One thing is clear from second quarter earnings season: Energy companies of all stripes are swimming in cash. With oil and natural gas prices on the rise, the sector is seeing the greatest profitability upswing since the 1970s.

But these same companies have a problem. Demand for oil is surging and prices are high, but they’re not finding enough oil to make up for and replace their production. Reserve replacement ratios industry-wide are very low right now.

The charts “Energy’s Rising Net Income” and “Flat Capital Expenditures” sum up the current situation quite dramatically. Net income for the companies covered by this chart has exploded over the past few years while capital expenditures are roughly constant to only slightly higher. That means that energy companies have been building up cash, but they haven’t been spending it on increased exploration and development activity. Instead, the cash has been used to pay down debt, boost dividends, and make acquisitions, or has simply built up as cash assets on the balance sheet.

Souce: ExxonMobil, Chevron, Apache

 

 

Source: ExxonMobil, Chevron, Apache

 

But that’s changing. As I outlined in The Energy Letter last week, the major energy companies are starting to get worried about their inability to boost proven reserves. The traditional go-to supply markets–Russia and Saudi Arabia–aren’t likely to keep up with rapidly growing global demand. Check out the chart “Russia’s Oil Production.”

 

 

 

Source: BP

Russian oil production has clearly flattened out recently. From 1990 to 2005, the Russians increased their crude oil production by an average of roughly 4 percent annually, adding up to a little under 3 million barrels of production growth from 1994 to 2004. This helped offset the effects of rising demand from Asia (and, to some extent, the US) as well as declining excess capacity to produce oil in the Middle East.

But most analysts agree that production has actually declined over the past nine months. Russian oil production is still nowhere near the 11.5 million barrel per day of the mid 1980s. While it’s true that uncertainty surrounding Yukos and a lack of new foreign investment have impaired oil production over the past year-and-a-half, the problem runs deeper.

The fact is the Russians massively overproduced their fields during the Soviet era, and most likely reduced the total quantity of oil they’ll be able to produce from their fields. Overly rapid reserve depletion can actually damage the reservoir itself.

Like most countries, oil production growth depends on one or two very big oilfields. In Russia’s case that field was Samotlor. According to the Oil & Gas Journal, Samotlor produced over 3.4 million barrels per day in the mid-80s, but has seen production decline violently to just 400,000 barrels more recently. Advanced technology is now being employed to stem the production decline, but the bottom line is that Russia will have a big problem actually boosting production much beyond current levels.

I’ve addressed Saudi Arabia’s oil reserves conundrum here. Suffice it to say that Saudi Arabia’s oil reserves data just doesn’t add up and there is no independently verifiable data to support the Desert Kingdom’s claim that they can continue to ramp up production at a rate that’s sufficient to keep pace with demand.

The combination of low reserve replacement ratios and some visible cracks in the armor of the world’s swing suppliers add up to one thing: a bull market in oil services names. Energy exploration companies are now spending some of their tremendous cash flows to look for and produce new reserves of oil and gas.

With cash flows rising rapidly, the largest exploration and production (E&P) companies could easily boost their capital expenditures by 20 percent annually and still have cash left over to pay dividends or keep paying off debt. It’s the energy services names that will be in a superior position to grab a large chunk of the cash being spent.

I’m upgrading Transocean (NYSE: RIG) to a buy in How They Rate and adding several oil services names to the list. While we have plenty of exposure to the drillers through Wildcatters Noble Corporation (NYSE: NE) and Global Santa Fe (NYSE: GSF), Transocean also has major upside from current levels due to its large fleet of deepwater rigs.

In addition, I’m adding Norway’s Petroleum Geo-Services (NYSE: PGS) to How They Rate as a buy and will continue to track the stock as a trade recommendation. While Wildcatters Schlumberger (NYSE: SLB) and Weatherford (NYSE: WFT) look like better plays in the long-run, Petroleum Geo has speculative appeal and I’ll continue to track it as a trade for those willing to take on a bit more risk.

