In the spring of 2003, a contract drilling crew supervised by a small group of British Petroleum (NYSE: BP) engineers began drilling one of the largest reservoirs of oil discovered in the past three decades–a mother lode of over a billion barrels of oil.

This discovery wasn’t made in the Middle East. Nor was this vast reserve found in Russia or West Africa. BP’s Thunder Horse project is located in one of the most developed oil and gas fields in the world–the Gulf of Mexico. Thunder Horse is situated a little over 100 miles offshore of New Orleans.

The interesting thing isn’t the reserve’s location; it’s how deep it’s buried under the sea. The water above the Thunder Horse field is over one mile (6,300 feet) deep. And BP’s drill went even deeper than that, an additional three miles under the sea floor and over a mile horizontally.

Drilling offshore in the Gulf of Mexico is nothing new. Back in 1949, a modified cargo barge was sunk just off the Louisiana Gulf Coast in 18 feet of water. With the barge resting on the bottom, a crew began drilling the first offshore well from a mobile platform. But this well was just the first of many–nowadays the shallow waters of the Gulf are dotted with literally thousands of producing wells and hundreds of mobile drilling rigs.

The US still gets considerable quantities of oil and nearly a third of its natural gas demands from the Gulf. But every year, production of both oil and gas from the region falls; these wells are in the twilight years of production.

Shell’s Auger tension-leg plaform located in 2,600 ft in the Gulf of Mexico.

^{Source: Royal Dutch Shell}

Just a bit further offshore is another story. The fact is that there are other reserves just like Thunder Horse. Most of the largest discoveries made in recent years both in the US and abroad have been in extreme deepwater environments. Of course, these ultra-deep wells pose all sorts of problems for oil companies–it’s much more difficult, expensive and dangerous to drill at such great depths. Despite these obstacles, the big oil companies simply must drill deepwater wells to keep up their production levels.

And deepwater drilling requires highly advanced and specialized equipment. Most deepwater wells require the use of advanced subsea equipment that’s installed directly on the sea floor, sometimes miles underwater. This equipment is in very high demand right now as the big oil companies struggle to develop deepwater reserves.

The two best plays on the booming deepwater drilling market and subsea equipment are FMC Technologies (NYSE: FTI) and Cooper Cameron (NYSE: CAM); I’m adding both stocks to the Wildcatters Portfolio.

Making Deepwater Work

Most investors remember the Exxon Valdez accident nearly 20 years ago. Tens of thousands of barrels of crude pouring out of the Valdez caused an ecological nightmare along the Alaskan coastline; the clean-up bill ran into the billions of dollars.

When drilling in deepwater, operators have to be careful to guard against such spills. The oil and natural gas they’re drilling for is located miles under the ocean and miles further under the sea floor. These hydrocarbons are under huge pressure and exposed to great geological temperatures. The last thing the oil companies want to see is a blowout. Blowouts occur when oil and gas under extreme pressure underground gush out of a well in an uncontrolled manner.

Modern drillers control underground pressures by pumping drilling mud–not actually mud but a complex mixture of clay, chemicals and water or oil– down the well under pressure. The mud helps to keep the oil from gushing back up through the well. The mud also forms a mud cake against the walls of the well hole, keeping oil from bursting through. Drillers vary the density and consistency of the mud–the mud weight–depending upon the pressures experienced underground.

But sometimes the drillers get it wrong. If the mud is too heavy it can drastically impede drilling speed. But if the mud is too light, gas or oil can start moving into the well and towards the surface–what’s known as a kick. As soon as a well kicks, drillers activate what’s known as a blowout preventer (BOP). BOPs are a complex stack of valves and pipes used to block off the entrance of a well and prevent oil or gas from spewing out of the well. BOPs also allow drillers to pump new drilling mud in the well, adjusting the weight to prevent further kicks.

In deepwater drilling, BOPs have to be installed directly on the seafloor. Most deepwater drilling is done from ships that are dynamically positioned–held in place by computer-controlled thrusters–a mile or more above the well itself. There’s no way to control blowouts strictly from the surface.

Once a well is completed, a series of valves, pressure gauges and monitoring equipment is installed on the well to control the rate that oil and gas flows from the well. This system of valves and control equipment is known as a Christmas tree, or simply a tree. Land-based trees can be a relatively simple set of valves and automatic safety equipment that shuts down the well if there’s a breach in the system.

Subsea systems, especially those in deep water, are far more complex. Pressures at 7,000 feet underwater are about 200 times atmospheric pressure at sea level. And as I mentioned above, undersea oil reserves are under tremendous pressure. Subsea systems have to be able to handle that sort of rugged environment. The most advanced designs are capable of handling up to 15,000 pounds per square inch of pressure, roughly 1,000 times atmospheric pressures.

