A year ago, investors and analysts couldn’t have been much more bullish on the energy patch. After a nearly three years of solid growth from the group, investors started projecting double-digit growth forward years into the future.

Those investors weren’t all wrong. Predictably, the North American market slowed down as natural gas prices fell steadily through 2006; however, there was no knock-on effect internationally as drilling and exploration markets remained red-hot. Nonetheless, in a climate of ultra-high expectations, even the best-performing energy firms had a tough time impressing the investment community by generating significant upside surprises.

But what a difference a year makes. Of all the major sectors, energy stocks have seen the most downside earnings expectation revisions since the beginning of 2007. Year-over-year earnings expectations for big US energy stocks are muted and among the worst in the S&P 500. Therefore, the bar of expectations that was set so high a year ago is now far easier to hurdle.

In This Issue

Expectations have been cut in an environment of improving fundamentals. Although North American gas-leveraged names remain weak, there are some tentative signs that the natural gas market is stabilizing; inventories of gas in storage have normalized considerably since late January.

And the oil market looks to be on the verge of a major run higher. US inventories of gasoline (petrol) currently stand way below average, and refiners, plagued by fires and outages, are struggling to build gasoline stocks ahead of the upcoming summer driving season. Meanwhile, the Organization of Petroleum Exporting Countries (OPEC) oil supply cuts are beginning to bite: OPEC’s March production output was the lowest since January 2005.

All in all, I see this as a bullish environment for my “traditional” energy plays in the oil and natural gas industries. In this week’s issue, we’ll review my current recommendations and take a look at two new picks: Weatherford International (NYSE: WFT) and Pride International (NYSE: PDE).

In the most-recent issue of The Energy Strategist, I outlined my bullish case for crude oil, highlighting the fact that the recent run-up in crude isn’t solely due to geopolitical factors. Predictably, oil did dip following Iran’s release of the 15 British sailors, but that dip was short-lived. The reason: Although some pundits continue to focus on geopolitics, supply and demand fundamentals continue to drive this market more than is widely appreciated.

Although traditionally trading at a discount to West Texas Intermediate crude, Brent crude has now reached a premium to the more-superior crude, a benchmark used more widely in the US. Let’s see how the US and global markets compare. See Premium Event.

The rise in oil inventories isn’t the next sign of a subprime bust or a weakened economy. Rather, it’s a result of refiners’ inability to process oil quite enough to meet demand. See An American Story.

A recent report from the International Energy Agency compounds the refining issue by forecasting increased demand and less oil supply. This also helps to explain the Brent/WTI premium. See The Global Picture.

Refiners are starting to come back on line, which should deplete the stock of WTI and raise its price. I hope to see a move toward $70 for both Brent and WTI in the coming months. See What This All Means.

As another major energy source, natural gas has also had issues with supply as the weather in the past year or two has greatly affected the amount used and stored. However, I see several factors that will limit the downside for natural gas in the coming years. See Natural Gas.

I already hold a number of stocks in my model Portfolios that have the proper exposure to the oil and gas markets. Here’s an update on these holdings. See How To Play It.

There are two companies in the drilling sector worth looking at. Although each company has its own weaknesses, both companies have seen a significant increase in call purchases in the past few months, which could be beneficial in the near future. See New Recommendations.

In this issue, I’m recommending or reiterating my recommendation on the following stocks:

• BG Group (NYSE: BRG)
• Carbo Ceramics (NYSE: CRR)
• Chevron (NYSE: CVX)
• Dresser-Rand (NYSE: DRC)
• EOG Resources (NYSE: EOG)
• ExxonMobil (NYSE: XOM)
• FMC Technologies (NYSE: FTI)
• Petroleum Geo-Services (NYSE: PGS)
• Pride International (NYSE: PDE)
• Rowan (NYSE: RDC)
• Schlumberger (NYSE: SLB)
• Seadrill (Oslo: SDRL, OTC: SDRLF)
• XTO Energy (NYSE: XTO)
• Weatherford International (NYSE: WFT)

Premium Event

One of the most unusual and interesting developments in the past two months has been the stark divergence in performance between two of the most common crude oil benchmarks in the world–West Texas Intermediate (WTI) and Brent crude.

I discussed and defined the importance of different types of crude oil in the March 21 issue of TES, Looking Refined. For those unfamiliar with this concept or refining economics in general, I recommend reviewing that issue.

To make a long story short, though, Brent is a slightly lesser grade of oil than WTI. Both oils are considered light, sweet crudes, but standard Brent has an American Petroleum Institute (API) gravity of about 38.1 degrees and a sulphur content of 0.39 percent. In contrast, WTI has an API gravity of 40 degrees and a sulphur content of 0.3 percent.

This is one reason why WTI has historically traded at a slight premium price to Brent. In fact, based on the past seven years of data, WTI has averaged a premium of $1.72 to Brent. Check out the chart below.


Source: Bloomberg

The chart above shows the premium of WTI over Brent in terms of dollars per barrel based on weekly data going back to April 2000. The solid line shows that average premium of about $1.72.