Before taking an in-depth look at these stocks and others, let’s review some of the oil services functions involved in drilling and producing oil and gas.

Exploration And Appraisal

The first step in producing oil is finding it. To understand how this is accomplished, it’s important to understand just how oil exists in a reservoir underground.

Basically, oil is held in the pores of rocks. One of the most common reservoir rocks is sandstone. Sandstone is made up of grains of coarse sand has lots of small holes and channels in it that can hold the oil. If the sandstone extended all the way to the surface, the oil could simply flow up through the ground and out onto the Earth–this is known as a seep. Undoubtedly a great deal of oil has simply seeped to the surface over the eons.

But sometimes a cap of impermeable rock–a seal or trap rock–sits atop the reservoir rock. The trap does not have many well-connected pores for the oil (or gas) to travel through so the hydrocarbons are actually held underground and cannot seep to the surface. There are many types of cap rock but shale is among the more common. Shale is naturally formed when clay is under extreme heat and pressure. Unlike sandstone, clay is made up of many fine and fairly uniform particles, so there aren’t many holes or pores to allow passage of hydrocarbons.

In the early days, geologists would look for surface tells indicating the presence of these sorts of reservoir formations. This likely started by looking for natural seeps–proof positive of underground oil.

Later, geologists got more sophisticated. One of the earliest and most productive wells in the US was Spindletop, first drilled in Texas in 1901. This well was located on a rounded hill. The rounded hill structure is caused by what’s known as a salt dome.

Salt domes are formed when sea salt buried under millions of years’ worth of sediment heats and turns to a liquid. Salt is much lighter than most other rocks so the molten salt can actually push upwards towards the Earth’s surface to create a giant underground plume. Salt domes are very common traps in Texas and Louisiana.

But surface tells won’t work in all situations. Offshore fields can be located miles underwater where it’s impossible to see any sort of formations. And not all fields have tells at all–sometimes the earth above a major reserve is totally featureless.

That’s where seismic services fit in. As the name implies, seismic technology involves using sound waves to examine underground rock formations. On land, this is done using specialized trucks that literally hit the Earth and create sound waves. Those sound waves then bounce off underground rocks and are read by microphones. Over water, boats tow microphones and use underwater air guns to generate sound waves.

Early seismic graphs simply generated a basic picture of underground rock densities. Reservoir rocks like sandstone have very different properties from trap rocks like shale. Geologists could try to discern the existence of a cap rock that might hold hydrocarbons. But newer techniques are far more sensitive. Much of the exploration done by the bigger energy firms employs three-dimensional or even four-dimensional seismic technology.

Three-dimensional seismic surveys offer a complete picture of the underground reservoir and the size of potential reserves. This is possible because computers can analyze millions of individual seismic readings, piecing it together to form a more detailed map of underground formations.

Four-dimensional surveys utilize time to monitor the movement of fluids, changes in heat over time as a well is produced. This information can help producers decide exactly how to maximize production from a flowing well.

It’s extremely expensive to drill an advanced offshore well. Energy firms do not want to be in the position of drilling a number of dry wildcat wells. This is one reason the use of advanced offshore seismic techniques has accelerated so rapidly in recent years.

The Players

Oil exploration and production companies don’t collect their own seismic data. This sort of information is collected by oil services companies and sold to the producers. The global leader in all sorts of seismic services is Wildcatter Schlumberger (NYSE: SLB). The company’s Western Geco subsidiary offers detailed seismic maps of the world’s main hydrocarbon producing-regions.

And Schlumberger also does seismic surveys of existing wells. One popular way to treat wells and make them more productive is using hydraulic fracturing. This involves pumping a gel into a poorly permeated reservoir rock (pores in the rock aren’t well connected) to actually crack that reservoir, creating channels for oil to flow through. Schlumberger’s seismic equipment allows companies to monitor the progress and efficacy of hydraulic treatments.

