This March, there were more than 1,300 drilling rigs operating in the United States and another 420 in Canada. That figure, known as the rig count, includes both rigs designed to drill offshore and land-based rigs. As you can see from the chart “Rotary Rig Counts,” it has been 20 years since the North American rig count has been that high.

And the same pattern holds overseas. The chart also shows the total global rig count–it’s been two decades since the world has witnessed this much drilling activity. Every region of the world is participating in the boom.

Contrary to what many believe, the big integrated oil companies generally don’t drill their own wells or own their own drilling rigs. The same is true for the smaller, independent exploration and production companies. Drilling is the province of a specialized group of companies known as the contract drillers. Most contract drillers own a large number of mobile drilling rigs and keep crews of personnel to run these rigs. Operating companies pay a day-rate for the use of rig and crew.

As you might expect, the strong rig count in North America and internationally has been great news for the contract drillers. Operating companies worldwide have responded to strong demand for oil and gas by increasing exploration activity and new drilling operations–that spells more contracts for the drillers. And with drilling rigs in such high demand, day-rates have been rising, whether it’s for the simplest land rigs or the most complex deepwater operations.

The drillers can be a volatile group and selectivity is key. The North American drilling market has seen several quarters of strong upside both in terms of rig counts and day-rates. But North American drilling operations are extremely cyclical–when natural gas and oil prices moderate, the rig count in the US generally drops. The fast growth for drillers leveraged to the domestic market is over.

As the title of this week’s issue suggests, the best growth for the next few quarters will be from offshore drillers specializing in international markets. Day-rates for advanced mobile offshore rigs are currently running at record highs. And spending overseas should be less cyclical–most of the big international projects now underway will take years to develop and are planned many months in advance. Such long-term projects will likely go ahead even if oil and gas prices moderate from current levels.

I’m adding driller GlobalSantaFe (NYSE: GSF) and oil services firm Weatherford International (NYSE: WFT) to the Wildcatters portfolio. Both companies are well placed with a concentration on international and offshore operations.

Drilling Basics

In the summer of 1859, Colonel Edwin Drake struck oil outside Titusville, Pennsylvania, completing the first commercial oil well in the US. Drake used what’s known as a cable-tool rig to drill his well. To understand what a cable-tool rig looks like, think of a giant, heavy chisel hoisted to the top of a derrick and allowed to drop. The chisel actually carved the well into the rock.

Cable-tool rigs were used rather widely until the 1950s in the US but were impractical for drilling in softer, sandy soil. Many of the huge Texas reservoirs that supplied so much oil to the US in the early 20th century could never have been dug using a cable tool rig. Instead, these wells were dug using a rotary drilling system.

The basic rotary drilling system employs a rotating bit and a circulating mud system (click here for more on mud systems). The drill bit is attached to a pipe known as the drill string. The basic drilling system involves rotating both the drill string itself and the bit.

There have certainly been vast improvements in drilling rigs and drive systems since the early 20th century but the same basic principle prevails even today and applies to almost all rigs whether based on land or water. What differs is where and how these rigs are mounted and their size and drilling depth. These are factors that determine the day-rates that drillers can charge.

Most land-based rigs are designed to be carried by truck to their drilling location. The rigs are simply disassembled, packed onto a truck and reassembled on location. Most of the global rig count (more than three-quarters) is made up of land rigs. While these rigs are more numerous, they tend to fetch lower day-rates. Land rigs are also easier and cheaper to build than offshore units; it’s possible to build new supply relatively quickly.

Offshore rigs are a bit more complicated but come in two basic types, bottom-supported rigs and floaters. The most common bottom-supported rig in use today is called a jackup rig (see photo below). These rigs are simply a platform supported by three or four metal legs. Jackups are towed to their location by barge with the metal legs in the air. The platform is then simply “jacked up” until the legs touch the bottom and the platform is well above the highest expected waves. Jackups are primarily used in shallower waters no deeper than 300 to 500 feet.

A jackup rig located in the Gulf of Mexico. (Source: www.webshots.com)

A popular floater rig is called a semisubmersible (see photo below). Semisubmersibles, commonly known as semis, are large floating platforms that are partially sunk when in position to drill–the bottom pontoons on the semi are sunk several meters under the sea. By partly sinking the platform, semis gain a measure of stability against rough seas. Semis are either anchored to the seafloor or dynamically positioned via computer. Some modern semis are capable of drilling in water with depths of 10,000 feet or more.

A semisubmersible rig. (Source: Getty Images)

Jackup rigs are far less technologically complicated and cheaper to build than semis. But as I pointed out in the last issue of The Energy Strategist, some of the largest reservoirs being discovered today are offshore in very deep water. Semis or other advanced floating rigs are necessary for such deepwater drilling operations.

Because semis are more advanced, more valuable and more expensive to run, they fetch far higher day-rates than jackups and other bottom-supported rig types.

