this deal might force their hands, prompting them to put together a similar bid sooner rather than later.

Before buying XTO, Exxon partnered with the producer on a field in Colorado; cooperation was undoubtedly a factor in making Exxon’s management team comfortable with XTO’s business. But Exxon isn’t the only international integrated energy giant partnering with smaller US-based exploration and production (E&P) firms. Just as Exxon’s venture with XTO helped seal their December mega-deal, other joint ventures could turn into outright acquisitions in coming months.

That means that any US gas producer with attractive exposure to major unconventional natural gas plays and experience producing them is a potential target.

Beyond Gas

The XTO-Exxon transaction has dominated the headlines, and unconventional natural gas is likely to be a hotbed of M&A activity over the next few quarters. But other energy sectors are worth watching; we’ve also seen important deals in the coal and oil services industry this year. I also expect acquisition activity in these sectors to accelerate next year.

Yanzhou Coal’s (NYSE: YZC) acquisition of former TES recommendation Felix Resources finally closed in mid-December. Some observers worried that Australian authorities would attempt to block the deal over concerns about Chinese companies buying up Australian resources. But Australian-Chinese relations have improved markedly since the midyear, and it’s clear that both countries benefit from cross-broader trade; strong demand for Australian commodities kept Australia out of recession amid the worst downturn for the global economy in decades.

China also needs Australia’s vast natural resources to feed its growing economy. And one of the most important resources of all is coal, both thermal coal used in power plants and metallurgical (met) coal used in steelmaking. Felix Resources produces both types of coal and has significant production growth potential thanks to expansions underway at its Yarrabee and Moorlarben mines in Queensland.

Although the media tends to focus on China, India is a market that gets far too little attention from investors. But India is also a major consumer of coal and needs to build considerable capacity to meet growing demand for electricity. Indian officials state that the nation will need to import as much as 200 million additional tons of coal over the next five years, making the country the world’s fastest growing importer. Australian coal will fill much of this gap, making fast-growing producers in the country even more valuable as takeover targets.

And there’s also potential for significant deal-making activity in the oil- and gas-services business. Increasingly, national oil companies (NOCs) are hiring the big oil-services firms to manage entire projects for them, a business known as integrated project management (IPM). These are profitable multi-year projects and firms with competency in a wide range of service functions have a big leg-up in winning such deals.

And don’t make the mistake of assuming that the oil business is low tech. Consider that deepwater producers are currently drilling wells as long as 35,000 feet in waters more than a mile deep. Temperatures in a deepwater oilfield can exceed 300 degrees Fahrenheit (150 degrees Celsius) and pressures can top 10,000 pounds per square inch (psi); for comparison, normal atmospheric pressure on Earth at sea-level is just 14.7 psi. And in some cases corrosive compounds are found naturally occurring with oil and gas, chemicals that eat away at pipes over time.

Successfully drilling and producing from such a well requires the use of advanced technologies; integration in the oilfield services business is often driven by a desire to acquire a key technology or beef up capacity in an important business line.

Bottom line: With credit market conditions easing throughout 2009 and valuations still well off their cyclical highs, the energy sector has been primed for merger mania for some time. The recent XTO-Exxon announcement is the sort of deal that acts as an accelerant; I expect a boom in M&A activity next year. Here’s a rundown of 10 potential targets for 2010.

The Picks

Petrohawk Energy (NYSE: HK) has solid acreage positions in three key US shale plays: The Fayetteville Shale of Arkansas, the Haynesville Shale of Louisiana and the Eagle Ford Shale of southern Texas. Of late, the company has added acreage aggressively in the latter two plays.

The Haynesville Shale currently dominates Petrohawk’s production, accounting for more than 40 percent of its total output. The firm has around 345,000 net acres of land in this region and estimates that the property could hold some 15.7 trillion cubic feet in total resource potential. Petrohawk has currently booked just 160 billion cubic feet (bcf) in proved reserves in the Haynesville; there’s plenty of upside as the company continues to drill aggressively in the region–each new well allows is booked as additional proved reserves.

