In late June, spot crude oil prices finally crossed the psychologically important $60 per barrel (bbl) level. Even adjusting for inflation, it’s been about two decades since oil prices traded at that level. Not surprisingly, the big question on most investors’ minds is whether such high oil prices are sustainable.

A quick glance at the latest inventory statistics suggests there’s room for a pullback in pricing. As the following chart of domestic oil inventories shows, the US is seemingly well supplied with crude. This chart compares seasonal inventory levels of crude–each line represents weekly stocks of crude over a calendar year. It’s clear that stocks are running well above the average for the past five years.


Source: Energy Information Agency

Additionally, the global rig count–the number of rigs drilling for oil worldwide–is near record levels. That suggests the world’s energy companies are actively drilling to tap reserves of oil and gas.

What’s most amazing is despite all that activity, oil prices have continued to hover near record highs. As predicted in The Energy Strategist in March, there was a brief pullback under $50/bbl in April. But crude was well supported at that price and high demand pushed crude higher again in May and June.

There’s good reason for the strength–the global energy market is far tighter than it has been since the 1970s. Rapid economic growth in Asia has powered a quantum leap in demand for oil and gas. Meanwhile, supplies remain tight as energy companies are finding it difficult and expensive to locate new reserves to meet demand despite all their drilling activity.

My long-term view remains unchanged: the era of low energy prices is over and crude prices will average over $45/bbl for at least the next five years. The inflation-adjusted high for oil is just under $100/bbl. I remain convinced that we’ll see that high surpassed over the next few years.

The short-term outlook for crude oil prices is much more bullish now than it was at the March/April highs. The chart below plots the buying activity of so-called non-commercial traders in the crude oil futures markets. The Commodity Futures Trading Commission (CFTC) reports this data on a weekly basis.

Source: Bloomberg

The chart can be interpreted as a measure of speculative activity in the crude oil futures market. When this line spikes sharply higher (as it did this spring) that suggests panic buying in the crude markets. Whenever there’s intense speculative activity in the futures, a pullback or consolidation in oil prices is likely.

It’s clear that speculative activity reached a climax in April before cooling off in May and June. The cooling of speculative activity in the futures market is at least partly responsible for the pullback in crude prices in April and May.

Speculative activity is ramping up, but remains way below the spring highs. The most recent data from the CFTC suggests that traders are just starting to jump back into crude oil futures on the long side. If activity once again jumps to the levels witnessed last spring, crude could easily move toward the $70 level this summer.

The rally in crude oil and natural gas prices has also been a major boon for energy stocks. The Philadelphia Oil Services Index is up 13.8 percent since May 1, and the S&P 500 Energy Index is up 2.9 percent. With that rally in mind and the end of the second quarter fast approaching, it’s time to review the portfolio recommendations and strategic positioning. In the next issue, we’ll detail the performance of the portfolios for the second quarter.

Please note in the portfolio table my tightened stop recommendations on several holdings, including Noble Corporation (NYSE: NE) and Marathon Oil (NYSE: MRO). These stocks have seen spectacular runs over the past few weeks–by raising our stops we can lock in solid gains. I remain bullish on the longer-term prospects for both stocks, but the speed of the recent rally suggests buying these names only on dips.

Despite the run, not all stocks in the space look overextended; a handful still offers outstanding value. Uranium stocks are vastly underappreciated by investors, even after some recent positive news from the nuclear power industry. Wildcatters Portfolio holdings Cameco (NYSE: CCJ) and Denison Mines (Toronto: DEN)–which have just recently begun to move higher–remain my top picks in the group. Below, I examine an even more direct play on uranium prices, a way of owning directly the physical uranium that the world so desperately needs.

Without further ado, let’s examine the recent news from our portfolio recommendations, and update the advice accordingly.

The Drillers

My favorite contract drilling stock right now is Wildcatters Portfolio member GlobalSantaFe (NYSE: GSF). This stock remains the only offshore contract driller that continues to trade well under its 1997-98 highs. The company is also far cheaper than its peer group despite outstanding earnings leverage to higher drilling day-rates.

