Mariehamne Aland Islands, Finland–The Energy Strategist joins you this week aboard the MS Deutschland, which is cruising the Baltic Sea in northern Europe on the KCI Investment Cruise. Last Thursday, we departed from the German port of Travemunde in the late afternoon; it never gets totally dark this time of year, and being this far north, we were afforded an opportunity to have a prolonged look at the German coastline.

What was most striking to me was the prevalence of hundreds of windmills both onshore and offshore, dotting almost the entire coastline. Some of these offshore wind farms are truly massive in scale.

I’ve written about Germany’s attempts to promote renewable energy in general and wind power in particular on several occasions in this newsletter. The nation employed the use of a feed-in tariff structure—a system that mandates utilities buy wind power and pay generous, subsidized rates. This system resulted in a massive jump in wind-power capacity after 1990.

But although Germany’s offshore wind farms are an impressive sight to behold, what’s most impressive is just how little all this wind-farm capacity contributes to the German grid. Only about 5 percent of the country’s power supply comes from wind after more than 15 years of strong capacity growth.

This is due partly to the inherent limitations of wind and partly to the fact that Germany’s grid, like that of most developed countries, wasn’t really designed and set up to accommodate the unique challenges of wind, solar and other renewable but intermittent technologies. The fact is, as I’ve stated before, wind is a limited technology that won’t be able to totally replace more-conventional power sources at any point in the near future. In fact, when I see Germany’s windmills, I don’t see a path to energy independence. Rather, I see a nation that’s set to see a drastic jump in the consumption of natural gas.

Gas strikes me as every bit as much a legitimate play on those windmills as turbine manufacturers or companies manufacturing windmill blades. And with few sources of domestic supply, I see Germany rapidly ramping up imports of natural gas in the coming years, mainly from Russia.

In This Issue

In today’s issue, I offer a detailed look at the European market for natural gas and the best ways to play the market. Given the strong growth expected in European gas demand in the next 20 years, the European Union (EU) gas market is becoming among the largest and most important anywhere in the world.

The long-term outlook for natural gas prices in Europe is even more bullish than in the US. With anti-nuclear sentiment still present and alternative power sources comprising a minimal percentage of total energy use, Europe will be relying more heavily on natural gas. See Across The Pond.

Since its discovery in the 1970s, the North Sea has been an excellent source of natural gas for the UK and Norway. However, some of the more mature reservoirs are beginning to dry up, causing a decline in supply. See Gas Supplies.

With quite possibly the world’s largest natural gas reserves, Russia is a key exporter to countries around the world. The EU’s dependence on the country, coupled with rising natural gas prices in other areas, should be beneficial for Russia and the country’s largest natural gas company. See Russia’s Role.

There are a number of smaller companies based in Europe focused on exploration for and production of natural gas. One is currently in the Wildcatters Portfolio; another is being added to Gushers Portfolio. See Exploration And Production.

I’ve focused on drilling in several past issues that are worth a second look. Although I recently sold out of one of my seismic plays, it had nothing to do with that trend at all. In this issue, I’m adding a new play on this are to replace it. See Services And Drilling.

I often look abroad for the best plays on energy. To help me in my endeavors, my colleague Yiannis Mostrous has provided the following guidance on Russia and one of its biggest energy companies. See Gazprom.

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

• BG Group (NYSE: BRG)
• Compangnie Generale de Geophysique-Veritas (Paris: GA; NYSE: CGV)
• Seadrill (Oslo: SDRL, OTC: SDRLF)
• Tullow Oil PLC (London: TLW)

Across The Pond

The long-term outlook for natural gas prices in Europe is even more bullish than in the US. North America appears in far better shape than Western Europe when it comes to meeting rising demand.

As with any market, it’s important to analyze both the potential supply and demand sides of the equation. On the demand front, gas consumption in key European economies is increasing far faster than in the US. For example, gas consumption in Germany rose by more than 15 percent between 1995 and 2005 compared to a slight decline in natural gas consumption in the US during the same time period.

According to the Energy Information Administration (EIA), Europe’s demand for natural gas is set to grow at an even-more-accelerated pace between now and 2030. Check out the chart “OECD Europe Natural Gas Demand” for a closer look.