Alongside the much-larger Chesapeake Energy (NYSE: CHK), Petrohawk is one of the biggest landholders in the Haynesville. And the company’s average well in the Haynesville showed an initial production (IP) rate of more than 18 million cubit feet of gas per day. This high IP rate indicates that Petrohawk’s wells are being drilled in the highest-return part of the play; the company has assembled prime acreage–not low-quality properties near the periphery of the Haynesville.

And the Haynesville is one of the few big US shale plays that’s profitable with gas prices near current depressed levels. With $900 million budgeted in capital spending on Haynesville in 2010, Petrohawk should have plenty of additional well results to report that will allow it to book more reserves in this play.

The Eagle Ford shale play is newer and less proven than Haynesville, but the early drilling results are promising and it’s shaping up to be a low-cost play. Petrohawk has 225,000 net acres and has identified 2,700 potential drilling locations. And Petrohawk has budgeted $350 million in spending on this play for 2010; additional well results play should help Petrohawk prove the value of its acreage in the region.

Any producer seeking to boost its position in the core of two of the most-discussed shale gas plays would find Petrohawk a tempting target. And with a total enterprise value (the market value of stock and all debt) of less than $10 billion, Petrohawk represents an easy target for a host of integrated oil companies and larger independents. Buy Petrohawk under 30.

EOG Resources (NYSE: EOG) is traditionally regarded as a US-focused producer of natural gas. However, the company’s recent activity has sought to boost production of crude oil and natural gas liquids (NGLs).

For several quarters management has forecasted that the firm’s production would be roughly an even split between natural gas and liquids; in EOG’s November 6 conference call, management noted that it should achieve this mix between 2011 and 2012. EOG expects oil and NGLs to account for 44 percent of its production mix in 2010, up from 36 percent in 2009. Overall EOG is looking to grow its liquids production an astounding 50 percent in 2010, while boosting gas output by just 3 percent. This strategy should pay off for EOG, as crude oil currently offers a far superior return on investment to natural gas.

EOG’s outlook for the North American gas market is broadly in-line with my own; management stated that it expects its natural gas business to begin the year weak but end the year strong. As a result, EOG’s plan to produce 3 percent more gas in 2010 consists of flat production year-over-year in the first half of the year, followed by 6 percent annualized growth in the second half. Much of this additional production will come from the Haynesville Shale of Louisiana and East Texas, one of the cheapest-to-produce and most prolific fields in the US.

EOG boasts an impressive slate of unconventional oil-focused plays in the US. The most unique is a field EOG calls its Barnett Combo play, located in the northern reaches of the Barnett Shale play near Fort Worth Texas. Most of the Barnett produces gas, but EOG has identified a swath of 90,000 acres that produces oil.

EOG made a 7,800-acre acquisition during the quarter, and management believes it has acquired the majority of the productive acreage. Now that the property is secured, the executive team provided detailed information on the Barnett Combo play for the first time.

In the eastern half of the play, the productive layer of shale is about 700 to 1,500 feet thick; EOG has sunk cheap-to-drill vertical wells spaced about 20 acres apart. Two of its recent wells in this part of the play showed initial oil production rates of 1,067 and 450 barrels per day, along with as much as 2.1 million cubic feet of NGL-rich natural gas.

In areas where the shale is thinner, EOG is sinking horizontal wells that drill down to the productive layer of the shale and then penetrate sideways through that layer, exposing more of the well to the oil-producing rock. These wells should produce similar IP rates to the vertical wells in the Barnett Combo’s thicker sections. All told, EOG believes that with crude oil trading between USD75 and USD80 a barrel, wells in the Barnett Combo should generate about a 70 percent return on investment.

The Bakken shale offers an even higher return on investment than the Barnett Combo play. In the North Dakotan core of this play, wells produce at an initial rate of about 1,000 barrels per day and generate an after-tax return on investment of 100 percent. Wells drilled just outside the core region offer lower initial production–500 to 900 barrels per day– but still produce a solid 35 percent return.

Other emerging oil plays include the Cleveland oil play in the Texas Panhandle and the Waskada oil project in Manitoba. Management noted that these plays yield after-tax returns of between 35 and 70 percent but offered less additional information–likely because the company is pursuing additional acreage and doesn’t want to tip its hand.

