Topping the list are stocks levered to deepwater drilling projects. Most such deals are led by the big integrated and national oil companies. These firms rarely cancel projects due to short-term volatility in commodity prices.

In some cases, such as Brazil and Mexico, new field developments are a matter of national strategic importance. I’m looking for a continued flood of growth in these markets this year.

In This Issue

In this issue, we’ll take a closer look at a number of oil services and equipment firms leveraged to these more defensive markets. See The End of Easy Oil.

The End of Easy Oil

In the last issue of The Energy Strategist, Growing Horns, I outlined my rationale for turning more bullish on crude oil and natural gas prices. To play that trend, I added Canadian oil sands giant Suncor Energy (NYSE: SU) to the growth-focused Wildcatters Portfolio; Suncor is among those exploration and production (E&P) companies in my coverage universe most leveraged to crude prices.

Suncor is also one of the only E&Ps with the scope to increase oil production relatively quickly when oil prices rise to levels that make production economic. I discussed the company’s deal to purchase Petro-Canada (TSX: PCA, NYSE: PCZ) in a March 23, 2009 Flash Alert, A New Canadian Giant.

My general take on the deal is that it’s a positive for Suncor; management is taking advantage of distressed valuations to pick up valuable oil sands acreage and top-notch refining operations. As I explained in the Flash Alert and in the previous TES, both fit well with Suncor’s existing asset base. I suspect Suncor will look to unload some of Petro-Canada’s overseas assets as valuations in the sector improve, sales that should help finance the acquisition.

But E&Ps such as Suncor are only one way to play a recovery in crude oil prices. Since last summer, oil services and equipment names, including Wildcatters Portfolio members Weatherford International (NYSE: WFT) and Schlumberger (NYSE: SLB), have languished alongside energy commodity prices.

However, from an intermediate- to long-term perspective, these names remain my favored plays in the energy industry. They’re uniquely placed to take advantage of an increasingly complex industry and the “end of easy oil” thesis.

Services firms don’t make money from higher oil and gas prices because they don’t sell a drop of oil or cubic foot of natural gas. Rather, these firms make money when drilling, exploration and development activity rises. The term “oil services” includes a broad range of operations, and the group is far from homogeneous.

Consider, for example, that the benchmark Philadelphia Oil Service Index (OSX) contains only 15 oil services companies. The worst performer in that index year to date is Rowan Companies (NYSE: RDC), a sell-rated contract driller in the TES How They Rate coverage universe.  The stock is off by nearly 23 percent.

The best performer in the OSX: offshore equipment and services provider Oceaneering International (NYSE: OII), with a gain of nearly 30 percent. Many investors find it hard to believe there’s so much variability in what’s supposed to be a small, tightly defined index. This illustrates the need to be extremely selective in playing the group.

Broadly speaking, these firms provide crucial services that enable the production of oil and gas. Here are three common examples of services functions:

• Seismic Services. This involves the use of sound and pressure waves to generate a map of underground rock formations both on and offshore. Producers use seismic data to look for potential new oil and gas fields as well as to evaluate how best to produce known fields.
• Logging and Wireline Services. These terms refer to the process of lowering into a well sensing equipment that provides information about the field being produced.  This data is used to determine whether the well is productive, holds economic quantities of oil or gas and establish the underground pressures and temperatures, among other data points.
• Contract Drilling. The contract drillers are usually lumped in with the services companies. Basically, these companies lease drilling rigs and related equipment to oil and gas producers for a daily fee known as a day-rate. Contract drillers typically specialize in a certain market such as land rigs, shallow-water offshore rigs or deepwater rigs.

Of course there are literally hundreds of functions performed by services firms; longtime TES readers will be familiar with scores of others highlighted in prior issues. These are just three of the more common terms you’ll hear from the big services firms.

Here’s the most important point to remember about the group: The production of oil and gas is becoming more complex and technology-intensive than ever before. Producers are targeting reserves located in harsh environments such as the Artic and deepwater. In addition, producers are going after smaller fields and fields that must be produced using more complex horizontal wells to be economic.