Source: EIA International Energy Outlook 2006

This chart only shows gas consumption from European countries in the Organization for Economic Cooperation and Development (OECD). Therefore, this chart applies only to developed European countries and excludes much of Eastern Europe and Russia. The chart also breaks down gas consumption by category of consumption—industrial, electric power and other.

There are two salient features in this chart. First, overall gas demand in Europe is projected to increase by nearly 4 percent annually between now and 2030, a total increase of more than 72 percent between 2003 and 2030. What’s interesting is that’s more than five times the 0.7 percent annualized growth in US demand; the EIA projects that US gas demand will increase by only a total of around 17 percent in the same time frame.

The second point worth noting is that by far the biggest contributor to growth in EU gas demand is the electric-power-plant sector. Demand for gas to fire Europe’s electric plants is set to jump to more than 180 percent by 2030 and will total 11.9 trillion cubic feet annually by that year.

Given that the EIA estimates that the US will only consume about 6 trillion cubic feet annually of natural gas in power plants by 2030, it’s not hard to see how important Europe is becoming to the global natural gas market. By 2030, Europe will account for 17 percent of global gas consumption against less than 15 percent for the US.

Although it’s important to note that these are just projected figures, there are some compelling reasons to expect strong growth in European gas demand. One of the most obvious is carbon emissions and global warming.

As I’ve noted on several occasions in this newsletter, I’m not here to save the world or make judgments about whether global warming is for real or to what extent it will affect the global climate.

The simple fact is that global warming is receiving plenty of attention all over the world, and governments are starting to regulate and tax carbon emissions. This is nowhere more true than in Europe. Therefore, as investors, we can’t ignore the issue or the global political climate; however, we can certainly find ways to profit from it.

Gas is certainly one way to profit from global-warming legislation and taxation. Burning natural gas in a power plant emits around 40 to50 percent less carbon dioxide than coal. And gas is also cleaner than coal in terms of other types of emissions, such as sulphur dioxide, nitrous oxides, mercury and particulate matter (ash).

At this point, it’s worth examining a little background on Europe’s pollution regulations. Europe regulates carbon-dioxide emissions using a cap-and-trade system. In other words, firms that pollute more than their allowed maximum must buy credits to cover excess pollution.

At the same time, green firms that reduce their emissions below their allowable maximums can sell those credits for extra cash. Companies that pollute above the allowed maximum and don’t own sufficient credits to cover that excess must pay a highly punitive fine that will be 100 euros per excess metric ton (tonne) emitted. Therefore, the system is supposed to encourage development of nonpolluting fuels and ways of making dirtier technologies less pollutant.

The European Emissions Trading Scheme (ETS) began operating at the beginning of 2005. The carbon credits are traded both on a spot market as well as in the form of futures and options traded on the London-based ICE exchange. Check out the chart of 2009 ICE carbon credit futures traded in euros/tonne.



Source: Bloomberg

Two points are worth noting on this chart. First, carbon credit prices collapsed from more than 33 euros per tonne in the spring of 2006 to around 10 euros per tonne earlier this year.

The rapid collapse was due to an EU report released in April 2006 that showed that five EU states had lower carbon emissions than previously estimated. These states had, in fact, over-allocated credits such that there was an excess of carbon credits on the market.

In fact, this hangover is still evident. The chart above shows 2009 carbon futures—carbon credits for the year 2009. Although these cost nearly 23 euros per tonne, the 2007 credits are currently trading at around 23 euro cents (0.23 euros) per tonne. Therefore, there are still excess credits available for this year.

But the ETS goes into effect in two stages. The first runs through the end of this year with the second running from 2008 to 2012. These stages were set to coincide with the Kyoto Protocol.

That means that regulations are getting more stringent and credit supply is dwindling as we head into stage two of the scheme. As you can see on the chart above, that’s one reason that 2009 carbon futures prices have risen from 10 euros per tonne early this year to the mid-20s more recently.
The bottom line: In the next two years, it’s going to get a lot more expensive to emit carbon in the EU. Put yourself in the shoes of a European utility firm for a moment. Carbon-dioxide regulations are becoming increasingly stringent and the cost of buying carbon-dioxide credits is rising, yet you still need to try to meet EU demand for power.

Because nuclear plants emit no carbon dioxide or any other pollutant, you could go out and build more plants. But building nuclear plants is time-consuming, and despite the benefits, there’s still a powerful anti-nuclear contingent in Europe, particularly in Germany. Therefore, although nuclear is, in my opinion, the best solution, it isn’t an option that’ll fix a ute’s problems in the next two to three years.