Although production from the aforementioned wells pales in comparison to some overseas wells, investors should consider that they’re among the most productive new wells drilled onshore in North American in decades. At the same time, don’t fall for the hype you’ll hear spouted from some commentators–the Bakken and Barnett Combo plays will never produce enough oil to make the US energy independent. But these plays certainly will flow enough oil to keep EOG’s production and bottom line growing for years to come.

And consider that XTO was also a player in the Bakken shale–international integrated oil companies may also be interested in exploring US unconventional oil plays. With exposure to attractive unconventional natural gas and oil plays, EOG offers a potential acquirer significant value. The stock rates a buy under 105.

Range Resources (NYSE: RRC) is a leading player in the red-hot Marcellus Shale located in Appalachia; in fact, the company drilled the first commercial well in the play back in 2004.

As a first mover, Range has also amassed one of the most extensive acreage positions in the play–a total of 1.4 million acres of potential Marcellus acreage and around 900,000 acres located in what’s thought to be the most productive core of the play, primarily in Pennsylvania. In total Range believes its potential resources in Marcellus could be as high as 22 trillion cubic feet of natural gas.

Currently Range produces over 80 million cubic feet of gas per day from the Marcellus and plans to end the year generating around 100 million cubic feet per day. In each of the next two years Range plans to double its production from Marcellus to a total of 200 million cubic feet per day by the end of 2010 and 400 million in 2011. To put that into perspective it’s 40 times what Range was producing from the Marcellus at the end of 2007.

Well economics in the Marcellus are among the best of any of the major US shale plays, particularly for wells drilled in the Pennsylvania core areas. Range estimates that at a gas price of $6 per million British thermal units, it can produce a return on investment of 64 percent in its core Marcellus acreage.

And, a good portion of Range’s Marcellus production is wet gas–natural gas that contains a high percentage of natural gas liquids (NGLs). Because NGLs typically sell for prices closer to crude oil than natural gas, Range’s realized prices are higher than the current NYMEX natural gas quotations would suggest.

Although Marcellus is Range’s most talked-about play, the company also has a solid acreage position in the Barnett Shale play in Texas, the most extensively developed gas shale play in the US. And Range is drilling the Nora play, another unconventional field in southwestern Virginia. Management estimates that the field contains over 2.3 trillion cubic feet of potential resources and has reported solid well economics.

Any company looking for an experienced operator in Marcellus with extensive acreage would find Range a tempting target. Buy Range Resources under 60.

With an enterprise value of more than $28 billion, Chesapeake Energy (NYSE: CHK) would be a mouthful for any acquirer but is certainly well within the reach of a host of integrated oil companies.

Chesapeake has significant acreage in all of the major US natural gas shale plays and is one of the country’s largest producers and most active drillers. In the third quarter, Chesapeake produced nearly 2.3 bcf of gas per day and drilled one out of every eight gas wells in the country. Chesapeake’s total reserves top 12 trillion cubic feet, and management sees upside to as much as 62 trillion cubic feet of potential resources.

Chesapeake is the largest acreage holder in the Haynesville Shale with more than half a million acres and in Marcellus with 1.5 million acres. The company also ranks second in both the Barnett Shale and Fayetteville Shale regions; Chesapeake typically targets the core areas of its major plays.

And Chesapeake has experience partnering with integrated oil companies that might ultimately become acquirers. In the Marcellus, Chesapeake has a joint venture arrangement with Statoil (NYSE: STO) of Norway, an energy giant with an $80 billion market capitalization. And in the Fayetteville Shale of Arkansas Chesapeake has a joint venture ongoing with BP (NYSE: BP).

Investors can purchase Chesapeake’s common shares or Chesapeake Series D Convertible Preferred (NYSE: CHK D, CUSIP: 165167842). This convertible preferred pays a USD4.50 annual dividend in four installments.

Based on the current price, the preferred offers an annualized yield of roughly 5.5 percent. Holders of the convertibles can exchange their preferred shares for 2.265 shares of Chesapeake common stock at any time.