To get an idea of the technical complexity of these wells, consider the big deepwater oil and gas finds announced in Brazil over the past year. I detailed Tupi and other major Brazilian finds in the March 5, 2008 issue, The Final Frontier. Suffice to say these more complex modern oilfield developments are more service-intensive than wells drilled a decade or two ago.

As production from easy-to-produce onshore oilfields continues to decline and producers move to more complex fields, the services firms face a massive secular growth in demand. In the short term, weak commodity prices have choked off drilling and exploration activity all over the world, even in regions that are typically relatively immune, such as the Middle East. This is a near-term headwind for the services firms.

However, I’m looking for oil prices to top USD100 a barrel again next year; when oil prices start rising again, you can bet the services firms will be generating record profits and revenues. Much the same can be said of companies that supply the advanced equipment used to target these more complex fields. In other words, the recent pullback in these stocks is a cyclical correction in a much longer, more sustained uptrend.

When oil services and equipment firms release first quarter earnings, I expect to hear more negative comments surrounding near-term drilling activity. But there are two points to keep in mind: The stocks are largely already pricing in the worst possible news on commodity prices, and there are some areas of relative stability and growth. Check out my chart below for a closer look.

Source: Bloomberg

This chart shows the price-to-cash flow (P/CF) for the Philadelphia Oil Service Index going back to the late 1990s. I’ve also put three additional horizontal lines in the chart, one representing the mean P/CF, one representing the mean plus one standard deviation, one representing the mean minus one standard deviation. For those unfamiliar with the term, standard deviation is a statistical measure of variability.

As you can see, valuations for the OSX tend to be mean-reverting–in other words, when the valuation rises towards or above the +1 standard deviation level, it tends to correct back toward the mean, and when the valuation falls below -1 standard deviation, it eventually corrects back toward the mean. This mean-reversion process can, of course, take a long time to occur.

The P/CF ratio for the Oil Services Index currently stands at around 5 times, the lowest level in more than a decade and well below the 9.5 level that marks -1 standard deviation below the mean. In other words, the current valuation looks extraordinarily stretched to the downside and poised for a reversion to the mean.

There are two extremely important points to note about this chart. First, the chart is based on historic cash flow for the OSX. Given the slowdown in oil and gas drilling activity worldwide, cash flow for the OSX in 2009 is highly unlikely to be as high as it was in 2008. Thus on a forward-looking basis, the P/CF ratio is much higher.

However, on a forward basis, valuations remain compelling. I took a look at current 2009 price-to-cash flow estimates for the Philadelphia Oil Services Index. Rather than taking the average of analysts’ estimates for each firm, I took the lowest estimate for each company. This would seem a logical method, as analysts have been overestimating earnings and cash flows in recent months. By taking the lowest published estimates I’m adjusting for that bullish bias.

Based on this worst-case estimate scenario, the OSX is trading at around 8.1 times 2009 cash flow, only slightly above the -1 standard deviation level. Based on the most conservative estimates I can find, the Philadelphia Oil Services Index looks like a good bargain at current levels.

Historically, buying the group when valuations are this depressed has been an excellent strategy because a great deal of negative news is already priced in. If valuations simply return to the mean, we could easily see a more than 100 percent run-up in the oil services group over the coming year.

The second point to note is that not all oil services and equipment firms face the same environment in 2009. Although most are likely to see earnings decline sharply, that’s not true for all members of the group.

My strategy is simple: Concentrate on those stocks with the best prospects of showing actual growth this year or, at least, stocks with the opportunity to show earnings resilience.

Given attractive valuations for the energy sector and improving fundamentals in the crude oil and (to an extent) natural gas markets, I suspect institutional investors will be hiking their exposure to the energy patch once again this spring. These investors will typically focus on the stocks with the best prospects for fundamental resilience in the face of a still-shaky market. Given this backdrop, it’s time to increase our exposure to the sector.