As you might imagine, coal isn’t a great option for cutting emissions of carbon. As I pointed out in the May 2 issue of TES, King Coal, coal is actually growing globally in importance. And even in Europe, it’s never going to go away as a power source entirely. However, the EU’s more-aggressive regulations probably make coal a less-attractive option for meeting near-term power demand.

Finally, as I also pointed out in the May 2 issue, alternatives are a limited option. For example, despite all the hype about wind accounting for more than 15 percent of Germany’s power capacity, the power supply only makes up about 5 to 6 percent of Germany’s power generation.

Without massive technological advances and a brand new approach to electricity generation and transmission, alternatives won’t make a dent in Europe’s power demand. And no such sea-change advances are likely to come in the next 10 years. But there’s one easy, quick-to-build type of power plant that can immediately reduce emissions–a gas-fired turbine.

Natural gas is expensive relative to coal and nuclear. Gas prices are also highly volatile; the cost of producing power in a gas-fired plant is highly variable over time. Therefore, the decision to use more gas spells higher prices for EU consumers.

In the short- to intermediate-term, I expect the EIA is totally correct about Europe. It’s going to be relying more heavily on gas for its power needs.

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Gas Supplies

With EU demand for gas rising, the obvious question is: Where will it all come from? This is becoming an increasingly large problem and one that’s politically touchy to say the least in Europe.

The biggest source of domestic EU gas production is from the North Sea, shared primarily by the UK and Norway. The chart “North Sea Gas Production” shows UK and Norwegian natural gas production since the early 1970s.



Source: BP Statistical Review of World Energy 2006

UK natural gas production, shown in purple, ramped up from around 3.8 billion cubic feet (bcf) per day in 1978 to a peak of 10.5 bcf per day in 2000. Since that time, UK natural gas production has declined by more than 26 percent despite relatively high gas prices during most of the period.

The rate of decline in UK gas production has actually accelerated in the past few years; in 2006, it actually fell below Norwegian output for the first time in history. This is a simple function of the fact that UK gas fields in the North Sea are now mature and are entering a decline phase.

Although there’s still plenty of gas left in the North Sea, extracting that gas is becoming more technically complex and more expensive. It’ll be tough for the UK to ever regain its peak production level. This is the same scenario that’s repeated on countless occasions all over the world.

Bottom line: Long an energy independent nation, Britain became a net gas importer in 2004. Last year, according to BP estimates, the nation imported 1.5 bcf of gas per day, roughly 16 percent of its domestic demand. By the middle of the coming decade, the British government has estimated Britain will be importing around half the gas consumed in the country.

A rapid jump in Norwegian gas production after 1996 has helped to offset some the decline in UK production. According to official figures from the Norwegian Petroleum Directorate (NPD), the nation should continue enjoying higher gas production during the next few years, with production rising around 40 percent in the next decade to between 125 billion and 140 billion cubic meters per year (4.4 trillion to 4.94 trillion cubic feet per year).

But two points are worth noting in regard to these estimates. First, growth in gas demand for Norway’s key export markets will swamp the increase in Norwegian production even if we use Norway’s most-optimistic output forecasts. And rising Norwegian production may do little more than offset declining production from the UK.

Second, the Norwegian government also said that oil production is declining sharply; the NPD had to revise Norway’s oil production estimates in early 2007 downward by about 400,000 barrels per day. Although it’s not a sure thing that a downward revision in oil output forecasts spells a downward revision in gas forecasts, it does highlight the danger of such predictions.

All too often, oil and gas production estimates prove to be overly optimistic, especially in more-mature reservoirs. Norway’s fields are hardly untapped in their own right; it may prove more challenging for producers to grow production than the government suggests.

A case in point is the gas fields in the UK. Back in 2000, with UK gas production hitting new heights, few predicted that UK gas production would decline by more than a quarter in the next seven years. Fewer still would have predicted the historic shift from a net exporter to a net importer of gas.

It’s worth noting that the North Sea isn’t finished as an important oil- and gas-producing region just because output may be nearing peak levels. Given rising demand for gas in Europe, growing or at least maintaining production from domestic sources is extremely important. There will still be plenty of exploration and drilling activity in the region for decades to come.