While the stock is already up nearly 20 percent from our late-April recommendation, upside appreciation to the mid-50s is likely over the next 12 months. (For a detailed review of the contract drilling business, check out the April 27 issue.)

Contract drillers don’t actually own oil and gas reserves or produce and sell oil. Instead, these companies own the drilling rigs that drill the well through which oil and gas are produced. Oil companies pay the contract drillers a fee–the day-rate–for the use of their rigs and drilling crews.

There are many different kinds of contract drillers. Some focus on drilling for oil on land, others handle mainly offshore work. The offshore market can be divided into deepwater drilling and shallow-water drilling.

The tightest drilling market right now is the market for deepwater rigs. These rigs are technologically complex–the most advanced designs can cost $500 million to $1 billion to build. Only a few new rigs are scheduled for construction over the next five years, so supply of available deepwater rigs will rise only slowly. Meanwhile, some of the largest, most promising recent discoveries of oil and gas reserves have been in deepwater. Demand for deepwater rigs is on the rise.

As you might expect, tight supply and strong demand has pushed up the day-rates drillers charge for using their deepwater rigs. GlobalSantaFe is a major player in this market with 11 semisubmersible rigs and three drillships (see the April 27 issue for definitions and pictures of these rigs). Two of the company’s drillships are designed for ultra-deepwater work in up to 12,000 feet of water. And three of the semisubmersible rigs are of the most advanced design, capable of extreme deepwater work.

Every week, the major drillers publish a fleet status report detailing the current location and contracts of every rig in the fleet. In the table below, I excerpt some of the information from Global’s most recent fleet status report. This table illustrates just how much leverage Global has to the strengthening drilling market and rising day-rates for deepwater rigs.

GlobalSantaFe Fleet Status

Rig Name	End Date*	Day-Rate^	New Contract#
Aleutian Key	late 07/05	$90,000	$130,000
Arctic I	late 07.05	—	$160,000
Arctic II	early 08/05	—	$160,000
Arctic III	mid 09/05	$110,000	$100,000/ $150,000
Arctic IV	late 01/06	$60,000	—
Celtic Sea	mid 09/05	$80,000	$100,000/ $170,000
Driller I	newbuild	—	$210,000
Driller II	newbuild	—	$180,000
Grand Banks	mid 01/06	$107,000	—
Rig 135	late 08/05	$120,000	—
CR Luigs	mid 06/05	$160,000	$180,000/ $220,000
Explorer	mid 06/05	$100,000	$130,000/ $230,000
Jack Ryan	mid 03/06	$200,000	$240,000/ $260,000/ $290,000

*Approximate expiration date of current contract. ^Current contract day-rate (rounded to nearest $10,000). #Day-Rate value of next contract (rounded to nearest $10,000).

Source: GlobalSantaFe

The table indicates the current day-rates that Global is realizing for each of the company’s rigs and when the current contracts are set to expire. I’ve also indicated the company’s new contract terms once the existing contracts expire. In situations where Global has booked multiple future contracts for rigs, the table indicates the day-rates for each of those new contracts.

Note that almost all of the company’s rigs have new contracts in the pipeline to take effect when existing contracts expire. In many cases, multiple contracts, stretching out for the next year or two, have already been established. This is an increasingly common phenomenon among the offshore drillers. The big energy companies are desperate to secure scarce rigs, so they’re contracting for those rigs at pre-established day-rates months–or even years–into the future. That gives the drillers almost unprecedented earnings visibility for the next few years.

More importantly, note the current contract expiration terms for most of GlobalSantaFe’s rigs. All of the rigs are set to be on new contracts by March of 2006. Most of the rigs are scheduled to see new contracts by the end of the summer.

And here’s the kicker: Global’s rigs are set to start new contracts at vastly higher day-rates very soon. Take the Celtic Sea as an example. This rig is a semisubmersible rated for drilling in 5,750 feet of water, considered deepwater depth for a semi. Currently working in the Gulf of Mexico at a day-rate of about $80,000, the rig will take a short, two-month contract at a $100,000 day-rate in September. That contract will be followed by a four-month commitment in the $170,000 range. Bottom line: by early 2006, the Celtic Sea will enjoy a day-rate more than double its current level.