I’m looking for three basic characteristics: exposure to Latin America, leverage to deepwater spending, and strong backlogs of business. Here’s a rundown of several stocks that fit the bill.

National-Oilwell Varco (NYSE: NOV)–National Oilwell is an oil services and equipment firm that operates in three basic businesses: rig technology, petroleum services and supplies and distribution services. Check out my chart below for a breakdown of the contribution from each of these business lines.

Source: National Oilwell Varco Public Filings

Last year was a broadly good year for all three of National’s business segments due to the fact that declines in drilling activity really didn’t impact results until the fourth quarter. Moreover, activity in the first half of the year was particularly strong due to the rapid run-up in commodity prices over that time.

The rig technology segment is the jewel in National Oilwell’s crown and its most promising business right now; however, let’s evaluate each of National Oilwell’s segments in turn, starting with the smaller two units.

Petroleum Services and Supplies accounted for about a third of total 2008 operating profits. This segment supplies basic consumable products used in the oil and natural gas business. The business includes some legacy products as well as the product line of Grant Prideco, a firm National Oilwell purchased in April 2008.

Examples of products sold include drill pipes and drill bits. Drill pipes sounds like a fairly low-tech business, but it isn’t; traditional vertical wells used to produce conventional onshore reserves could be drilled using basic steel pipe.

However, as I highlighted in the previous TES and in the March 25, 2009 Energy Letter, much of the new production from markets such as the US is coming from unconventional fields like the Barnett Shale of Texas and the Haynesville Shale in Louisiana. Drilling such fields economically requires the use of horizontal wells, wells that can extent for thousands of feet horizontally underground. Drilling horizontal wells puts a great deal of additional stress on drill pipe. To prevent failure, companies have been forced to use more advanced metals in their pipe and to use pipes that are seamless.

These issues become even more extreme offshore. Imagine drilling a well in a field like the Tupi of Brazil. This field is located in water two miles deep and involves drilling two miles under the seafloor. The pressures and temperatures encountered at those depths are tremendous. Drill pipe must be designed to meet the task.

The situation with drill bits is somewhat analogous. More complex and expensive bits are needed to drill more complex fields; the bit business is also a beneficiary of the “end of easy oil.” In addition, bits must be replaced more frequently in drilling many of these complex plays, a source of recurring revenue for National Oilwell. In addition to drill pipe and bit this division also includes downhole motors, well inspection services and corrosion control products.

While this business certainly has some leverage to increasing well complexity and deepwater demand growth, the biggest factor driving growth is drilling activity. Further, North America accounted for nearly 60 percent of the Petroleum Services and Supplies unit in 2008. North America is a mature market, and most of the drilling activity targets natural gas, not crude oil. As a result North American drilling activity is declining at a far faster pace than in most international markets. Check out my charts below for a closer look.

Source: Bloomberg

Source: Bloomberg

It’s clear from these two charts that drilling activity in North America is declining at a far faster pace than drilling activity outside the US. The main catalyst for this, as I’ve discussed on numerous occasions, is the sharp decline in US gas prices since last summer coupled with a severe credit crunch. The credit crunch has made it increasingly difficult for smaller producers to finance operations; many have simply shut down projects.

I’ve heard from several acquaintances in the US natural gas drilling business that these smaller producers are having trouble paying their bills. Creditors are filing liens against wells to attempt to collect bad debts. The number of such liens has been exploding in many of the hottest drilling markets around the US. It shouldn’t come as much of a surprise that this is going to have a negative impact on revenues and profitability for the Petroleum Services and Supplies unit.

National Oilwell’s management team highlighted and fully admitted these risks in its fourth quarter and full year 2008 conference call in early February. The company stated that it was already seeing pricing pressure at that time as customers demand lower prices for equipment and services. Although the company’s exposure to premium markets will help soften the worst of this blow, it’s no secret whatsoever that this market is going to be weak in 2009.

As the distribution segment is so small, I won’t linger on analyzing it at great depth. Suffice to say that the equipment and services in this segment are mainly related to the repair and maintenance of older wells. Moreover, this segment is the most heavily centered of all on North America–the US and Canada account for roughly three-quarters of total distribution revenues. Management was careful to explain that this business is going to face severe headwinds in 2009 thanks to the collapse in North American drilling activity.