As you can see, prior to 2006 there were a few short-lived spikes when the price of Brent temporarily exceeded WTI. But the action in the past year looks notably different: Brent has moved to a premium on several occasions.

Since the beginning of 2007, that pattern has become even more notable; Brent has been trading at an ever-widening premium to WTI. That premium now exceeds $4 per barrel, a far cry from the normal discount of $1.72.

At first blush, this doesn’t appear to make much sense. If Brent is a slightly inferior crude, then it should trade at a slight discount. If we factor in current US gasoline prices and current prices for Brent and WTI, it’s clear that US refiners would prefer to refine WTI over Brent right now. That’s because the crack spread on a barrel of WTI is roughly $6 more than for a barrel of Brent.

This is why historically whenever Brent has traded at a premium, that premium has closed quickly. When Brent trades at a significant premium to WTI, US refiners start refining more WTI (and other types of crude) and less Brent. This reduces demand for Brent and pushes up demand for WTI, putting downward pressure on Brent prices relative to WTI.

This is a fancy way of saying that the relationship between Brent and WTI tends to be stabilized over time because of simple market forces. In the past, these temporary inversions of the normal WTI/Brent premium have been caused by short-lived supply disruptions.

Recent experience, however, suggests that other factors have entered the equation. There are obviously more forces at work in the crude oil market than just the quality of the crude and current refining economics. This enigma can be explained when you consider where these crudes come from and how they’re priced.

Major oil producers including Russia and Nigeria use Brent as a benchmark for pricing the crude they produce. In total, it’s estimated that a little more than 20 million barrels of daily oil production are priced using Brent as a benchmark; it’s a key crude blend for the European market and, to some extent, for Asia.

In contrast, WTI has historically been more of a US crude oil basket. Not only is it used as the basis for US-traded oil futures, but it’s also a key benchmark for US production. Therefore, WTI more closely reflects US supply/demand fundamentals, while Brent tends to be more influenced by global events and international supply/demand fundamentals.

Of course, traditionally the US and global oil markets have been closely related; the US is, after all, still the world’s single-largest consumer of crude oil, as well as the largest importer. But right now, there are some very real reasons this traditional relationship has shifted. To understand this, you need to examine the current oil and gasoline demand situation in the US as it compares to the rest of the world.

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An American Story

According to the latest Oil Market Report, released by the International Energy Agency on April 12, US gasoline demand is unusually strong right now. US gasoline demand averaged 9.4 million barrels a day during the four weeks through April 6, roughly 2.5 percent above the same levels last year. This is nearly double the long-term average pace of annual gasoline demand growth.

That demand growth is impressive when you consider that retail gasoline prices have been rising steadily since January. In the West, prices are already rising above $3 per gallon, yet there’s little sign of slowing gasoline demand.

This situation is clearly visible when you consider the big shortage developing in US gasoline inventories as we enter the run-up to the peak demand summer driving season. Take a look at the chart below.



Source: Bloomberg, Energy Information Administration (EIA)

This chart uses data going back five years. I’ve included four lines showing the maximum, minimum, 2007 year-to-date and average US gasoline inventories during this five year-period.

It’s clear that 2007 gasoline inventories were at the high end of the historic range for the first few weeks of the year. In fact, for much of January, inventories were actually above the maximum levels recorded in any year going back to 2002.

But that’s all changed. In the past nine weeks, inventories of gasoline have fallen precipitously; current gasoline inventories are way below average for this time of year. Even more interesting, as I pointed out in the most-recent issue of TES, those inventories are actually continuing to fall quickly during a season when US refiners typically build their inventories.

And I’m not adjusting these figures to account for the higher-than-normal gasoline demand in the US right now; these are raw inventory figures from the Energy Information Administration (EIA). If we adjusted for the recent, sustained, heightened demand, the inventory picture for gasoline would look even more bullish.

In addition to far stronger-than-normal gasoline demand, gasoline prices are also rising because of reduced output from US refineries. As I explained in the March 21 issue of TES, a series of refinery accidents, fires and outages have severely curtailed refinery output so far in 2007. The best measure of this is refinery utilization, a measure of what percentage of total US refining capacity is currently working.

Simply put, the higher the percentage, the more petrol that’s flowing out of refineries. Check out this seasonal chart of refinery utilization below.



Source: Bloomberg, EIA

Just as with the chart of gasoline inventories, this chart is based on the past five years worth of data. I’ve once again depicted the maximum, minimum, and average capacity utilization data in this five-year history. I’ve also overlaid the current year-to-date (2007) utilization numbers.

What’s clear here is that refinery utilization has remained far below average this year because of these ongoing refinery outages. This means even though American consumers are demanding more gasoline and diesel than normal this year, US refineries aren’t able to produce enough gas to meet that demand. A powerful combination of both strong demand and weak refinery utilization is behind that precipitous drop in inventories.

Of course, the one commodity that’s not in short supply in the US right now is crude oil. Check out the chart of current US crude oil inventories.