Also note the two new rigs coming on line for Global, to be delivered this year from a Singapore shipyard. Both are advanced deepwater semis capable of drilling in depths of 7,500 feet. Right out of the gate, Global will have contracts near $200,000 per day for both rigs. And the Artic II is also just coming out of long-term storage to enjoy a day-rate of $160,000.

Bottom line: Global’s new contracts on existing rigs, coupled with the addition of three new semisubmersible rigs to the fleet this year, will push earnings sharply higher going into next year. Analysts have already pushed up earnings estimates for 2005 by 13.8 percent over the past three months and over 33 percent for 2006.

Nevertheless, as we pointed out back in April, Global continues to trade at a discount to its peer group in terms of price-to-book and price-to-earnings value. It’s also the only stock among the offshore drillers that has not exceeded the highs witnessed at the last cycle high for drillers in 1998. That high was in the mid-50s I expect a retest of that level over the next year.

The other two recommendations in the drilling group are Noble Corporation (NYSE: NE) and a short in Patterson-UTI (NSDQ: PTEN). Noble Corporation remains levered to rising day-rates and is the best managed stock in the contract drilling space. Noble’s key asset is its inventory of baredeck hulls, unfinished rigs Noble plans to prepare for deepwater drilling work. Noble will be able to bring new capacity online to take advantage of the strong day-rate environment.

That said, some of Noble’s superior fundamental performance is factored into its valuation. On most measures, the stock trades at a premium to its peer group. I am maintaining Noble as a buy, but investors should use dips to accumulate shares.

While I remain bullish on the contract drillers, I’m maintaining a short recommendation in US-focused land driller Patterson-UTI. The best upside in day-rates will be found in the offshore market and outside the US. The US land-drilling market is extremely volatile and can see day-rates drop sharply on any pullback in natural gas and oil markets. Most foreign contracts are longer term, improving earnings visibility.

Patterson has moved against us approximately 10 percent, compared to 15 to 20 percent gains in Noble and GlobalSantaFe. But Patterson remains a valuable hedge for our primarily long-only portfolio and I’m maintaining a short recommendation.

Finally, it’s worth mentioning Todco (NYSE: THE), a shallow-water driller focused on the Gulf of Mexico market. I recommended this stock in a Flash Alert three weeks ago; the stock remains an attractive play for the next three to six months. As I view Todco as more of a trade than a long-term holding, I won’t be tracking it as a portfolio pick. I will, however, update my recommendation in every issue of The Energy Strategist.

Todco primarily operates a fleet of jackup rigs. These rigs are designed for work in water of a few hundred feet in depth. Jackups are also easier to build than semisubmersibles and drillships. A number of new jackups are scheduled for construction and delivery over the next few years; supply isn’t as tight as it is for deepwater rigs.

Nevertheless, it’s incorrect to dismiss the jackup market as a low-margin “commodity” business. The shallow-water Gulf remains an extremely active drilling environment. Major new finds in offshore Africa and offshore India are also being drilled using jack-ups. The global market for the rigs is very tight (with utilization near 90 percent in most markets), and it’s likely that the markets will easily absorb any new supply of rigs.

The CEO of Frontline (NYSE: FRO), John Fredrikson, is aggressively buying jackups that are still under construction. Fredrikson is one of the most astute CEOs in the energy markets and made most of his considerable wealth in this market. It seems highly unlikely that he would spend millions on jackups if he didn’t believe the shallow-water drilling market was strengthening.

Day-rates are rising rapidly worldwide for jackups and Todco is uniquely leveraged with several rigs available for reactivation. Todco rates a buy.

Going Nuclear

Even the most passionate environmentalists are coming around to the idea that nuclear power is the only way to ensure the world has access to abundant, efficient and environmentally friendly energy. In a recent speech before Congress, Greenpeace founder Patrick Moore stated that the benefits of nuclear power far outweigh the risks. That’s something most people never expected to hear from a prominent environmentalist.

This shift in sentiment is already apparent globally. The United Kingdom, for example, has been among the world’s foremost supporters of renewable energy. The Labour government has pushed wind, wave and even solar power in recent years as a way of reducing carbon dioxide emissions and meet environmental targets.