Most deepwater developments involve several wells–sometimes a dozen or more–linked to a single floating production platform. Workers on the platform need to be able to control and monitor each of these subsea trees remotely. Therefore, subsea systems are technologically very advanced.

FMC Technologies is the world leader in subsea Christmas trees and BOPs. And the company has been quickly gaining market share in this segment over the past few years. In 2001, for example, FMC installed about 22 percent of all subsea trees worldwide; last year, the company’s share of the global market jumped to 47 percent. Out of 81 subsea tree contracts awarded in the fourth quarter, FMC installed 38 trees.

FMC has also been involved in some of the most technologically sophisticated deepwater projects in the world. Its Shell Na Kika project in the Gulf of Mexico has officially set the record for the deepest project in the world. The wells in this field range from about 5,800 feet underwater to more than 7,500 feet. The field includes 12 subsea trees and related equipment as well as a subsea production system.

Subsea trees are most definitely not a commodity business. Therefore, FMC’s involvement in the most advanced projects gives it a leg up on competitors when bidding on new advanced deepwater projects.

Outside of subsea, there’s also potential for the company’s loading systems business. FMC makes equipment used to load and unload oil and liquefied natural gas (LNG) tankers. As I outlined in the inaugural issue of The Energy Strategist, LNG will become a prime source of energy by the end of this decade and to meet demand for LNG more LNG terminals, unloading docks and degasification plants will need to be built–FMC fits into that mix. I’m adding FMC to the Wildcatters Portfolio.

The second largest player in the subsea business last year was Cooper Cameron with about a 20 percent share of the subsea market. Like FMC Cameron was involved in several high-profile projects and is considered a leading bidder for deepwater contracts this year. In fact, late last year Cameron won a huge $110 million contract from ChevronTexaco to supply the company’s Tahiti deepwater drilling project in the Gulf of Mexico.

But Cameron is more diversified than FMC–the company currently only derives about a quarter of total revenues from subsea equipment. Cooper’s other main businesses include valves used to control the flow of gas and oil from wells, along pipelines and through processing and refinery facilities. And the company also makes compression units used at natural gas processing facilities and to compress natural gas into underground storage.

The valve and compressor markets are sensitive to overall drilling and production activity. And right now, there is very little spare capacity worldwide for drilling–most drillers are working flat out to meet demand. In listening to conference calls in the first quarter, I’ve heard several companies complain of a lack of rigs available to produce new fields. That suggests that the overall drilling and production environment remains very strong. This should be supportive for Cameron’s valve and compressor units. I’m adding Cooper Cameron to the Wildcatters portfolio.

Drilling Deep

There are really two basic varieties of mobile offshore rigs: bottom-supported rigs and floaters. Bottom-supported rigs are used in shallower waters; these rigs in some way touch the seafloor during normal drilling operations.

There are several different types of floaters but these rigs are generally designed to handle deeper waters than bottom-supported rigs. For example, drillships are giant ships with built in drilling rigs. As I mentioned above, these ships rarely anchor; they move dynamically, positioned by computer-controlled propellers.

Another popular floating rig is the semisubmersible often referred to simply as semis. Semis have air tanks that can be inflated while the rigs are being towed into location. When the rig is over the oil field, the tanks are flooded partially sinking the semi–this provides stability for drilling operations.

Major oil companies like ExxonMobil (NYSE: XOM) and Royal Dutch Shell (NYSE: RD) do not own their own drilling rigs. The same is true of the independents like Marathon Oil (NYSE: MRO). Instead these companies contract with a drilling firm to provide rigs and drilling services.

Wildcatter Noble Corporation (NYSE: NE) is the best deepwater drilling firm to own now. The company has a total of 60 rigs, 41 jackups (bottom-supported rigs), 13 semi-submersibles and 3 drillships. While there are about 35 jackup rigs being built for deployment industry-wide over the next few years, there is little or no additional semi-submersible or drillship capacity in the works.

Given the rapid development of deepwater projects worldwide, these floating rigs will remain in particularly tight supply over the next few years. Day-rates–the cost of renting a drilling rig for one day–are already near all-time highs for these rigs as operating companies scramble to book available rigs in order to develop new projects.

Some of Noble’s more advanced semi-submersibles are receiving day-rates of more than $150,000, up from $50,000 to $70,000 three years ago. There is even some speculation that contracts are being negotiated in the industry for a $300,000 day-rate for an ultra-deepwater semi. Such a contract would likely push day-rates higher industry-wide. I’m retaining Noble as a buy recommendation in the Wildcatters portfolio.

 

The Price of Oil

By Yiannis G. Mostrous

As stated here previously, low oil prices are a thing of the past. Yet I continue to expect a pull back in the $40-to-$50 range in the near future.