Source: Bloomberg, EIA

This chart is identical in construction to both the gasoline inventory and capacity utilization charts. What really jumps out from this chart is that US crude oil inventories are above average for this time of year; the US has plenty of oil in storage. In fact, US inventories set new five-year highs several weeks earlier this year before flattening out more recently.

The large inventories of crude oil in the US have absolutely nothing to do with weak demand. It’s the refiners that use crude oil, not consumers directly. You don’t fill your car with crude oil; you fill it with gasoline. Refiners buy crude oil to make gasoline and other refined products.

The reason that oil inventories are so high right now is simply that the nation’s refiners aren’t working at anything close to normal capacity; therefore, they’re not refining all the crude inventoried to make gasoline.

Don’t make the mistake of thinking that high US crude oil inventories are a symptom of a weakening US economy, the latest subprime bust or any other macroeconomic problem. The true demand picture in the US is revealed by the gasoline market. Gasoline demand is high, and inventories are falling at the fastest pace in many years. The broken link that’s causing crude oil inventories to build domestically is the refiners.

These factors bring us back to the WTI/Brent spread paradox mentioned earlier in the intro. You can clearly see why US oil demand is relatively low: Refiners already have plenty of oil and are unable to refine it fast enough to meet demand.

As I noted earlier, the price of WTI is heavily influenced by the picture for US crude oil supply and demand. The current high inventories of crude are weighing on WTI prices.

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The Global Picture

Globally, the supply/demand situation for the crude oil markets is different. In the April 4 issue of TES, Oil Nuclear And Alternatives, I highlighted the fact that current global oil demand is strong and that OPEC is severely curtailing crude supplies.

The International Energy Agency’s (IEA’s) most-recent report suggests that those trends have continued to strengthen. Total crude and refined products stocks in the Organisation for Economic Co-operation and Development (OECD) countries—the developed world–fell by about 80.5 million barrels in February.

In addition, according to preliminary data for March, inventories continued to decline in the OECD in a season when inventories typically build. The IEA estimates that total stocks in the US, Europe and Japan declined at a rate of more than 1 million barrels per day throughout the first quarter of the year–a higher-than-average decline for that time of year.

But what’s even more bullish is the global supply picture for oil. According to the IEA, March oil output from OPEC totaled about 30.1 million barrels, a further 165,000 barrels per day cut from February levels. When you factor Angola–a new OPEC member in January–out of the equation, it’s the lowest output from OPEC since January 2005. The IEA has reiterated the fact that OPEC’s current oil output isn’t high enough to allow global oil importers to build their crude stocks ahead of the summer driving season.

Once again, the fundamentals of strong growth in demand, coupled with static to falling supplies, are supporting higher global oil prices. Add in continued unrest and weak output from Nigeria, terrorist attacks in Algeria and tension in the Middle East, and there are plenty of reasons to be concerned that supplies could be cut even further from current anemic levels.

This scenario brings us back to the Brent/WTI premium. Brent prices tend to be influenced more strongly by global supply-and-demand fundamentals than WTI. Global stocks of refined products and oil are low; there’s no crude oil inventory overhang as in the US.

OPEC production is also falling, raising the specter that oil inventories in Europe and Asia won’t see a strong seasonal build-up this spring. The current tighter supply/demand environment accounts for Brent’s unusual premium valuation to WTI.

When you couple the tight global supply/demand balance with the unusual refiner-induced crude build in the US, it’s easy to see why Brent/WTI prices are acting so unusually.

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What This All Means

The scenario I just outlined is extremely bullish for crude oil and refined products prices. However, the temporary weakness in WTI relative to Brent is significantly obfuscating this bullish picture for many US-based investors.

I’m looking for WTI prices to rise back to their traditional premium to Brent in the next few months. I’m also looking for both benchmark oil prices to rise well into the $70s per barrel by midsummer; I’m basing this projection not on any sort of one-off geopolitical event but simply on tightening supplies and rising demand.

Consider that US gasoline stocks are already ultra-low and dropping counter seasonally. To meet surging US gasoline demand, refiners will need to accelerate their gasoline production soon as the period of peak demand is now only a couple months away. With gasoline demand already strong, it looks like this could be another stronger-than-normal summer driving season.

Already some of the idled refineries are coming back on line, albeit at reduced capacity levels. Other refineries that have been undergoing prolonged maintenance this spring are also finally starting to produce gasoline. Think about the current situation from the refiners’ perspective: They’re looking at strong gasoline prices and some of the strongest refining economics in years.

They’re also looking at rapidly falling gasoline inventories that will approach dangerous levels soon if the drawdown continues. US refiners are behind on demand and looking at a very profitable refining environment; they’re going to produce at the maximum pace possible this spring. We’re seeing the very early innings of this right now with refinery capacity utilization slowly ticking higher from low levels.

By definition, as refiners start producing gasoline, they’ll be using up those crude stocks that have kept a lid on WTI prices this year. In fact, those stocks should draw down rapidly as the nation’s refiners shift into high gear for summer. If, as I expect, gasoline demand remains solid, those inventories could quickly drop below average levels.