In the most recent quarter, revenue growth for Western Geco topped 30 percent year over year and management indicated that spending plans were on the rise. The company’s backlog was close to $600 million. And Western Geco is only one small piece of Schlumberger’s business. Schlumberger remains a buy.

This booming business is also boosting Norway’s Petroleum Geo-Services (NYSE: PGS). You may recall the company declared bankruptcy back in 2003. There were really two major problems that led to that bankruptcy, a prolonged recession in the oilfield services space and some overly creative accounting.

As for the first problem, that wasn’t really unique to Petroleum Geo. Depressed oil and gas prices led to a prolonged period of weakness for most oil and gas stocks. Drillers retired or coldstacked rigs to conserve expenses, and even the big integrated oil companies cut back their exploration and capital expenditure budgets. Obviously, that pullback in exploration activity wasn’t good news for the seismic firms. Schlumberger got hurt back then but had a diverse enough revenue stream to survive. Petroleum Geo wasn’t so lucky.

The accounting issues led to massive restatements. But the SEC has now cleared the company’s accounting and the stock was allowed to relist on the New York Stock Exhange late in 2004 (NYSE stocks are held to higher accounting standards than firms on Nasdaq or the over-the-counter markets). The accounting problems look to be in the past.

Having sold off a small exploration and production subsidiary earlier this year, the company now operates in two major business lines: seismic services and production.

On the seismic front, Petroleum Geo-Services owns a fleet of 10 advanced seismic ships as well as equipment for collecting seismic data onshore. This business can be further divided into two parts: multi-client sales (MCS) and contract work.

MCS is basically a library of data. Companies wishing to look at detailed seismic data on a particular block offshore of Africa could simply order that data–the simple sale of archived data files earns Petroleum Geo a fee. In contrast, when companies come to Petroleum Geo with specific seismic surveys they need done, this is contract work.

Results across both seismic data business segments have been very strong. MCS sales rose nearly 30 percent to over $70 million in the second quarter. The beauty of this segment is that the same data can be sold over and over to different clients. Contract sales were even stronger, up over 65 percent for the quarter. The company scored some big project contracts such as a deepwater seismic survey in Brazil.

Rampant overcapacity of seismic ships caused Petroleum Geo to get into trouble a few years ago, but I see little chance that overcapacity will develop now in an industry bent on finding new reserves.

That brings us to the production business–Petroleum Geo owns a fleet of four mobile production vessels. These are mobile platforms shaped like ships that are used to process and store oil produced from a field. These ships are commonly used to produce smaller fields where it might be uneconomical to build a large permanent platform.

Petroleum Geo leases these vessels out to operators in the North Sea–it’s already the largest operator of such vessels in that market. While this business isn’t seeing the growth of the company’s seismic business, the North Sea is a very hot exploration market. Transocean and Noble, among others, have enjoyed a dramatic bump up in rig rates for the region over the past few months. If activity continues to pick up in the North Sea, that’ll be good news for the floating production business.

A word of caution: Petroleum Geo-Services is not the highest quality play in oil services–I continue to recommend both Schlumberger and Weatherford as the best long-term plays. But Petroleum Geo is a good, leveraged play on a strong oil services market that should see particularly strong near-term action and is a buy in How They Rate.

Starting The Drill

Even the best seismic surveys can’t guarantee economic quantities of oil and gas. Eventually, companies have to determine the feasibility of a well the old-fashioned way: Drill a well, test it and see if sufficient quantities of oil flow. Drilling is also not a straightforward business and is a lot more complex in harsh environments like deepwater offshore fields.

In a basic well, a drilling crew attaches a drill bit that’s studded with industrial diamonds to a pipe called a string. The rig then rotates the pipe–the bit and entire string rotates–causing the bit to cut. As the well becomes deeper, crews add sections of pipe to the string.

The benefit of the string is that it’s the conduit for the mud circulation system. A complex mixture of chemicals and clay is pumped under pressure down the drill string and through the bit. Once the mud exits the bit it travels back up the outside of the string to the surface of the well, carrying rock cuttings with it. The mud under pressure also helps to prevent oil from the reservoir formations from entering the wellbore and blowing out the top of the well, a potentially dangerous and costly situation.