The situation is much like that in the US: Even though oil production in the states peaked more than 30 years ago, producers continue to drill and are always looking to squeeze more oil out of already mature fields or find smaller pockets of oil. And there are even new frontiers for exploration, such as deep sea or Artic drilling operations.

Bottom line: Don’t make the mistake of ignoring the North Sea just because oil and gas production in the region won’t show dramatic growth in the coming years.

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Russia’s Role

The North Sea accounts for around two-thirds of all gas produced in the EU. But even with this domestic source of production, Europe remains woefully short of gas. Check out the chart “The Great EU Gas Gap” below.



Source: BP Statistical Review of World Energy 2007

This chart shows daily consumption and production of natural gas from current EU countries since 1970. The space between these two lines represents the EU’s need to import gas.

The simple fact is that the EU as a whole has always been a net importer of natural gas. However, the situation has become direr in recent years as demand has accelerated while production has begun to decline.

As of last year, the EU gas gap was approaching 20 bcf per day despite the fact that an unusually warm start to the winter caused a slight fall in EU gas demand. Over time, Europe’s import dependence will only grow given the projected growth in EU demand in the next two decades.

Let’s put this massive gas gap into perspective. Consider that the US consumed 60 bcf of gas per day in 2006. That’s considerably more than in the EU. However, as I noted earlier, that’s rapidly changing because of the region’s more-rapid growth in demand.

But more important, US production totaled more than 50 bcf per day. The US only needs to import a touch under 10 bcf, roughly half of what Europe imports. And the vast majority of US imports come from neighboring Canada. That’s not to say that the US has no gas supply problem; it’s just less pressing than for the EU.

To finance its gas gap, the EU looks east to Russia. Russia is far and away the world’s largest producer of natural gas, and it’s estimated to have the world’s largest reserves of natural gas.

At the current time, the EU imports more than 4 trillion cubic feet of gas annually from Russia by pipeline alone. That works out to more than 11 bcf per day or around half of EU gas imports.

Check out the charts below.




Source: BP Statistical Review of World Energy 2007

Source: BP Statistical Review of World Energy 2007

The first chart shows Russian gas production from the mid-’80s to the present day. The dip in production witnessed during the late ’80s and early ’90s was primarily a function of weak gas prices and the fall of the Soviet system. The decline in production isn’t likely to be related to an inability to produce more gas.

This is borne out by the fact that Russian gas production has surged in recent years to higher its 1989 peak. Because Europe is connected to Russia by a number of pipelines and has been growing production, it’s a logical trading partner when it comes to meeting EU gas demand.

The second chart shows global gas reserves by country and region. In this pie chart, it’s clear that Russia, Iran and Qatar dominate the global natural gas reserve base. Russia alone holds more than a quarter of the world’s known reserves of natural gas.

To make a long story short, investors simply can’t afford to ignore Russia’s role in supplying gas to a massive, gas-hungry European marketplace. The EU is highly dependent on Russian gas and remains Russia’s biggest customer.

This simple fact is that reliance on Russia isn’t always politically convenient in the EU. For example, Chancellor Angela Merkel of Germany has been critical of Russian President Vladimir Putin on certain security-related issues, and other European leaders have decried the Russian state’s heavy involvement in business affairs.

Another problem is reliability. On several occasions during the past two years, supplies of Russian gas to the EU have been cut, typically because of a pricing dispute with key countries located along pipeline routes from Russia to Europe.

On one occasion in early 2006, Russia cut gas supplies to the Ukraine because of a pricing dispute. Because a key pipeline to Europe runs through the Ukraine, that cut resulted in a massive drop in EU gas inventories. There were legitimate worries of a major shortage in countries particularly dependent on Russia, namely Germany and Italy.

But despite all the EU’s political objections to Russia, the region remains dependent on Russian gas so this rhetoric can only go so far. In addition, at the end of today’s report, my long-time friend and colleague Yiannis Mostrous, editor of The Silk Road Investor, offers a more in-depth guest piece on the investment climate in Russia and the case for buying the nation’s dominant gas producer, Gazprom.

Although I don’t currently hold Gazprom in the TES Portfolios, I’ve written extensively on the company in past issues. It’s the premier play on growing EU demand for gas and its reliance on Russia as a supplier. Political headline risk aside, long-term investors should have a position in this stock.