Because of the convertible option, the preferred tends to track the basic performance of Chesapeake’s common shares over time. In fact, the preferred topped out over the summer at more than USD170 when Chesapeake was trading north of USD70 per share. The preferred offers investors a chance to earn a solid 5.5 percent yield and capture significant upside potential in the event of a takeover. Buy Chesapeake Energy’s common shares under USD32 and the preferred shares under 100.

On Nov. 30, 2009, EnCana Corporation split into two energy firms, EnCana Corp (NYSE: ECA), which focuses on natural gas, and Cenovus Energy (TSX: CVE), an oil and refining firm. The former, now firmly focused on natural gas, would be a tempting acquisition target due to its exposure to the Haynesville, Montney and Horn River gas shale plays.

I’ve discussed the Haynesville with reference to several other firms in this report, so I won’t belabor the point. Suffice it to say that Encana has 435,000 acres in the play, though not all of it is in the Louisiana core. Its initial production rate of around 10 million cubic feet from a Haynesville well isn’t as high as some of the rates achieved by Petrohawk and Chesapeake but is still respectable.

The Montney and Horn River shales are located in Canada, primarily in the province of British Columbia. Although neither is as fully developed as the big US shale, both are potentially enormous plays, and Encana holds sizeable land positions in both.

And EnCana also partners with other firms on several of its developments. In the Horn River shale, the company is working with US independent producer Apache (NYSE: APA); in the Haynesville shale, EnCana is working with international oil giant Shell (NYSE: RDS.A). Buy EnCana Corp’s US-traded shares under 35.

Southwestern Energy (NYSE: SWN) has a small position in the Marcellus shale of Northeastern Pennsylvania, but its biggest growth potential is likely to come from the Fayetteville shale, located primarily in Arkansas. The Fayetteville doesn’t receive as much attention from the media as the Marcellus and Haynesville, but that’s unfair–it’s a smaller play but offers some of the most attractive economics of any of the gas shale. 

Southwestern put close to three-quarters of its 2009 budget into drilling its 875,000 acres in the Fayetteville shale. Over time Southwestern has gained considerable experience in the Fayetteville, and its well performance is improving; on average, the initial production rate for Southwestern’s Fayetteville wells has tripled since the first quarter of 2007.  Southwestern drilled more than 300 wells in the first nine months of 2009, and midway through the fourth quarter production topped 1.2 billion cubic feet per day–up from less than 700 million in late 2008.

Southwestern’s Marcellus operations are in their infancy, though the firm has reported positive initial drilling results. And in the Haynesville shale, Southwestern’s acreage is mainly on the less-productive East Texas side of the play. That being said, the firm has drilled four wells this year in the play and has experienced IP rates as high as 16.7 million cubic feet per day. Buy Southwestern Energy under USD55.

Devon Energy (NYSE: DVN) is primarily a North America-focused play, and natural gas accounts for roughly two-thirds of its production. Although 94 percent of its production currently comes from North America, Devon has invested in projects in the deepwater Gulf of Mexico and offshore Brazil. In both markets, Devon has reported some major successes.

But in November Devon announced that it plans to sell most of its oil and natural gas exploration and production assets outside North America in an effort to focus its attention on onshore plays in the US and Canada. Because its international operations have been largely a success, Devon should be able to generate significant value by selling those assets. Management estimates that by year-end 2010 it could net after-tax proceeds of between $4.5 and $7.5 billion from these sales; I suspect that if oil prices remain near current levels and interest in deepwater remains strong (likely on both counts), Devon will garner proceeds closer to the top of that range.

In addition to outright proceeds from selling assets, deepwater developments are capital intensive; refocusing its operations will free up significant cash to focus on core domestic activities.

Devon is the largest natural gas producer in the Barnett shale of Texas. The Barnett was the first major US shale play to be produced and acted as the blueprint and “proof of concept” for the entire shale gas industry as we know it today. Drilling activity has slowed in the Barnett of late, mainly because gas drilling in the Barnett is less economic than in some of the other shale plays.