The crew on a drilling rig provides this basic service. In most instances, that’s the province of the contract drillers. (I’ve covered the drillers at length here.)

Companies at this time and throughout the drilling process usually perform detailed tests on the well itself to evaluate the quality of the formation and the presence of hydrocarbons. This is a process known as well logging.

Once the desired depth of the well is reached and the crew determines the presence of hydrocarbons in sufficient quantity, it’s time to complete the well. Crews insert a heavier pipe called casing into the hole. Special cement is then pumped around the outside of the drill string. The purpose of casing and the cement is to prevent water, natural gas or other impurities from entering the wellbore and contaminating the hydrocarbons produced.

The final steps normally involve using explosive charges to penetrate the walls of the casing, allowing oil to flow from the reservoir into the wellbore. Nowadays, it’s rare for oil to be produced directly through its casing. Usually a coiled tubing string is inserted into the well and fixed in place. This tubing can be relatively easily replaced if corroded unlike segments of casing cemented in place.

Wells are rarely drilled vertically now. Oil and gas deposits are often located in bands at a particular depth underground. A horizontal well can be dug in such a way that the bulk of the well comes in contact with the hydrocarbons. Some even more modern wells are dug with multiple horizontal branches to increase the surface area of contact even further. Horizontal wells are normally far more effective in producing oil or gas.

With horizontal wells you cannot rotate the entire drill string to move the bit. These wells use some type of downhole motor. The bit is powered by equipment in the hole and can rotate independently of the string.

Other complications can arise while drilling. The list would include extremely harsh temperature and pressure environments that require careful monitoring of the density of the drilling mud employed. Mud that’s too light can result in blowout, but mud that’s too heavy can enter the reservoir rocks and damage the formation. Also, some wells need additional treatments such as hydraulic fracturing to produce properly.

While the basic drilling rig and crew are the province of the contract drillers, much of the other equipment and many services mentioned in this section are performed by service crews. These crews often handle the cementing and completion of wells, perform well and mud-logging tests and handle any necessary stimulation to get a well to produce.

The important point here is that as wells become more complex to reach ever more complicated and deepwater reserves, the oil services firms are in greater and greater demand.

The Services Players

My two favorite oil services names remain Schlumberger (NYSE: SLB) and Weatherford (NYSE: WFT). Schlumberger is the most advanced service name from a technological standpoint so it’s best positioned to benefit as drilling techniques become more advanced.

Weatherford is a world leader in technologies used for mature wells. As the world’s existing oilfields age, companies will want to squeeze as much oil as possible from existing reserves. This includes underbalanced drilling, a method for drilling older wells that prevents drilling mud from damaging the reservoir formations.

Schlumberger and Weatherford have large, diversified international operations, and are leaders in their respective niches. Both stocks remain buys in the Wildcatters portfolio.

I also track a number of other oil services firms in How They Rate.

National Oilwell Varco (NYSE: NOV) is the world leader in most of the actual equipment located on drilling rigs, including the drawworks used to hoist pipes and casing, motors used to rotate the bit and even the bit itself. After taking over Varco International earlier this year, National Oilwell has garnered a dominate market share in many key businesses–it controls about 90 percent of the market for drawworks and mud circulation pumps and systems. The equipment provider also performs some traditional services, including servicing older wells and installing coiled tubing. National Oilwell is extended at present and rates a hold.

Baker Hughes (NYSE: BHI) is the global leader in wireline technologies. This involves lowering specialized equipment into a well and evaluating the reservoir, the presence of hydrocarbons and how best to produce the well. That’s a business that will continue to boom as the exploration cycle heats up. While I have plenty of exposure to services in the main portfolios, Baker Hughes is an extraordinarily well-placed company. Baker Hughes is a buy in How They Rate.