Gazprom is unique in that it’s Russia’s dominant gas producer and, therefore, has privileged access to the world’s largest gas reserves. The Russian government treats the firm somewhat like a national champion.

Gazprom has partnered with foreign firms in the development of key projects; the Russian government clearly prefers foreign firms to partner with its main firm (or other Russian firms) on projects, allowing the domestic firm to maintain control over oil and gas assets. These joint ventures give Gazprom privileged access to advanced foreign technologies and capital.

As if Gazprom’s reserves and privileged political position weren’t enough, I see significant upside for Russia’s domestic gas industry. The firm currently makes most of its money by exporting gas to Western Europe. The prices it receives in Europe are based on a formula that ties the price of gas to the price of crude oil with somewhat of a time lag.

But in Russia’s domestic market and in other former Soviet-controlled states, Gazprom isn’t allowed to charge full world prices. Instead, the firm sells gas at subsidized rates that can be 20 percent or less than the price Western Europe pays. Needless to say, Gazprom doesn’t make much money in these markets.

The problem is that subsidies create price distortions and undesirable behavior. Because the price of gas is so low in these domestic and regional markets, consumers use more gas than they otherwise would.

Booming demand in these low-price markets means less gas is available for Gazprom to export to high-price countries in Western Europe or even the US. With the Russian economy growing robustly the past few years, demand for gas has been growing at a particularly quick pace.

But the Russian government realizes this problem and seems to have undertaken a strategy of gradually adjusting prices in Russia and former Soviet states to bring prices more in line with what Western Europe pays. The Ukrainian gas dispute was just one manifestation of this strategy.

The root cause of the dispute is the fact that the Ukraine was paying about 10 percent what Western Europe was paying for gas. Russia wanted to adjust that price so the country was paying closer to half Western European rates.

As you might expect, this wasn’t a particularly popular plan in the Ukraine. That said, Russia is raising prices in the Ukraine and elsewhere–a process that’s likely to continue for some time.

I see this as a huge positive for Gazprom. Regardless of what happens to global natural gas prices, the company will see the tailwind of gradual upward adjustments to domestic gas prices. To the extent that these price adjustments affect domestic demand, the policy will also free up additional gas supplies for Gazprom to export.

I’ll continue to follow Gazprom in the How They Rate section for now. I also recommend all readers check out Yiannis Mostrous’ more-detailed analysis of the stock below.

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Exploration And Production

I’ll leave a detailed discussion of the major EU-based integrated oil and gas firms to a planned upcoming issue of TES focused on integrated oils. It’s worth noting, however, that there are a number of smaller companies based in Europe focused on exploration for and production of natural gas.

The London marketplace in particular has become an important market for a host of small exploration and production (E&P) firms with highly attractive fields and prospects. Many of the E&P firms listed in the US are focused more on development than exploration; they’re predominately involved in producing known reserves or maximizing production from mature fields.

But in London, there are a host of smaller, more-obscure companies that have existing production but are more growth-oriented. They’re exploring for oil and gas and drilling speculative so-called “wildcat” wells. Although these carry high risk, they can make for excellent speculations for investors.

For a relatively safe, proven play on the European gas market, you can’t do better than Wildcatter recommendation BG Group, once known as British Gas. This company has a large reserve base of “stranded” natural gas fields.

Stranded fields are simply fields located far away from existing pipeline infrastructure. Traditionally, gas is produced and transported via pipeline, and these fields were essentially worthless.

But the advent and adoption of liquefied natural gas (LNG) technology has changed all that. LNG involves cooling natural gas to a temperature of minus 260 degrees. At that temperature, the gas is in a compressed liquid form that can be easily transported by specialized tanker ship just like crude oil.

LNG frees gas from the global pipeline grid and facilitates imports of gas from just about any field in the world. Once the gas reaches its intended market, it’s regasified and injected into the local pipeline distribution network.

Europe is set to become a major player in LNG technology. Several European firms are building LNG terminals, a move that makes a great deal of sense economically.

Relying solely on pipeline gas limits potential suppliers and heightens supply risk; only producers located near pipelines are potential suppliers. And if the pipeline travels across politically unstable countries, there’s risk of a sudden cut to supplies. By building LNG terminals, Europe has more flexibility to source gas imports.