But a recent government white paper casts doubt on the success of that strategy. While renewables are certainly worth pursuing, they will never provide the always-on power that consumers and businesses demand. According to London’s Observer, the UK’s white paper highlighted the need to consider quickly proposals to build new nuclear power facilities.

The UK may prove an early testing ground for nuclear power’s resurgence. The country gets more than a fifth of its power from nuclear, but nine of its 12 operating plants are scheduled for decommissioning by 2020. The remaining three plants will only be able to chip in a marginal 7 percent of the nation’s power supply. Given the long licensing process and extensive public debate likely to surround new plant construction, the nation will need to decide to go ahead with new plant construction very soon or not at all. What’s clear, however, is that the nuclear option is back on the table in Britain.

One also has to wonder about Germany. The current administration there has remained a committed foe of nuclear power and the nation has committed to decommissioning most of its plants over the next few decades. But despite leading the world in new wind power development, it’s doubtful Germany can make up for the loss of the 30-percent chunk of its power supplied by nuclear. But Chancellor Gerhard Schroeder’s administration is shaky right now and it’s highly likely a new ruling coalition will emerge. It’s unlikely that Germany will be able to ignore the nuclear option forever.

And then, of course, there’s the US. The Energy Information Agency (EIA) is projecting very little domestic growth in nuclear power generation between now and 2025. Central to that outlook is the notion that there will be no new plant construction in the next 20 years, only the expansion of existing facilities. With natural gas prices on the rise, that is a very shaky assumption.

At any rate, the economics of nuclear fuel–uranium–remain positive, whether or not the US, Germany and the UK decide to build new power plants. In the US, the major utilities are starting to become concerned about a shortage later this decade in uranium supply necessary to the operation of existing plants. (For a more complete analysis of the nuclear sector, check out the May 26 issue.)

Commercial stockpiles of uranium now stand at less than half of 1985 levels. And production of uranium from mines satisfied only about half of world demand in 2003. Bottom line: Uranium demand is being met by drawing down rapidly dwindling inventories. According to most pricing sources, spot uranium prices are at the highest level since 1981, at about $30.00 per pound.

In addition to uranium purchases by utilities, there’s a new class of buyer on the block: uranium funds. Portland, Oregon, hedge fund Adit Capital Management began buying physical uranium oxide–yellowcake–last December. The fund simply buys uranium and stores it in approved warehouses.

On May 10, 2005, the physical uranium market also opened up for US investors when Uranium Participation (Toronto: U) listed in Toronto. The company used the proceeds of its initial public offering (IPO) to purchase a total of 2.15 million pounds of yellowcake for delivery between now and the end of summer. The company plans to store that uranium in approved warehouses and act as a sort of uranium exchange-traded fund (ETF) for retail investors who are obviously unable to buy physical uranium themselves. Uranium Participation is being managed by Wildcatters Portfolio holding Denison Mines (Toronto: DEN), one of the best-known, best-managed miners in Canada.

I have two key takeaways from this development. First, the recent spike in uranium prices and spot market activity is likely due to the action of these funds. This buying provides yet another source of demand for uranium and enhances liquidity and pricing transparency in the uranium spot market. I would not be at all surprised to see more companies try to jump on the same bandwagon. This is bullish for uranium.

Second, new IPOs can be volatile for the first month or two of trading. But Uranium Participation looks too attractive to pass up, so I’m adding the stock to the Wildcatters Portfolio. Because of its potential volatility, I view it as a long-term story. (A detailed report on how to buy Canadian stocks is available here.)

On the uranium-mining front, only Denison and Cameco are in full-scale production. Cameco is the industry’s dominant player and the safest bet on uranium. Denison is smaller but has great potential and some exciting reserves. Cameco and Denison are both buys.

Oil Services

I’m maintaining my buy recommendations in both Weatherford International (NYSE: WFT) and Schlumberger (NYSE: SLB). I also highly recommend that all subscribers take a short position in BJ Services (NYSE: BJS) as a hedge against exposure to the group.

The key to the oil field services business for the next few quarters will be international operations. Just as with the contract drilling group, the North American services business is very strong but very volatile. Service contract terms in North America tend to be short whereas most major international contracts cover several years. That means there’s more visibility on profitability for the international levered names.