However, Devon benefits from its early entry in the Barnett, paying less for its leases than many competitors. In addition, the vast majority of its acreage is located in the core of the play where production costs are lower. Given its existing infrastructure in Barnett, top-notch acreage position and experience, Devon’s breakeven cost in the Barnett is lower than most producers, and the company’s average reserves booked per well exceeds that of any other major producers.

The firm plans to accelerate Barnett drilling activity in 2010, sinking 85 more wells than in 2009. Bottom line: Devon’s Barnett production is likely to grow and is economic even at low gas prices.

Devon also holds significant acreage in the Haynesville shale. On the less productive east Texas side of the play, Devon controls 110,000 acres and estimates that the property contains 4 trillion cubic feet of potential resources. And in the southern part of the play–across parts of Texas and Louisiana–Devon has a further 47,000 acres. The firm plans to drill around 65 wells across its Haynesville acreage in 2010, a move that will help it book proven reserves in the Haynesville.

The Woodford Shale tends to have a higher breakeven cost than the other major US shale. However, just as with the Barnett, Devon was an early mover in the play and enjoys a lower cost of production. In 2010 the firm plans to drill 80 new wells. Production stands at 53 million cubic feet equivalent per day and should grow steadily as Devon drills new wells.

And Devon, like Encana, has significant Canadian exposure. On the gas side of the equation, the firm has acreage in the Horn River Basin play, where it has drilled 5 wells to date. Devon also has exposure to oil via its Jackfish 1 and Jackfish 2 oil sands projects in Alberta. The first stage of Jackfish is currently churning out 35,000 barrels of oil per day and the second stage of the project is expected to come online in 2011.

Devon has exposure to several of the best North American gas shale plays and should be able to significantly expand its footprint following planned asset divestitures. Buy Devon under 76.

On the oil services front, my top M&A pick is Smith International (NYSE: SII). Smith could be a tempting takeover target for a larger services firm.

Alternatively, Smith would benefit immensely from making an acquisition of its own. Smith has recently raised billions of dollars in capital and looks poised to acquire the 40 percent stake in its MI-SWACO unit that it does not own. If Smith does make that acquisition it would become a dominant force in the red-hot deepwater drilling market, opening up significant upside potential for its stock.

Smith generated revenue from three main divisions: M-I Swaco (47 percent), Distribution (25 percent) and Smith Oilfield (28 percent).  

By far the biggest and most important business on this list is MI-SWACO, a joint venture 40 percent owned by Schlumberger (NYSE: SLB) and 60 percent by Smith. MI-SWACO is a leader in drilling fluids and related systems.

In modern drilling operations, producers use what’s known as a circulating mud system. When drilling for oil or gas, drillers pump a substance known as drilling mud into the well. Originally, drilling fluids were made quite literally of mud; the story goes that early operators in Texas had cattle walk through puddles to produce the mud they needed.

Nowadays, fluids are far more complex. The purpose of drilling mud is to offset the natural underground pressure of the hydrocarbons in the reservoir. In other words, the pressure of the mud in the well helps prevent oil from rushing into the well and gushing out the top of the well bore. In addition, drilling mud picks up debris and rock shavings that are generated while drilling and lubricate and cool the drill bit. Mud literally circulates, moving down the drill pipe, through the drill bit, and back to the surface.

The mud circulating system pumps the mud under pressure down the well and then processes and removes impurities from the mud so that it can be recycled down the well.

Although this sounds like a rather simple operation on paper, it’s a far more complex proposition in offshore and deepwater fields where pressures and temperatures encountered are far higher than in traditional onshore operations. Obtaining the proper weight and composition of the drilling mud is important and can impact the productivity of the well and the speed and efficiency of the drilling operation. And when you consider that it can cost an operator more than $600,000 per day just to rent a rig to drill a deepwater well, time savings equals real money in the bank.

MI-SWACO dominates this business and in 2009 was awarded 77 percent of all contracts for deepwater fluids.  Given its leadership in the premium offshore fluids business and the coming expansion in deepwater drilling activity over the next few years, Smith’s fluids business has significant growth potential.