BG Group is becoming a major play on the LNG market, particularly in Europe and the US. BG Group continues to rate a buy.

For a more-speculative play on gas, consider UK-based Tullow Oil PLC (London: TLW). Tullow isn’t a pure exploration firm because the company actually has oil- and gas-producing assets. However, the company is involved in a considerable amount of relatively high-risk, high-potential drilling activity in several key regions of the world.

When evaluating E&P firms, I look for two key characteristics: significant planned drilling activity in promising reserves and existing, growing production. Tullow scores on both counts.

In 2006, Tullow’s total production was around 65,000 barrels of oil equivalent (boe) per day, split roughly 50/50 between oil and natural gas. The vast majority of its production came from two sources: developed reserves in the UK North Sea and the company’s fields in Africa. The company’s total reserve base at the end of 2006 stood at a little more than 500 million boe.

But although Tullow’s production is evenly split between the UK and Africa, the company has firmly focused its exploration expenditure on promising reserves in Africa. This year Tullow projects it will spend GBP25 million (USD50 million) on exploration in the North Sea and GBP92 million (USD184 million) on exploration in Africa. The company has been pursuing an aggressive drilling program so far this year, and it has plans to drill a series of new exploratory wells throughout the remainder of 2007, mainly in Uganda and Namibia.

Tullow has seen significant success in drilling commercial wells in both markets, so these drilling programs could well result in important finds. In fact, I see that as a key catalyst for the stock for the remainder of 2007.

As Tullow continues to release results of its drilling programs and well tests, there’s plenty of potential for positive surprises. Last year, as the company reported positive results from its drilling programs, the stock jumped. I expect a similar result this year.

Of course, there’s no way to know for sure if Tullow’s wells will result in economic production. Wildcatters Portfolio holdings EOG Resources and XTO Energy are both E&P firms just like Tullow. However, these companies don’t carry a great deal of exploration risk; they’re known as resource plays because they target well-known reserves, such as the Barnett Shale in Texas.

Gas in the Barnett Shale is widely distributed, so the risk of any individual well coming up dry is minimal. Resource plays routinely have well success rates of more than 90 percent.

That isn’t the business Tullow is engaged in. The company performs significant seismic mapping work and uses other techniques to look for oil and gas. But there’s no way to know for sure if a particular well will produce economic quantities without actually drilling a well and producing gas or oil from that well.

Therefore, there’s always an element of chance involved with Tullow’s projects. All we can go on is the company’s past record of success and experience drilling in a particular area.

Last year, Tullow was successful with about 58 percent of the exploratory wells it drilled; in other words, the firm spudded wells that flowed economic quantities of oil or gas more than half the time. That is considered a highly favorable success rate for a firm drilling speculative wells.

This strategy has allowed Tullow to grow its production more than 11 percent in 2006 against 2005 levels. In the past three years, the company has boosted production by more than 160 percent. Last year, Tullow was able to book another 150 million boe reserves, a 45 percent increase to its 2005 reserves.

I’m adding Tullow to the aggressive Gushers Portfolio as a buy recommendation. Remember, the Gushers Portfolio is for high-risk/high return plays. Keep that in mind when allocating cash to this stock.

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Services And Drilling

One of my favorite subgroups of the energy patch is the services and contract drilling stocks. Several of the best-positioned plays are based in Europe.

The list includes Norway’s Seadrill. Seadrill owns a fleet of deepwater drilling rigs, many capable of drilling the most-complex reserves located in the deepest waters and least-hospitable regions. I explained the importance of deepwater drilling and deepwater-focused contract drillers in the January 3 issue of TES, The Deep End.

I won’t repeat all those arguments here; I strongly suggest all new subscribers check out that issue. It’s worth noting that one of Seadrill’s competitors, Transocean, recently booked a contract for a deepwater rig at $660,000 per day to start next year.

This is the first time a deepwater rig has received a day-rate above $600,000 per day for 2008. This suggests continued strong demand for rigs to perform deepwater drilling work and a willingness to pay up for rigs to secure supply.

It’s also unquestionably bullish for Seadrill. Although I like Transocean’s fleet of high-specification deepwater rigs, the problem with the company is that it’s already committed the majority of its rigs under long-term drilling contracts. Therefore, it doesn’t have many rigs left to contract in the next few years; this leaves it with relatively little exposure to rapidly rising rig demand and current sky-high day-rates.