That said, current oil prices–above $52 per barrel (/bbl) as of this of writing–seem to be factoring in the worst possible short-term scenario: Continuing demand growth of 3 percent and zero non-OPEC supply response over the next 12 months. OPEC will continue to produce above demand for the next two months to build up inventories, driving oil below $50/bbl in the near term.

While The Energy Strategist continues to be selective in our recommendations, we will become more aggressive on any meaningful pullback in oil prices.

Demand remains strong and–barring a global recession–oil prices can spike decisively above $55/bbl at the end of the year and into 2006. If demand holds, don’t be surprised if oil averages $60/bbl in 2006 with highs around $75/bbl. This is assessment is rooted in the many uncertainties surrounding oil producers.

For starters, OPEC has become once again, as in the 1970s, the undisputable force in the oil market. As time passes, this change will create more uncertainty on the supply part of the equation.

Investors must also be aware of certain domestic issues confronting Saudi Arabia, the most important place on earth when it comes to oil. (For more on this subject, click here)

The world’s increasing reliance on OPEC for its energy needs is occurring as sources of additional non-OPEC production are replaced from the US and the North Sea to Russia and other former Soviet states and West Africa–not the most stable places on earth.

Investors should also pay special attention to Russia and other former Soviet states since they account for 13.5 percent of global oil supply. Russia has been providing strong supply growth; although it will remain a major force longer-term, we are not certain that this rate of growth is sustainable given the current uncertainty regarding higher export tariffs and tougher regulatory control. If these uncertainties are dealt with successfully, Russia will be on track to deliver more than 10 million barrels per day (Mbbl/d) in the next three to four years, from 8.8 Mbbl/d today (see chart “Russia Crude Oil Production”). Needless to say, Russia’s failure to deliver would render the oil price scenario outlined above increasingly realistic.

^{Source: Energy Information Administration}


Finally, one important statistic to gauge US oil demand is gasoline consumption for commercial transportation. The flow of import containers to the ports of Los Angeles and Long Beach (see the chart “Inbound Containters”) has been robust, indicating that high oil prices have not yet affected commercial consumption. All these goods are being transported throughout the US, reflecting strong consumer demand and driving commercial fuel demand. This is further support for the price of oil.

^{Source: Port of Los Angeles, Port of Long Beach}

A Stockholder’s Stock

Total (NYSE: TOT) is one of the five major oil companies in the world. Its exploration and production portfolio is one of the best: it’s well diversified, low cost, exposed to the industry’s “hot spots” (Bolivia, Nigeria and Algeria) and growing rapidly, and it also has a very profitable chemical division. Total’s refining and marketing businesses are Europe-oriented.

Total’s most recent financial results were extremely strong, driven by continued strong performance in the upstream business. The company has demonstrated impressive exploration success, a lower-maturity asset base and a lack of exposure to declining basins (i.e., the North Sea). This combination has led to strong production growth and lower operating costs. Total has reaffirmed that its growth target for the upstream business remains at 4 percent compound annual growth rate (CAGR) until 2010.

Total also had strong cash flows, which enabled it to return $10 billion to stockholders last year through dividends ($5.6 billion) and buybacks. Given its ability to generate strong cash flows, Total is approaching the likes of ExxonMobil one most stockholder friendly big oil companies.

Furthermore, management has indicated that all free cash at prices above $20bbl will be returned to investors through stock buybacks. We would not be surprised if Totalspends around $5 billion per year for at least the next four years in share buybacks. Keep in mind that during the last four years the company has acquired over 17 percent of its outstanding stock. This is a nice addition to the 3.1 percent yield the stock currently offers. Management is also targeting a payout ratio of over 50 percent (up from 36.6 percent) and they are moving toward achieving that target.

The Russian Move

Last September Total announced the acquisition of a 25 percent stake in the Russian company OAO Novatek (Russia: NVTK). Novatek, formed 10 years ago, owns very large gas fields, most of which came into production in 2003. The fields are very close to the Gazprom pipeline network, an additional plus on the transportation front. Novatek, managed by a group of Russian gas experts and westerners focused on cost controls, has proven-plus-probable reserves of 4 billion barrels of oil equivalent (boe), mostly gas.

Total is currently reviewing the deal because Novatek’s value has increased to $4 billion. The initial $900 million Total wanted to invest may not be enough to acquire the originally intended stake.

The deal would be favorable for Total if it goes through, allowing it to participate in Novatek’s potential 20 percent production growth per year. Total would also capitalize on rising Russian gas prices as the government liberalizes the market in an effort to comply with the World Trade Organization (WTO) accession requirements. Total is added to the Proven Reserves portfolio.

 

Portfolio Talk

By Elliott H. Gue

BJ Services (NYSE: BJS) is an oil services company that derives more than 80 percent of its revenues from pressure pumping services. Pressure pumping is a rather broad term used to describe several oilfield activities that involve sending fluids down a well under extremely high pressures. This requires the use of high-pressure pumps mounted on special rigs–normally mounted on small skids or on specialized offshore vessels.