They are also in far shorter supply. There are approximately 35 jackups currently under construction or scheduled to be built between now and 2008. Right now, there is plenty of demand to meet this additional supply. However, jackups will never be as scarce as floaters.

 

 

 

There are almost no new semis scheduled for construction over the same time period. Only recently, a Norweigan firm–Eastern Drilling–has scheduled shipyard time and tried to put together a deal to build a new semi for a projected cost of $550 million. The company is partly owned by Smedvig, a major Norweigan drilling firm.

But the construction is pending a successful initial public offering (IPO) of stock on the Oslo Stock Exchange to fund the construction. That semi won’t hit the market for at least three years, probably longer. Bottom line: there’s no appreciable new supply in the pipeline. Advanced semis are in high demand and short supply; there’s tremendous upside for day-rates.

A solid play on the strong semi market is Wildcatter Noble Corporation (NYSE: NE). Noble has a fleet of 41 jackup rigs, 13 semis and three drillships. Two of the company’s semis are rated for drilling in 10,000 feet of water, the type of ultra-deep drilling capacity that’s in particularly high demand.

What I find particularly attractive isn’t the company’s existing fleet but its scope to grow organically. Some time ago Noble purchased two bare-deck Bingo hulls for $23 million each. These are essentially unfinished semisubmersible drilling rig hulls; the hulls are rated for ultra-deepwater operations in 10,000 feet of water or more.

These rigs are likely to be brought into service over the next few years at very high rates–Noble is one of the only drilling firms on the planet with meaningful capacity to cheaply expand its fleet. For more on Noble’s organic growth potential, click here for a detailed analysis of the company’s earnings conference call.

I’m adding GlobalSantaFe to the Wildcatters portfolio. GlobalSantaFe, like Noble, has exposure to both the semi and jackup markets. The company has 45 advanced jackup rigs capable of drilling in up to 45 feet of water. In addition, Global has nine semis and three drillships. One of the semis is an advanced semi capable of ultra-deepwater work while two of the company’s drillships are rated for depths of 12,000 feet.

The company’s deepwater semi looks like a particularly valuable asset. The semi is contracted for the next year in the low $80,000 range with a follow-up six-month contract for next year at over $170,000 a day. Based on recent contract awards, this semi could ultimately see day-rates well above $200,000.

While GlobalSantaFe’s portfolio of drilling assets is solid and there’s upside to day-rates for the company’s fleet it trades at a notable valuation discount to other offshore-levered contract drillers. Using a peer group consisting of Diamond Offshore (NYSE: DO), Transocean (NYSE: RIG) and Noble, GlobalSantaFe trades at a 28 percent discount based on price-to-sales basis and 37 percent based on price-to-book. This is highly unusual for the stock–the company has historically traded in line with its peer group.

The reason for the discount: temporary weakness associated with an $810 million share offering by GlobalSantaFe. The company issued over 23 million shares in mid-April and used the proceeds to buy back and retire stock held by Kuwait Petroleum. The transaction leaves Kuwait Petroleum with about a 9 percent stake in the company, down from over 18 percent before the offering.

The share issue and potential share overhang (selling pressure if Kuwait Petroleum were to sell its stake) are behind the company’s valuation discount, not fundamental performance in its drilling operations. It’s likely that this valuation discount will close over the next few quarters. It’s therefore a great time to buy GlobalSantaFe as a cheap play on the offshore drilling business.

On the wrong side of the trend, Patterson-UTI Energy (NSDQ: PTEN) is primarily a US-focused land-drilling firm with a fleet of about 361 drilling rigs. Most of these rigs operate in Texas, Louisiana and New Mexico, the traditional US land drilling markets. In addition to standard contract drilling operations, Patterson also offers pressure-pumping services.

The US rig count is already very close to all-time highs. And much of the expansion in US land drilling of late has been natural gas exploration and production; 1,170 of the 1,306 rigs currently working in the US are drilling primarily for natural gas. The longer-term fundamentals for natural gas are extremely strong–in a future issue we’ll cover the promise of unconventional gas reservoirs such as the Barnett shale, tight gas and the Gulf of Mexico deep shelf play.

But right now, I see downside for natural gas prices. As the chart “US Natural Gas in Storage” shows, natural gas supplies are more than adequate right now and well above the levels witnessed over the past few years. With the winter heating season now over, gas in storage should start to rise to a peak sometime in the autumn. This is not a seasonally strong period for natural gas prices or related stocks. A better buying opportunity will emerge this summer.



Patterson is ultra-leveraged to any pullback in gas prices. North American projects are often postponed or delayed when gas prices fall, at least temporarily. And with the land rig count already at historic highs, there’s only limited room for further growth. Patterson doesn’t have exposure to the less cyclical foreign markets. I’m adding Patterson-UTI to the Wildcatters Portfolio as a short recommendation.

In addition to the contract drillers, a number of other companies are involved in constructing new wells. Many of these companies are grouped together under the broad classification of oil services.