But with US oil benchmark (WTI) prices below prevailing international benchmark (Brent) levels, US refiners are going to have trouble finding any oil to import; better oil prices are available internationally than in the US. Of course, there are certain oil supplies (such as Venezuelan heavy crude) that are relatively captive to the US market. However, with WTI prices so far under international levels, it will be tough for the US to attract additional barrels.

It’s simple economics: If the US is going to attract imports, US benchmark prices will need to rise toward international levels and WTI will have to close its discount to Brent.

Moreover, as US crude inventories start to draw lower and the nation begins importing again in earnest, this will represent another wall of demand for the international crude oil markets. In other words, strong US gasoline demand will eventually represent a strong draw on global crude oil supplies. Those supplies are already tight, and OPEC shows no sign of letting up on its campaign to cut output.

All told, I see this as a recipe for a significant rally in crude. In addition, such an environment is bullish for oil exploration and production activity levels. We’ve seen no letup in the red-hot pace of international drilling and exploration activity; I expect no such slowdown to develop. In fact, if anything, the current environment should accelerate global oilfield activity.

This is a bullish environment for oil services and contract drilling stocks. I’ve highlighted this group on multiple occasions in TES. To summarize, oil services firm is a catch-all term used to describe a wide variety of oil production and exploration-related functions. Suffice it to say that producers–firms such as ExxonMobil and Chevron–need oil and gas services firms to find and produce hydrocarbons.

And because development and exploration work is increasingly turning to more-complex reserves, such as deepwater and Artic drilling, producers need the services firms more than ever. New subscribers looking for a more-detailed treatment of these issues should check out the January 3and February 7 issues of TES, The Deep End and Be Selective, respectively.

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Natural Gas

But, as I pointed out in the February 21 issue, All Eyes On Gas, the big issue for oil services stocks during the past nine months hasn’t been the strength of oil-related services but weakness in natural gas prices. Or, more specific, the weakness in the North American drilling market has been precipitated by weakness in natural gas prices; most land-based North American drilling activity targets gas, not oil.

This has been an ongoing theme in TES for more than a year now. Weakness in the North American drilling market is behind the marked underperformance of stocks like BJ Services and Patterson-UTI that are predominantly dependent on this market. Companies like Wildcatter Portfolio recommendation Schlumberger have more-diversified international exposure and have seen little or no impact from the slowing American market. Investors have recognized this fact, and stocks like Schlumberger’s continue to perform well.

But much of the worst possible news is already priced into the US- and gas-leveraged services and contract drilling names. I outlined this case at some length in the April 12 issue of The Energy Letter, Lowering The Bar. I won’t repeat all those arguments here; suffice it to say that the North America-leveraged stocks have stopped reacting meaningfully to negative news about the North American drilling environment. These stocks are, quite simply, washed out and have limited downside.

In addition, I’m beginning to see some fundamental reasons to get more bullish on natural gas. Here’s a quick rundown:

• Declining Canadian Production–The Canadian rig count is down around 50 percent year-over-year. Drilling and exploration work targeting gas in Canada is way down; all of the North America-leveraged names have highlighted the extraordinary and rapid slowdown in this market as a major issue. But gas well decline rates in Canada are close to 30 percent–each year production from a given well tends to drop by nearly a third–so maintaining production requires constantly drilling new wells. Therefore, declining activity in Canada spells falling production and reduced imports for the US market.
• Normalizing US Storage–Throughout 2006 and the beginning of 2007, very high inventories of stored gas in the US kept pressure on US gas prices. But since that time, inventories have begun to normalize. Although inventories of natural gas are still higher than average for this time of year, they’re well below last year’s elevated levels; the coldest February on record for the US in 30 years helped drive a surge in demand. In addition, after a few spring-like weeks in March, temperatures across the Midwest and Eastern US have dropped and remain far below average in April. This will limit inventory buildup during the spring months.
• Flattening US Production–Although US drilling activity certainly hasn’t dropped off a cliff as it has in Canada, there’s been a slowdown. Drilling in the Rockies has been effected by weather-related delays and storms. And higher-cost reserves, such as coal-bed methane and parts of the shallow-water Gulf of Mexico, aren’t being produced as aggressively as they would be at higher prices. Bottom line: US production probably won’t grow much near term, further limiting supply and putting upward pressure on prices.
• Hurricanes And Hot Weather–These are two tough-to-predict factors. However, a developing La Nina current in the tropical Pacific raises the odds of an active hurricane season for the Atlantic Basin. In addition, the rising use of gas in electric power plants means that a hot start to the summer would drive a surge in gas use. In the heat of the summer last year, there were actually big drawdowns of gas inventories, an unusual phenomenon during the summer months.

My conclusion from all this is that natural gas prices have limited downside going into summer. And with gas-leveraged stocks trading at such depressed levels, the risk/reward in the space is tremendous.