I also continue to be concerned about overcapacity in one particular service business in the US, pressure pumping. Pressure pumping is a way of rejuvenating older, depleted wells to make them productive again.

Oil does not exist in underground lakes but is held in tiny, connected pores in rocks. Some of the oil in these pores is unable to flow to the well because not all of the pores in the rock are well connected. In other words, there is no channel for the oil to flow through. When the pores in a rock are well connected, the reservoir is said to be highly permeable. In reservoirs with poor permeability, more than 80 percent of the oil can be left behind during the initial phases of production.

One way to increase production from an impermeable reservoir is to create new channels through which oil can flow. Hydraulic fracturing, a common type of pressure pumping, involves pumping a gel-like liquid down the well under extremely high pressure. The gel then enters the reservoir and, if enough pressure is applied, it can actually crack the rock. These cracks enhance the recovery of hydrocarbons left behind during initial production.

But due to high demand, a lot of new pressure pumping equipment has been built and there is a vast oversupply in the North American market right now. There is a danger of a glut in capacity, particularly if commodity prices moderate later this summer. The major focus of BJ Services’ operations is US pressure pumping. That makes the company more vulnerable to such a glut.

Schlumberger and Weatherford both have better international exposure. Both stocks will be better positioned to withstand and pressure pumping overcapacity in North America. And because international contracts tend to be of longer duration, I’m more confident in their earnings prospects over the next few quarters.

Also attractive is Weatherford’s recent acquisition of certain business lines from Precision Drilling (Toronto: PD) of Canada for $2.28 billion in cash and stock.

Weatherford acquired Precision Energy Services (PES), a service subsidiary focused on three main business lines: wireline services, directional drilling and underbalanced drilling. I’ll explain each of these businesses in turn.

PES’s wireline services unit can be merged with Weatherford’s existing operations. Wireline services involve lowering special equipment into a well to evaluate the reservoir and the stability of the well itself. Wireline is a very important part of producing additional oil from mature wells. This equipment can help operators determine the best ways of maximizing production from wells that are already at least partly depleted. Given the importance of brown field services (revamping existing wells) to global oil production, this is a high growth business.

PES brings to the table some advanced wireline technology that Weatherford did not have pre-merger. About 80 percent of Precision’s wireline business was in the western hemisphere–Weatherford’s giant international operations will open up new markets for the company.

Weatherford’s management team stressed the potential synergies between underbalanced and directional drilling. While Weatherford’s fastest growing segment has been underbalanced drilling, it lacked a world-class directional drilling segment prior to the acquisition.

Consider that oil and gas located deep underground are under considerable pressure. If a driller were to simply drill a hole in the ground, as soon as an oil zone is hit that oil would rush into the drill hole and to the surface of the well, spewing out uncontrollably. This is what’s known as a blowout.

Blowouts are wasteful because it’s tough to collect all that oil spewing out at the surface. They’re dangerous because oil and gas can ignite at the surface and create extremely hot fires that are tough to extinguish.

To control this problem, drillers use what’s known as a mud circulation system. Drillers pump mud–actually a complex mixture of many chemicals and solids– under pressure into the well. In conventional drilling–or overbalanced drilling–the pressure of the mud in the well exceeds the pressure of the oil in the reservoir. The oil can’t travel up the well and blow out at the surface.

But there are problems with overbalanced drilling. The drilling mud can actually overwhelm the reservoir pressure and move into the pores of the reservoir rock itself. Cuttings from the drill bit can get forced into these pores along with the mud. This can actually clog the pores and drastically reduce the productivity of the entire well. This is a significant problem in mature fields because reservoir pressure is depleted over time–mud and debris can more easily push into the reservoir.

Underbalanced drilling can help resolve thee problems. In underbalanced drilling, mud is pumped at a pressure below that of the underground hydrocarbons. In this way, mud does not enter the rocks. Oil does force itself into the well during drilling, but the mud is under enough pressure to control that rate of flow. At the surface, the hydrocarbons that mix with the mud can be separated and isolated for sale. Underbalanced wells are more expensive to drill and manage, but they can drastically improve overall production from a well.