BJ Services (NYSE: BJS) is the global leader in pressure pumping operations. This term loosely refers to any process that involves pumping liquids under pressure down the well, but probably the hottest area right now is hydraulic fracturing. Hydraulic fracturing is the key to unlocking some of the most promising unconventional reserves worldwide such as the Texas shale gas plays. BJ has the most modern fleet of pressure pumping equipment in the world. Nevertheless, due to the company’s massive exposure to the volatile North American market, I’m maintaining BJ as a hold for now.

Dril-Quip (NYSE: DRQ) specializes in offshore drilling and production equipment. This includes subsea trees and risers. In deepwater fields, the valves and production equipment used to control the flow of oil and gas from the well are normally located right on the seafloor. That oil is then pumped (or allows to flow) to the surface production facilities through what’s known as a subsea riser, basically a flexible pipe. I can’t argue with DrillQuip’s basic business model and focus on offshore technologies, but I prefer Wildcatters FMC Technologies (NYSE: FTI) and Cooper Cameron (NYSE: CAM), which operate in some of the same businesses but are better diversified. I recommended selling out of Dril-Quip if you own it and switching into Cooper Cameron and FMC.

Two companies with tremendous leverage to deepwater drilling are Transocean (NYSE: RIG) and Diamond Offshore (NYSE: DO). These companies own the most highly advanced and expensive deepwater drilling rigs in the world.

Deepwater reserves are extremely important to global oil supply. Over the past few years, deepwater has accounted for up to one-third of total new oil discoveries worldwide. Onshore areas have already been widely explored so it’s unlikely major new reserves will be found in these areas. To the extent that it will be possible to find and develop new reserves, those reserves are likely to come from deepwater.

Contract rig rates for hiring the most advanced rigs have more than tripled over the past three years. And over the last week or two some markets like the North Sea and West Africa are seeing rig rates push to new highs. This is cash in the till for the drillers.

Two factors support continued upside in the group despite the recent run. First, drillers normally put some of their rigs out on charter contracts at fixed day-rates. Therefore, rising rig rates can take a few quarters to show up in results as contracts eventually expire and are readjusted. Between now and early next year there will be a massive readjustment cycle–the drillers will be letting out their rigs on new contracts at much higher day-rates. That will be the sweet spot of profitability.

Second, check out the long-term charts of Transocean and Global Santa Fe. Despite the fact that this is the most profitable cycle in the energy markets since the ‘70s, these stocks have not yet taken out their late ‘90s peaks.

Transocean (NYSE: RIG)

Source: www.stockcharts.com

Global Santa Fe (NYSE: GSF)

Source: www.stockcharts.com

 

Oddly, while the fundamentals are well known, the stocks haven’t yet priced in all the good news. With the largest fleet of deepwater rigs in the world, I’m raising Transocean to a buy in How They Rate. I continue to prefer GlobalSantaFe and Noble slightly–these remain the portfolio picks.

It’s worth noting my other drilling recommendations. In a flash alert last week, I recommended selling out of half of your trading position in shallow water driller Todco (NYSE: THE) for a profit of about 35 percent in a month-and-a-half. My reasoning was simple: The stock ran up ahead of its earnings release and would likely see a pullback once the good news was released.

This is now playing out according to plan. I am maintaining a buy recommendation on Todco in How They Rate. I’ll alert you when it’s time to sell out the second half of your positions–for now, simply raise your stop-loss on the remaining position to breakeven.

We were stopped out of the recommended short position in Patterson-UTI (NSDQ: PTEN), a US-based land driller. I held onto this position as the sole short in the portfolio as a hedge if (or when) oil prices pull back. The opportunities in land drilling remain less attractive than in offshore deepwater. I’ll follow Patterson-UTI in How They Rate as a hold.

Shell’s Transition

Please note that the transition of Proven Reserves Portfolio member Royal Dutch Shell’s (NYSE: RDS) share structure to a single entity is complete. I recommend the class A shares that trade on the NYSE under the symbol “RDS A.”