With earnings reports for most services stocks rolling in during the next few weeks, I expect to have a lot more to report on the North American gas issue.

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How To Play It

We’re already playing the strengthening environment for oil and gas with a slew of services, equipment, and exploration and production (E&P) firms. In this issue, I’m also adding two new stocks to the portfolios. Here’s a quick rundown of my current recommendations levered to this strengthening oil and gas environment.

Schlumberger remains the world’s premier services play. The company has the most-advanced technologies in a slew of major services functions. For example, the company’s Q-Ship seismic vessels are the most advanced in the industry; they’re highly sought after by producers doing deepwater oil and gas field development. Schlumberger also holds some unique, differentiated technologies in markets such as horizontal drilling and intelligent well design–wells that can actually sense if they’re producing too much water and shut down well segments accordingly.

One of the longest-standing themes of this newsletter has been the end of “easy” oil. The world’s giant, easy-to-produce, onshore oil reserves are now mature and experiencing flat or declining production. Increasing, new production will come from harder-to-produce reserves such as deepwater fields. New technologies also allow producers to maximize their production from mature fields. I explained this at some length in the January 3 issue.

Schlumberger is the perfect play on the end-of-easy-oil scenario. The company’s high-tech service offerings are exactly what the world’s producers need to exploit these more-complex reserves.

The stock has recently shot above my buy target; in this issue, I’m raising that target in the Wildcatters Portfolio table. Schlumberger remains an excellent buy.

As an aside, I’m often asked about the Halliburton, the other 800-pound gorilla of the services space. My take: Halliburton isn’t as attractive as Schlumberger, and they are not the same company.

Halliburton still has huge exposure to North American gas markets; it’s been hit far harder than Schlumberger by the slowdown there. This accounts for Schlumberger’s 28 percent return over the past six months, while Halliburton has returned only 11 percent. This is also the reason I haven’t been recommending Halliburton in the TES Portfolios; for many months I rated it a sell in How They Rate.

Halliburton does have a solid international business that’s growing like a weed. It really should come as little surprise that the company is shifting its focus away from North American gas market services to international investments. This is a positive development.

I’m also warming up to Halliburton simply because all the bad news on its US gas operations is well known. Bottom line: I’m not quite ready to recommend Halliburton in the Portfolios–I prefer Schlumberger–but I no longer recommend selling the stock.

Along a similar vein, I also recommend FMC Technologies, a manufacturer of subsea equipment that’s used to produce deepwater fields. I highlighted this stock at great length in the January 3 issue of TES. FMC remains a buy. Note that I’m raising this stock’s buy target as well. Also, please be aware that FMC’s symbol is FTI not FMC.

With a fleet of seismic ships, Norway-based Petroleum Geo-Services is also benefiting from the strong market for deepwater exploration and development. Schlumberger’s Western Geco seismic division remains its strongest and fastest-growing business right now; Schlumberger just can’t keep up with demand. And during the past few months, every other company with a significant seismic division has also reported serious strength in this business. Keep buying Petroleum Geo-Services.

Another big winner is deepwater rig specialist Seadrill. Seadrill is a contract-drilling firm that owns a host of deepwater drilling rigs; it’s also contracted with shipyards to buy additional advanced rigs.

Day-rates—the fee charged for leasing a rig—for deepwater rigs have soared during the past few years to unprecedented heights as producers continue to expand their deepwater exploration programs. In addition, there are very few deepwater rigs available for contracting in the next three years. This scarcity of rigs available for work has further pushed up day-rates.

Seadrill has the largest fleet of uncommitted rigs; the company stands to benefit most from the current strong day-rate environment. I highlighted the stock in depth in the January 3 issue.

One of the issues for Seadrill this year has been an ongoing legal battle with the Oslo Stock Exchange (OSE) concerning the company’s proposed acquisition of Eastern Drilling, another Norway-based contract driller. Seadrill owns a little more than 60 percent of Eastern Drilling shares; the company purchased the last chunk of that stake in the third quarter of last year.

As in many other countries, Norwegian law mandates that Seadrill must make an all-out bid for Eastern Drilling’s remaining shares. This mandatory bid was triggered when Seadrill’s ownership stake exceeded 50 percent. Seadrill made an offer of 92 Norwegian krone for the remaining stock. (The current exchange is about 6 krone to one US dollar.)

Norwegian law stipulates a mandated takeover price, and Seadrill felt this offer was in line with the regulation. However, the OSE doesn’t agree; the OSE appeals board recently ruled that Seadrill must offer 135 krone for the remaining shares.

But this problem looks close to resolution. Seadrill recently announced that it will make a bid at the OSE-mandated price of 135 krone. The company continues to dispute the price the exchange has mandated for this offer; the price is higher than Seadrill believes it should have to pay. The company will seek reimbursement by the exchange in Norway’s courts.

Although paying a higher price is obviously a negative, Eastern Drilling has some valuable rigs that will earn high returns for Seadrill. Furthermore, Seadrill will remain in strong financial shape after the deal; in fact, the board continues to look for other acquisition opportunities.