That’s not to say that Transocean hasn’t contracted rigs at attractive rates. Rather, it’s that the rates for the rigs already locked in are fixed and, therefore, can’t participate in additional upside near term.

That’s not the case with Seadrill. This driller still has plenty of uncommitted capacity left to sell; in fact, it’s the only driller with much deepwater capacity uncontracted through 2010. This $600,000-plus contract suggests that Seadrill should have little problem leasing its remaining rigs at highly attractive day-rates. By holding out for better contracts, Seadrill may even be able to book a rig for a rate of more than $700,000 per day.

With the Transocean contract booked, there are only seven deepwater rigs left available for work at any time during 2008. There’s clearly a major squeeze ongoing in the deepwater rig market, and Seadrill is the best-positioned company in the world to take advantage of it.

In the most-recent issue of the newsletter, I recommended selling out of Petroleum Geo-Services for a significant gain. Petroleum Geo owns a fleet of seismic ships designed to perform exploratory work in deepwater.

I didn’t recommend selling this stock because I see weakness in seismic activity. In fact, this is among my favorite groups longer term. Schlumberger has a major seismic division and continues to see strong demand and sky-high profit margins. The company just can’t seem to build new seismic vessels fast enough to keep pace with demand.

I recommended selling Petroleum Geo only because the company has decided to delist its US-traded American Depositary Receipts. Most investors find trading on the Oslo stock exchange rather inconvenient, so this delisting presents a problem.

However, there’s another European firm with even more leverage to the red-hot seismic services market—France-based Compangnie Generale de Geophysique-Veritas (Paris: GA; NYSE: CGV). Compagnie Generale (CGG) acquired US-based Veritas last year, making it the largest pure-play seismic operator in the world.

CGG performs seismic services both on land and offshore fields. And CGG owns a fleet of 20 seismic vessels—the largest such fleet in the world.

As I’ve noted before, every company with exposure to seismic services has reported strong demand, particularly for deepwater work. It seems that producers are willing and able to pay up big time to make sure they’re able to secure seismic ships for their projects. Day-rates charged for seismic work are sky-high, and margins have been expanding.

CGG is no exception. The company reported its first quarter results in early May; revenue growth was close to 85 percent year-over year. CGG also reported strong fleet utilization: Its 20 seismic ships are in almost constant use, and there remains strong demand for land-based seismic service, particularly outside North America.

The company noted that producers are already booking its ships for 2009. That means CGG is already locking in customers for work two years from now.

In addition, CGG has reported very strong multiclient sales. Multiclient surveys are seismic survey databases for a particular region. Instead of performing a specific survey for a particular company, these databases are sold to multiple clients. Typically, multiclient surveys are used as the basis for doing further exploration work.

Not only is CGG having no trouble selling these surveys, but it’s also been able to pre-fund sales. In other words, customers are actually paying for multiclient data before CGG even performs the surveys; the company doesn’t have to put any money down upfront to perform these surveys.

Finally, CGG’s Sercel division makes seismic equipment. As you might expect, demand here is accelerating, too, as a number of new seismic ships are under construction to meet accelerating demand. I’m adding Compagnie Generale de Geophysique-Veritas to the Wildcatters Portfolio as a buy.

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Gazprom

By Yiannis G. Mostrous

Gazprom has been a long-time favorite of mine and a holding in my The Silk Road Investor model Portfolio. The company is the largest natural gas company in the world by reserves and production. It fits very well with my view that energy is in a multi-year bull market and that Russia will play a pivotal role in the future as it develops its position as a global energy supplier. Nevertheless, the stock has been trading lower recently.

Oddly enough, one of the main reasons for the stock’s underperformance is its size (14 percent of the Russian index) and liquidity. In other words, investors have sold Gazprom as an easy way to reduce exposure in Russia, take profits or use the proceeds in order to buy into the countless initial public offerings that took place in Russia this year.

There are some stock-specific concerns, but there are also some positives. For starters, the company recently said that its export revenue this year could be below last year’s. According to the Industry and Energy Ministry, in the first four months of 2007, Gazprom’s non-CIS countries’ (i.e., former Soviet republics) exported volumes dropped by 21.7 percent year-over-year to 46.8 billion cubic meters (bcm), while sales to the CIS fell 15.2 percent to 13.5 bcm from the previous year.