Weatherford International (NYSE: WFT) is an oil services company with a focus on offshore operations and a large international footprint. The company performs such vital tasks as repairing damaged wells and adding equipment to increase production from older wells.

Also of particular importance to the offshore industry, a line of sand screens used to keep small sand particles from clogging oil and gas wells. I’m adding Weatherford International to the Wildcatters portfolio.

The Golden Standard

ExxonMobil (NYSE:XOM) has been a solid company with great leadership for more than 90 years. For some, and we would not necessarily disagree, it is the best-run company on earth. Its current incarnation the result of a 1999 merger, the company has come a long way since John D. Rockefeller formed the Standard Oil trust in 1882.

ExxonMobil has set the benchmark in its industry in terms of financial and operational performance. Its balance sheet is the best in the industry–its cash position of $18.5 billion exceeds its debt by almost $10 billion.

The company is expected to have cash flow from operations and asset sales of approximately $40 billion per year for the next three years, allowing it to comfortably meet its investment needs, increase dividends (it has done so for 21 consecutive years) and spend around $15 billion per year in share buybacks. After all this, the company will still have more cash than debt. ExxonMobil also has one of the best-integrated portfolios in the industry, and the largest reserve base among its peers (13.7 billion barrels of oil equivalent).

With an annualized average return of 16.6 percent over the last 25 years, ExxonMobil’s long-term stock performance has been superb. During the same period, the S&P 500 has managed 13 percent, while the Nasdaq composite has provided the investors with a 10.5 percent per year return.

At the end of 2004 ExxonMobil published a report, “Energy Outlook for the World to 2030,” which reinforced The Energy Strategist’s theory of a new structural bull market in energy. The report states, in pertinent part:

“Economic growth of about 3 percent per year through 2030 will continue to drive energy demand. In concert with rising personal incomes, we expect energy demand to grow about 1.7 percent per year. By 2030, demand could be about 335 million barrels per day of oil equivalent, or about 50 percent more than today. The vast majority of this increase will be in developing nations, consistent with faster economic growth and substantial increases in personal vehicle use.”

Regarding oil in particular, ExxonMobil is forecasting demand of 120Mbpd by 2030, up from less than 80Mbpd today. Of even more interest is the company’s estimation that natural gas demand will grow substantially, eventually “converging with that of oil.” This prediction also fits very well with The Energy Strategist’s views on liquid natural gas (LNG).

Investing for the Future

Despite its leadership status, and given the above-mentioned expectations, ExxonMobil has been trying to position itself for the future by developing new technologies and investing in new oil and gas projects around the world.

ExxonMobil has developed a “Molecule Management” technology to better deal with the lower quality of crude oil increasingly being pumped from the ground.

Molecule Management involves analyzing the differences in crude types and using that knowledge to increase margins. According to ExxonMobil’s research, “Finding out how much nickel, vanadium and salt a certain crude type contains, is essential for optimizing the product yield from a refinery.” Given the importance of refining in the industry, the company is gaining a long-term advantage over its competition.

ExxonMobil is also successfully expanding in LNG, gas-to-liquids (GTL), tight gas and oil sands. The Energy Strategist will cover all of these aspects of the energy market in future issues.

ExxonMobil is also focusing more on oil production in emerging markets, and slowly its US and European upstream strongholds will decline in importance because of saturation is older fields. Some of the “new” places oil gains will come from include Angola, Chad, Nigeria, Azerbaijan, Kazakhstan and Russia.

It is clear that ExxonMobil is moving forward to face the challenges of the future, and given its long-term success there is no reason to doubt the outcome. Investors should be prepared for setbacks along the way, especially because of the increased exploration and production (E&P) exposure in emerging markets. These efforts are hamstrung to an extent because of the limits of Production Sharing Agreements (PSAs, through which exploration companies and countries divide the proceeds from the oil). PSAs are becoming more and more important given that the majority of the new oil discovered is in emerging markets that demand increasingly higher compensation.

ExxonMobil remains a solid energy holding for any portfolio, but investors should avoid buying at these levels given that the price is reflecting a lot of its supreme characteristics. If you own ExxonMobil hold it; otherwise wait for a better entry point.

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 investors own a lot of different energy stocks, we have been expanding our recommendations to include a greater number of companies of energy-related stocks.

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. 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.

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 (click here for more on the company’s unique dividend policy). 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.

Earnings…Earnings Everywhere

It’s earnings season and there are a host of key new developments for stocks recommended in The Energy Strategist as well as other major industry players. I’ve prepared a separate, detailed report with my key takeaways from listening to the recent spate of earnings conference calls and analyst question and answer sessions.

In that report, I also take a look ahead at some major reports due out over the next few days. To access this special supplement, please click here.

We’ll send subscribers a special flash alert detailing any key developments we hear as earnings trickle in over the next few weeks.