Directional holes are (as the name implies) wells dug at some angle other than vertical. Directional wells can also increase production by allowing drillers to expose more of the well pipe to oil and gas deposit zones. Unfortunately, directional drilling leaves even more debris in the well during drilling. If directional drills are drilled overbalanced, the drilling can damage the reservoir and drastically decrease production.

Precision’s major technological investments in directional drilling coupled with Weatherford’s core competency in underbalanced drilling make for a synergistic merger.

In subsea equipment and services I continue to recommend both Cooper Cameron (NYSE: CAM) and FMC Technologies (NYSE: FTI). These companies make the equipment that makes deepwater drilling possible. For a detailed review, check out the April 13 issue.

In the near term, FMC is the better buy. The stock was unduly beaten down by cost overruns at one of its projects. It’s still a market leader in subsea trees and equipment.

The Majors

Royal Dutch Shell and (NYSE: RD) shareholders have voted to end a century-old tradition and merge the two companies. The new entity will be the world’s third-largest publicly traded company after ExxonMobil (NYSE: XOM) and BP (NYSE: BP).

The benefits will be of paramount importance. Decision-making will be easier, allowing for more flexibility. Although the pros and cons will be the subject of endless analysis in the press, the important thing for us is that the proposed arrangement gives more freedom to the company for acquisitions.

In the past, the company’s structure made it difficult to use stock for acquisition purposes. The merger will make that easier, although not as much as it could have been if the company was going ahead with one-class shares (the current plan calls for the issuance of A and B shares).

Under the new structure, there is a higher probability that the potential acquisition identified in the March 29 issue–Royal Dutch acquiring BG Group PLC (NYSE: BRG)–can take place.

Royal Dutch remains the best turnaround story in the industry and one of the most compelling across industries. The company’s exposure to gas is a big plus, given the importance that gas is gradually gaining in the energy sector. The company has also an extremely strong downstream position, and given the importance of refining in the industry, Shell will continue to benefit dramatically. Finally, share buybacks will continue; given the elevated oil prices, next year the company could spend more than $10 billion. It will take time for Royal Dutch Shell to solve all its problems, but if successful it will be one of the best investments of the decade.

TOTAL (NYSE: TOT) is a must-have in an energy portfolio. A little-known aspect of the company’s structure is TOTAL’s stake in the pharmaceutical company Sanofi-Aventis (NYSE: SNY).

The company acquired the position while merging with ELF in 2000. And although thoughts of divesting have been floated before, and remain management’s long-term goal, Sanofi’s good performance and promising pipeline has given TOTAL’s management a good reason to wait.

The company’s stake in Sanofi-Aventis is currently valued at $16 billion, and obviously the cash can eventually be used for acquisitions, returned to stakeholders (usually a favorite action for TOTAL) or both. TOTAL’s stake in Sanofi-Aventis is a major plus for long-term stockholders. The market will eventually start factoring this into the price of the stock

ConocoPhillips (NYSE: COP) has improved its position dramatically as it has been able to move beyond the merger related challenges. Disciplined capital management, de-leveraging and growth have become the focus.

The company continues to pay off debt while increasing dividends. Free cash flow should reach $6 billion by the end of 2005, allowing more room for investments, share buybacks and more dividend increases.

The Transporters

As we’ve recently reviewed our master limited partnership and tanker recommendations in great depth, I won’t linger on the stocks. I continue to recommend a pair trade to play the tanker space. Buy General Maritime (NYSE: GMR) and short OMI Corporation (NYSE: OMM) in equal dollar amounts. For a detailed explanation why I think we’re approaching a key inflection point for the tanker stocks, click here.

I discussed Penn Virginia (NYSE: PVR) and Enterprise Products (NYSE: EPD) in the June 8 issue. Both stocks remain low-risk ways to play energy and pay large dividends while you wait.

I am particularly encouraged by Enterprise Products’ recent purchase of natural gas liquids (NGL) storage and terminal facilities from Ferrellgas Partners (NYSE: FGP). Enterprise is a major player in NGL storage, transport and processing and I see this as a key growth business. The reason is that deepwater gas tends to be rich in such liquids–this gas requires more of the processing that Enterprise can offer.