Smith’s other two business units are solid, though less compelling than MI-SWACO. The company’s oilfield segment sells drill bits, assorted drilling tools and tubular products used in well construction. A drop-off in North American gas drilling activity hit the division’s revenues over the past year, though the international side of the operation appears to be stabilizing and, perhaps, turning positive again.

The distribution business involves selling basic drilling products via a network of supply branches across North America. More than 95 percent of revenues are from North America, so this segment was the hardest hit by the slowdown in US and Canadian drilling activity. A pick-up in activity is likely, as gas prices recover in 2010; solid growth in unconventional gas drilling should help stabilize this business.

Companies never get as much credit for joint ventures as they do for owning a key business outright; Smith’s shares would likely receive a significant boost if it purchased the minority stake in the MI-SWACO joint venture from Schlumberger. In addition, outright ownership of MI-SWACO would make Smith a far more attractive takeover candidate.

With a total enterprise value of just $8 billion, Smith is a second-tier services companies that isn’t in the same league as Schlumberger, Halliburton (NYSE: HAL) or even Weatherford (NYSE: WFT). However, MI-SWACO would be a valuable business line for almost any of the other services companies; owning the premier offshore fluids business would give a services firm a leg up in bidding on offshore contracts.

Smith’s shares were punished recently when the company announced a secondary offering of 28 million new shares priced at $26.50 per share. Management stated the proceeds were earmarked for debt repayment and acquisition opportunities. In addition to that $750 million cash raise, Smith also arranged a new $1 billion credit facility this month.

It certainly appears Smith is taking advantage of strong capital markets to build a war chest of cash and unused debt facilities. I suspect that the company is trying to put together a deal to buy out MI-SWACO. Buy Smith International under 35. 

With an enterprise value over 18 billion, Weatherford International (NYSE: WFT) is a large firm but pales in comparison to Schlumberger and Halliburton. 

Weatherford is perhaps best known as an expert provider of services related to mature oilfields. Traditionally, Weatherford has had a strong presence in North American, particularly in Canada. North American oilfields have been extensively developed for decades and, in some cases, over a century. It shouldn’t come as a huge surprise that North America has been a proving ground for all sorts of technologies that squeeze oil from older fields. An example is underbalanced drilling, a technique that prevents damage to mature fields.

Weatherford’s genius in recent years has been to take homegrown North American technologies and sell them internationally. The firm has gradually lessened its exposure to North America and forged into international markets where profit margins are higher and profitability cycles less severe.

This trend has accelerated in recent quarters. As with most oil services firms, Weatherford’s North American business has been hit hard, particularly services related to drilling in conventional fields in Canada. As a result of low profitability, Weatherford has aggressively downsized its North American operations to maintain profitability.

Weatherford also wins points for expanding its business in Russia, a key market for both oil and natural gas production. Specifically, Weatherford purchased the oil services business of TNK-BP, BP’s joint venture in Russia. This service business has historically been dedicated to serving the joint venture, but Weatherford will now be able to market the same services to other firms in Russia.

Weatherford’s stock has significantly underperformed the rest of the oil services industry since October, primarily due to concerns about Weatherford’s Chicontepec contract in Mexico. Chicontepec is a heavy oilfield that is the centerpiece of Petroleos Mexicanos’ (PEMEX) strategy to stabilize and grow oil production.

The problem PEMEX faces is that production from its largest field, the offshore Cantarell oilfield, has fallen off rapidly in recent years to the point that Mexico’s oil exports have tumbled. According to a company presentation from October 2009, the company forecasts that total crude oil production will fall by 200,000 barrels per day in 2010 to just 2.5 million barrels per day. Thos drop-off in production translates directly into lower exports, which are projected to fall to 1.1 million barrels per day in 2010–a painful decline when you consider current oil prices.

Chicontepec was expected to offset this production decline, as it’s one of the largest relatively untapped reserves of crude left in Mexico. But despite drilling aggressively and spending billions, Chicontepec production was still less than 30,000 barrels per day in September–well under PEMEX’s expectation of 100,000 barrels per day.