Nevertheless, given that gas prices are expected to rise this year–substantially in CIS countries–the company should see an increase in net export gas revenues (after export duties) to around 13 percent, reaching USD42.5 billion.

The stock was also hit when reports came out indicating that the Finance Ministry and Ministry of Economic Development and Trade suggested a big tax hike on domestic gas production. Although statements were issued afterward that such an increase isn’t imminent and will be much more moderate than initially thought, investment sentiment was hurt, especially in regard the short-term players. Furthermore, industry sources have indicated that the gas extraction tax wouldn’t be raised before 2010, at which time it’s expected to reach USD14.50 per million cubic meters.

In other Gazprom news, the company announced that its budgeted investment program (including acquisitions) will be USD30 billion for 2007. Until now, it’s spent around USD10 billion acquiring shares in exploration projects or ownership stakes in domestic and international energy companies. Given its huge cash flows and improvement in spending less money on noncore projects, Gazprom won’t have a problem achieving its goals while maintaining solid profit numbers.

As has I’ve mentioned before, the upcoming elections in Russia–especially the presidential one in March 2008–could be potentially disrupting for the markets. A lot of investors may want to see Vladimir Putin’s successor in office and get a feel for his policies before committing to the market.

This is a legitimate concern because Russian politics can offer many surprises. But the process–and most important, the transition of power–should be quite smooth relative to the country’s historic experience on the subject.

The secret, of course, is that President Putin controls the process and is expected to cut short any potentially damaging catfights among the frontrunners. If he’s successful, the country should enjoy a relatively stable election period that will translate positively to the markets and the Russian economy, especially if the new president doesn’t dramatically alter economic policies.

Of course, the usual rhetoric should be expected in an election year–rhetoric that sometimes makes foreign investors uncomfortable. But this isn’t a uniquely Russian trait. Bashing China, for example, has become a national sport for politicians in Washington; someone else should always be blamed for the various shortcomings of political leadership.

Election periods have always provided opportunities for outrageous promises to be made and big words to be spoken, always to be forgotten once in office. This is a global phenomenon.

Furthermore, investors should be careful in separating reality from fiction and not depend on any one “authenticity” in order to get the facts correct. Two examples demonstrate how misinformation or plain phobia can be very costly indeed.

One is the legendary wrong predictions made by The Economist–the well-known authoritative weekly from England–back in 1998. To wit, Russia GDP will fall by 25 percent, inflation will shoot to 10,000 percent, and oil will go to USD5.

In regard to Russia, the story unfolded much differently, and although the authoritative weekly revised its numbers, it never–to the best of my knowledge–was able to give good advice on the Russia issue. Consequently, investors who followed its opinions missed out on one of the greatest opportunities in recent memory.

The second example has to do with the lectures of well-known investor Jimmy Rogers. He’s been warning of an upcoming Russian collapse since I can remember and advising against investing there. His main rationale for this is the corruption and other endemic drawbacks Russia has and has been quite slow in fixing.

There’s nothing wrong with this assessment. What’s mind boggling, though, is what usually follows–namely a strong recommendation to buy in China and Africa, where, as everyone knows, corruption and the like are totally absent. I leave the conclusions to you.

If I’ve gone on for too long on this issue, it’s because that political noise should be treated as such, especially when there’s no real threat for a big change in economic policy, as is the case in Russia right now. Consequently, although risks should always be kept in mind, avoiding the Russian market solely on the assumption that something will go terribly wrong on the political front doesn’t seem to be a good idea right now.

Turning to the narrower subject of the market, it’s a fact that the Russian market has been one of the best performers in the past six years, rising by 1,142 percent in USD terms. Consequently, it’s been having a weak year; it’s down around 5 percent. For comparison purposes, some of the hottest major markets in the past six years have produced (in USD terms) more-inferior results: Brazil (250 percent), India (380 percent) and, the less-corrupted one, China (136 percent).

As I’ve mentioned previously, the Russian market can correct 25 percent and still be in a major uptrend. I don’t anticipate that, although a general global market selloff or an exogenous shock could do the trick.

Be selective and try to buy good Russian assets at lower prices, which the current weakness in the market offers. This should be done with long-term investment in mind; the summer months shouldn’t produce a spectacular rally in Russia, but something could happen later in the year. Russia remains a buy.

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