Although the company has said it will have to raise money by issuing stock to fund the purchase, this was already widely anticipated and shouldn’t have a major effect on the stock. The market’s been pricing in this scenario for months. And by making this bid public, Seadrill brings this battle with the exchange closer to a conclusion, allowing investors to refocus on actual fundamentals.

I expect Seadrill to eventually switch its primary listing to another country as it’s threatened to do on several occasions since this legal battle started. Most likely, that would involve listing in either London or New York. This would be a huge positive for the company; a listing in a larger market would raise the company’s profile with investors and make it easier for US-based investors to buy stock.

And don’t be surprised to see Seadrill buy a US-based driller. The company has made no secret of its desire to become the largest contract driller in the world. And management has also admitted it’s been in ongoing talks with several US-listed drillers. Keep buying Seadrill.

As I pointed out in the most-recent issue of TES, Dresser-Rand is another big beneficiary. The company makes equipment used on drilling rigs, in refineries and in subsea deepwater developments. These are three of the hottest markets I can think of. Dresser-Rand rates a buy.

And, of course, higher oil and gas prices also benefits companies involved in the actual exploration and production of crude oil. This list would include both pure-play E&P firms and the major integrated oils. I outlined the fundamentals of the E&P business in the Dec. 6, 2006, issue of TES, Looking For Some Upside.

I continue to favor E&P firms with the scope to actually grow their production at attractive costs. My favorite gas-focused E&P firms are XTO Energy, EOG Resources and Britain’s BG Group. Again, be careful to note that BG Group’s symbol is BRG not BG. I’ve raised my buy targets for all three stocks; XTO Energy, EOG Resources and BG Group are buys.

The two biggest businesses for integrated oils are E&P and refining; both markets look attractive right now. I outlined my bullish case for refining in the March 21 issue of TES. My two favorite integrated oils are ExxonMobil and Chevron, both in the Proven Reserves Portfolio.

Finally, we’re playing the washed-out North American natural gas market in the Gushers Portfolio with two recommendations: Carbo Ceramics and Rowan.

Carbo Ceramics makes proppant. As I outlined in the February 21 issue, proppant is used to produce unconventional gas reserves in the US and, to some extent, internationally.

The company’s ceramic proppant is far more effective than the older-style proppants on the market. However, at this time, ceramic proppants only account for a little less than a fifth of the world market; sand and resin-coated sand have a more than 80 percent share.

In recent quarters, Carbo has seen its sales grow faster than the overall rig count and the overall market for proppant. This suggests that it’s actually taking market share away from competitors.

In addition, ceramic proppants are grabbing a bigger share of the global market at the expense of traditional sand because ceramics are more effective. In 1996, ceramic proppants accounted for only 10 percent of the global proppant market, so the ceramic market share has already roughly doubled.

I also like Carbo’s recent expansion into the Russian market. Outside the US, Russia is one of the most promising markets for hydraulic fracturing, a type of service that requires the use of proppant. And Carbo is setting up a manufacturing facility there to better target this market. Buy Carbo Ceramics.

Rowan is a shallow-water contract driller. The company owns a fleet of jack-up rigs used for drilling in water less than 300 feet deep. Rowan’s fleet is a high-specification fleet; the company’s rigs are capable of handling rough weather and high seas.

Traditionally, Rowan has focused its attention almost exclusively on the US shallow-water Gulf of Mexico–a mature oil- and gas-producing region that’s been exploited for decades. It’s also a spot contract market; operators tend to lease rigs to drill individual wells or handle short-term contracts.

Lately day-rates in the Gulf have cooled because of weakness in the North American gas market. At the same time, international markets for jack-ups remain red-hot; Rowan has been moving rigs from the Gulf to work on longer-term contracts abroad at sky-high day-rates. And Rowan isn’t the only company doing this; a number of other operators have moved rigs out of the Gulf.

There are 89 jack-ups currently available for work in the Gulf, but 10 of those rigs are work-over rigs used for repairing wells. In the first quarter this year, seven rigs departed the region for international markets and an additional 10 rigs are expected to leave later this year. That means that a total of 17 jack-ups will leave the Gulf in 2007 out of a total fleet of 86 rigs (as of Dec. 31, 2006). That’s a 20 percent reduction in jack-ups available for work in just one year, on top of the big exodus of rigs last year.

Unless day-rates for jack-ups in the Gulf rise to higher international levels, this exodus of rigs will continue. And with most jack-ups worldwide booked under long-term contracts, there isn’t much marginal rig supply to flow back to the Gulf if activity picks up again. In other words, the rigs that are leaving are laving for good.

If, as I expect, the North American gas market stabilizes and begins to improve, demand for rigs in the Gulf should begin to pick up smartly. But operators will find that a huge number of rigs have already left the Gulf for other markets; there’s a high probability of a supply squeeze. At the very least, the exodus of rigs from this market should put a floor under day-rates in the region.

Meanwhile, Rowan is earning solid, near-historic day-rates in its international business. Keep buying Rowan.