Accordingly, PEMEX has decided to reexamine its development plans for Chicontepec and has cut investment in the field 22 percent in its 2010 budget, boosting spending on Cantarell instead. Because Weatherford is a big player in Chicontepec, its stock has fallen.

Although PEMEX’s recent announcements caught the market by surprise and are bad news for companies with significant exposure to Mexico, the selloff that’s hit Weatherford’s shares is overdone.

Mexican oil production is falling fast; the country will have no choice but to bump up spending on Chicontepec. Although it might not be politically popular to spend so much cash on a project that isn’t meeting its targets, the Mexican government gets some 40 percent of its budget from energy exports–it needs to maintain production at all costs.

In addition, PEMEX is known to change its investment plans midyear as conditions warrant. If production continues to plummet, PEMEX would be forced to boost its budget– including bumping up spending in Chicontepec.

Finally, Weatherford is trading at less than 17 times 2010 earnings estimates. This compares favorably to Schlumberger’s stock, which trades at 22.5 times 2010 earnings estimates. Shares of Halliburton and Baker Hughes (NYSE: BHI) trade at 21 times 2010 earnings. Weatherford’s deeply discounted valuation more than prices in all the bad news surrounding Mexico and Chicontepec. 

This temporary weakness also might make Weatherford an appealing target or merger partner for an oil services firm wishing to beef up its competency in the company’s well-regarded service lines. Take advantage of the recent decline to buy Weatherford International under 26.

Macarthur Coal (Australia: MCC; OTC: MACDF) is a Queensland, Australia-based coal miner that’s 22.4 percent owned by CITIC Group, a China-based investment fund that has interests in a long list of commodity plays. Steel plays ArcelorMittal (NYSE: MT) and POSCO (NYSE: PKX) own 16.6 percent and 8.3 percent stakes in the firm, respectively.

Macarthur firm owns a 73.3 percent share of a joint venture controlling the Coppabella and Moorvale mines in Queensland, Australia, which combined produce 6.3 million metric tons of coal annually. In addition, the company owns a 74.6 percent share of the Middlemount Mine Project. These mines have traditionally focused on a type of coal known as pulverized coal injection (PCI) coal.

PCI coal is crushed and injected into steel blast furnaces as a replacement for expensive metallurgical coal; Macarthur’s mines produce roughly one-third of Australia’s exports of PCI-grade coal. This connection to the steel industry is exactly why Asian steel producers have taken an equity interest in Macarthur.

Global steel output collapsed after summer 2008, which, in turn, resulted in falling demand for metallurgical and PCI coal. Not surprisingly, the stock collapsed. Also hurting Macarthur were persistent rumors that the firm was soon to be acquired. As the credit crunch intensified and commodity markets soured, traders marked down the odds of such a bid.

But Macarthur’s business picked up quickly in 2009 thanks to a strong rebound in demand and steel output in Asia. Quarterly sales dropped off sharply in the March quarter but rebounded into midyear as spot sales of coal accelerated. Much of this uptick in spot sales volume was attributable to what Macarthur calls “non-traditional” coal buyers. China falls into this category, having imported 24.5 million metric tons of met coal from Australia through the first nine months of the year–compared to just 1.3 million metric tons in the entirety of 2008.

And the company recently noted that normal contract sales–sales of coal under long-term deals rather than spot contracts–returned to normal levels in September. 

More important, Macarthur ships all of its coal out of the world’s largest coal export port, the Dalrymple Bay Coal terminal (DBCT). The DBCT is currently undergoing a massive expansion project, and Macarthur has been able to secure additional guaranteed export capacity; its total export capacity is set to rise from 5.1 million tons per year to 7.7 million tons.

After 2012 the company will gain additional an additional 3 million tons per year of export capacity. Because a shortage of coal export capacity was a major problem for many miners last year, this is an advantage for Macarthur.

Macarthur’s shares have risen sharply over the past few months but remain well below their 2008 high. I also like that Macarthur partners with CITIC on many of its key mines and new mine exploration projects. This is a sure sign that China sees the value of Macarthur’s mines and is keen to secure access to these resources. Macarthur Coal rates a buy under AUD13.