In most cases, we can divide pressure pumping into two parts: cementing and oilfield stimulation. When a well is dug, the walls of that well are not normally left open. Instead, the well is lined with a special heavy-duty pipe called casing. That casing is then cemented into place–cement is pumped into the well under high pressure so that it moves into the annulus, the area between the casing and the sides of the well hole. The cement and casing keep the well from caving in; casing also prevents water from entering the well or becoming contaminated by oil and gas in the well.

A second part of pressure pumping is stimulation, a term that defines several methods of increasing oil and gas flows from a well. Stimulation services account for more than half of BJ’s total revenues. In many cases, stimulation is performed using hydraulic fracturing. Fracturing involves pumping a gel-like material into a well under extreme pressure. The gel literally cracks the rocks surrounding the well; these cracks improve oil flow.

All of BJ’s businesses are doing fine right now, but there are problems on the horizon. Specifically, I was troubled by some comments out of oil services giant Schlumberger back in late January. During the company’s conference call Schlumberger’s management team expressed concern about excess pressure pumping capacity in North America.

The company stated that it was concerned that this excess capacity would become a problem towards the end of 2005, forcing the big pressure pumping providers to reduce prices or at least moderate the pace of price hikes. Schlumberger stated that it was not adding capacity in North America, preferring instead to focus on foreign markets. North American pressure pumping is the only business where Schlumberger specifies fundamental weakness.

Unfortunately, BJ Services derives the bulk of its revenues from the North American pressure pumping market. This is one of the most vulnerable businesses, especially if energy prices cool going into the early summer.

About 85 percent of North American land production is for natural gas, not oil. I am convinced that natural gas prices will remain at high levels for longer than most expect.

As the chart “US Natural Gas Storage” shows, current natural gas in storage in the US is running at levels far higher than in either 2003 or 2004; this will pressure gas prices in the short term. That’s especially true going into early summer, normally a period of seasonal weakness for gas prices. This will increase pressures on the North American drilling market and companies like BJ Services that are heavily exposed in this market.

^{Source: US Department of Energy}

 

BJ Services is vulnerable now and may well disappoint analysts later this month when the company releases earnings; I’m adding the stock to the Wildcatters portfolio as a short.Portfolio Philosophy

The Energy Strategist portfolios are designed to be the investor’s guideline to the industry. The aim of the portfolios is to offer the best ideas in the sector and advice of when to buy, hold or sell. Stop-loss (stops) recommendations are protection against huge drops, especially in more volatile stocks like those of drillers and service companies. The Wildcatters portfolio companies offer growth and sustainable dividends that are not affected by the short-term gyrations of the market.

As the portfolios are constructed, the suggested stocks will try to capture in the best way possible our thinking regarding the short- and long-term direction of the energy market. Investors should evaluate the rationale behind each theme and decide if they want to add the suggested stock in their portfolio.

Since this is an energy-only portfolio, it should be viewed as complementary to investors’ general allocation portfolios. And because I know that investors own a lot of different energy stocks, we will be expanding our recommendations to include a greater number of recommendations of energy related stocks.

As a start I’m adding Exxon Mobil (NYSE: XOM) and ConocoPhillips (NYSE: COP) as holds in the Proven Reserves portfolio. And once again, pay attention to the stops as well as the “buy under” recommendations suggested in the portfolio tables.

Pairing the Tankers

I would like to remind all subscribers to read the March 30, 2005, issue of The Energy Strategist carefully. This issue is posted in the archives here.

Consider that every day the world consumes more than 80 million barrels of oil; that’s 3.36 billion gallons. Of course, much of that oil is produced in the Middle East and Africa but consumed in North America, Japan and Europe. The vast majority of oil moved around the world spends at least some time aboard a tanker ship.

The large tanker companies are benefiting from booming trade in oil. Better yet, the best in the business have been using their huge cash flows to pay out enormous dividends for shareholders–yields as high as 30 percent.

But tanker stocks aren’t immune from risk–when oil prices fall, the stocks tend to get hit. One of the pillars of the Proven Reserves portfolio is to preserve capital and minimize volatility. To grab these attractive yields and reduce risk, we’ve added a pair trade to the portfolio.

In essence we recommend buying General Maritime (NYSE: GMR) and shorting OMI Corporation (NYSE: OMM) in equal dollar amounts. In other words, if you buy $5,000 worth of Maritime, short $5,000 worth of OMI.

OMI pays a 1.7 percent yield and General Maritime could pay a yield between 15 and 20 percent this year (for more on the company’s unique dividend policy click here). By purchasing General Maritime you’ll get the big dividends. And if oil pulls back, the short in OMI will hedge your risk of capital losses.