Back To In This Issue

New Recommendations

In this issue, I’m adding Pride International to the Wildcatters Portfolio. Pride owns a mixture of different rig types, including deepwater drillships and semi-submersibles, as well as jack-ups and land rigs.

Pride owns eight high-specification deepwater rigs. As noted above, these are the most-valuable rigs; they’re in very high demand right now as producers scramble to start deepwater exploration and development projects.

Two of its most-capable rigs are drillships: the Pride Africa and Pride Angola. As the term suggests, drillships look like regular ships except they’re fitted with drilling equipment. Check out the photo below of the Pride Africa for a better idea of what a drillship looks like.



Source: Pride International

Both of these drillships are capable of drilling in water up to 10,000 feet (3,048 meters) deep. These rigs are also capable of drilling a total of 31,500 feet (9,600 meters) from the bottom of the rig to the bottom of the well. That means Pride’s drillships can handle just about any deepwater project you can conceive. Both are working offshore Angola under contracts extending to June 2009 and December 2010, respectively, for day-rates of roughly $173,000 per day.

Producers are already looking to secure rigs for the 2009-10 time frame, so it’s likely these rigs will receive excellent day-rates when the contracts are renewed. In fact, I’d expect to see Pride sign new contracts at far higher day-rates for its drillships; both drillships were committed to contracts in Angola in late 2004 and early 2005 when day-rates for such rigs were far lower than they are today. Some drillships are currently being contracted for day-rates closer to $500,000.

Although the company’s deepwater semi-submersible rigs are less capable than the drillships, a number of these rigs can handle deepwater work in water 5,000 feet to 7,500 feet deep. For those unfamiliar with semis, such rigs are fitted with large pontoons at the base and towed into location. Once on location, the pontoons are flooded and the rig partially sinks, adding stability.

Currently, Pride’s highest specification semi is the Pride North America, currently drilling offshore Egypt on a contract with BP. BP initially contracted the rig in January 2006 at a day-rate of $188,000, but that rate will jump all the way to $443,000 in January of next year. Pride has already signed a follow-on contract with BP extending to December 2010.

The Pride South Pacific, currently drilling in Angola, rolled onto a new contract with ExxonMobil this month. The rig, previously earning less than $200,000 per day, is now earning $425,000. That’s more than double its previous day-rate.

Pride’s other semis are earning day-rates in the $150,000 to $250,000 range. In any event, the company won’t have trouble finding new customers when the rigs roll off contract gradually in the 2010-13 period.

Finally, Pride also owns a large jack-up fleet including high-specification jack-ups capable of doing international work and low-specification jack-ups that are more or less captive to the Gulf of Mexico. As I noted above, the North American Gulf of Mexico jack-up market has been weak lately; the company’s large jack-up fleet has been a drag on the business of late.

On the other hand, several of the company’s high-specification jack-ups are on long-term contracts at solid day-rates. For example, the Pride Hawaii will go on contract in India this month for a day-rate of $144,500 per day.

I’ve just highlighted some of Pride’s more notable contracts. Because these are long-term contracts at fixed rates, operators are committed to take the rigs and pay the specified day-rates. That makes these contracts more or less guaranteed future revenues.

Pride’s total backlog across its fleet stands at $5.2 billion; the company’s market capitalization is just under $5.5 billion. Therefore, Pride is currently trading at only a 5.2 percent premium to its existing, rising backlog of guaranteed contracts.

Consider Pride’s competitors Transocean and Global SantaFe. As of February 14, Transocean’s total backlog stood at $21 billion, with its stock is valued at about a 16 percent premium to that backlog. Global SantaFe trades at an even larger 33 percent premium to its backlog of contracts. On this basis, Pride is the cheapest major contract driller out there.

Of course, just because Pride is cheap doesn’t mean it’s a great buy; sometimes stocks are cheap for a reason. In this case, I see four major reasons for this discount:

• Pride was poorly managed until a management shake-up in 2005. Several senior managers departed Pride back in 2005. This management team had taken Pride on an acquisition spree in the 1990s that cost the company dearly. Management also got Pride involved with some business lines unrelated to drilling; the company totally lost its sense of focus.
• Pride’s fleet is too widely diversified. It’s not a pure play on deepwater rigs because of its huge jack-up fleet. And the company isn’t a pure play on jack-ups either. Investors looking for exposure to a particular rig market likely find Pride too diversified. Although it’s not uncommon for a driller to own jack-ups and a few semis, no other driller owns quite the menu of different rigs Pride does.
• There’s temporary weakness in the Gulf of Mexico jack-up market. I discussed this point at some length earlier this issue. This market is a drag on earnings right now, and Pride has hefty exposure to the region.
• It has a lagging Latin American land rig and services business. This business has consistently failed to generate acceptable returns.

I think Pride is taking steps to eliminate these problems. The company’s new management team has refocused the company on becoming a premier player in the deepwater market. To that end, Pride is planning to divest its Latin American land rig and services business this year. These noncore businesses have been a constant distraction.

I also suspect that Pride will be looking to gradually add to its deepwater fleet in the next few years; the company has already bought out minority interests in two of its rigs. And Pride may look to upgrade some of its existing rigs to handle more deepwater work.

Management has also reduced Pride’s debt and cleaned up the balance sheet. This puts the company in a far better position to make rig acquisitions or fund overhauls of existing rigs. That discount to the rest of the industry group should close gradually as management executes its restructuring and divestiture plans.

And, as I noted for Rowan, I see tremendous upside for the Gulf of Mexico jack-up business this year as more rigs leave this market, constraining supply. Any improvement in the Gulf of Mexico would send Pride shooting higher; Pride has 28 commodity rigs in this market that aren’t typically suitable for working on international projects.

Pride itself is also a takeover target. A competitor may wish to buy up Pride’s jack-up business or just take over the company entirely; after three years of solid day-rate growth, most drillers are flush with cash. In addition to its strong free cash flow and cleaned-up balance sheet, Pride may be a target for a private equity-led buyout.

In fact, activity in the Pride call options market suggests that some big players are betting on this stock, possibly as a takeover play. Check out the chart below.


Source: Bloomberg

This chart shows the July 35 Pride call options. These options are out of the money; they will only have value if Pride closes above $35 by late July options exploration. Without delving into options theory here, suffice it to say these contracts represent an aggressive long bet on Pride. The stock will have to rise quickly for these contracts to pay off.

Since early March, there’s been tremendous and unusually strong buying activity in this call contract. Note, in particular, the huge volume bars on March 9, 10 and 11. Further analysis of these trades suggests that most came in large blocks of 1,000 contracts or more.

In addition, most of these trades happened near the ask (or offer) price. This suggests they were buy transactions, not sells.

Although we can never be 100 percent certain, this looks like an institutional trader or hedge fund call purchase on Pride. Those 30,000 contracts traded in early March at an average price around 90 cents are worth $2.7 million. That’s a significant bullish bet. Turnaround play and new addition Pride International rates a buy under 35 in the Wildcatters Portfolio.

My second addition to the Wildcatters Portfolio this week is international oil and gas services giant Weatherford International. Check out the chart of this stock for the past year.



Source: StockCharts.com

Note, in particular, the severe selloff in Weatherford back in January. Weatherford’s stock reacted negatively that month to a series of earnings warnings from North America-leveraged services names. These warnings prompted many to believe that its results for the fourth quarter wouldn’t meet analysts’ expectations.

The company’s primary problem: It’s more exposed to the Canadian market than any other big service firm in my coverage universe. As I noted in last week’s edition of The Energy Letter, the Canadian drilling market is even weaker than the US.

But there’s a good reason why Weatherford is so leveraged to Canada: The company bought Precision Energy Services (PES) back in 2005. (PES was the oil services business of Canada-based Precision Drilling.) When Weatherford bought Precision, the company’s services were marketed almost entirely within the Canadian market. This legacy is to blame for Weatherford’s Canadian exposure

However, PES has significant capabilities in services that are eminently marketable abroad. That’s exactly what Weatherford has been doing for the past few years–using its existing sales force in international markets such as the Middle East to sell PES services.

One of the company’s hottest, fastest-growing services right now is what’s known as underbalanced drilling. When a crew starts to drill a well, a liquid known as drilling mud is pumped down that well under pressure. Oil and gas reserves are under tremendous geologic pressure underground and would naturally tend to move into a well and shoot to the surface as the well is drilled, a dangerous situation called a blowout.

In conventional drilling, wells are drilled overbalanced. The drilling mud is pumped down the well at a pressure that exceeds the geological pressure of the oil and gas. In overbalanced wells, the drilling mud actually prevents oil and gas from shooting out of the well.

But overbalanced drilling can damage older reservoirs. If a driller isn’t careful about pressures, it’s possible to actually pump the drilling mud into the reservoir rock itself. Because oil and gas are held in tiny pores in rock and travel through channels and cracks in that rock, drilling mud clogged in these pores can impede flows. Underbalanced drilling involves pumping mud at a pressure that’s less than the natural geologic pressures of the reservoir.

The advantage of this is that the mud won’t move into the reservoir rock. The disadvantage is, of course, that oil and gas will flow into the well, albeit at a reduced rate. Therefore, in underbalanced operations, producers must carefully control pressures so that the movement of oil and gas into the well proceeds at a controlled pace. This is becoming an increasingly important technique in international markets such as the Middle East.

Weatherford reports earnings on April 25. Because the market already expects some weakness in Canada, I don’t see the stock plunging on any negative news related to the region. Nabors Industries and Baker Hughes both released warnings in recent weeks, and the stocks recovered within weeks. I recommend more conservative investors look to buy a half position in Weatherford at current levels, with the intention of buying a second raft of stock after the release.

It’s also worth mentioning that, like Pride, there’s been heavy buying of out-of-the-money call options on Weatherford in recent weeks. That’s yet another sign of strength. Buy Weatherford under 55.