The Rig Technology unit accounted for nearly two-thirds of National Oilwell’s operating profits in 2008 and is by far its most promising unit, at least in the near term. This unit is likely to see only a minor impact from the severe pullback in North American drilling activity and the more modest decline in international growth.

The Rig Technology unit builds key equipment used on both land and offshore rigs. Rigs are nothing more than mobile units that house equipment used to drill oil or natural gas wells. Onshore rigs are usually designed to be moved by truck or, in more remote regions, by helicopter. Offshore units come in two major types: bottom-supported rigs and floaters.

Jack-up rigs are the most common type of bottom-supported rigs at use in the world today. These rigs have long legs that rest on the seafloor; they’re designed to drill in water of up to a few hundred feet in depth.

To target deepwater plays, producers use floaters–rigs that actually float on the surface like a ship. One of the more common types of floater is a so-called semisubmersible; check out my picture below for a closer look.

Source: Lodic

This is a semisubmersible rig. As you can see, the bottom of the rig consists of two large pontoons. These can be flooded with water, sinking the bottom portion of the rig–thus the name “semi-submersible.” This process gives the rig stability, even in rough seas.

National Oilwell sells all sorts of key equipment used on rigs such as:

• Cranes and Pipe Handling Equipment. Cranes are used to move heavy sections of pipe and other tools used in the process of drilling wells.
• Mooring Systems. Mooring systems are used to keep offshore vessels and rigs stationary. Active, dynamic positioning systems use thrusters to compensate for waves and currents. Rigs can also be moored in place using cables that attach a rig to the seafloor; these systems require the use of winches to pull in cable.
• Mud Systems and Pumps. In modern drilling operations, producers use what’s known as a circulating mud system. When drilling for oil or gas, drillers pump a substance known as drilling mud into the well. Originally, drilling fluids were made quite literally of mud; the story goes that early operators in Texas had cattle walk through puddles to produce the mud they needed. Nowadays, fluids are far more complex than that. The purpose of drilling mud is to offset the natural underground pressure of the hydrocarbons in the reservoir. In other words, the pressure of the mud in the well helps prevent oil from rushing into the well and gushing out the top of the well bore.In addition, drilling mud picks up debris and rock shavings that are generated while drilling and lubricate and cool the drill bit. Mud literally circulates, moving down the drill pipe, through the drill bit, and back to the surface. The mud circulating system pumps the mud under pressure down the well and then processes and removes impurities from the mud so that it can be recycled down the well.
• Derricks. Most investors know what a derrick is because it’s probably the most recognizable feature of any rig. Basically, it’s a tall structure used to support the drill string, the long section of threaded pipes that extend from the surface to the bottom of the well.
• Wireline Units. I described wireline services above. Wireline units are used to house such equipment and related cables on a rig.

The key point to note about all of this is that it plays directly into the “end of easy oil” thesis. As producers target more complex and harder-to-access reserves, they’re demanding rigs with higher power and more technologically complex equipment. Consider, for example, that the rigs currently being used to drill deepwater fields like Tupi were beyond the limits of state-of-the-art technology just 10 years ago.

But it’s not just offshore rigs. Land rigs used to drill long horizontal wells in unconventional US gas plays also require higher power than older generations of rigs.

Due to depressed oil and natural gas prices through the 1980s and ’90s, few companies invested much money in building new rigs. As a result, much of the world’s fleet of onshore and offshore drilling units is old and obsolete. For example, of the world’s 432 jackup rigs, 350 were built more than 20 years ago.

This all plays right into National’s hands. The company has been winning orders both for equipment to be used on new rigs and modern equipment used to upgrade older rigs to handle modern, complex oilfield developments.

But the unit’s attraction isn’t just leverage to the long-term upside of the “end of easy oil” thesis. Roughly 14 percent of the Rig Technology unit’s sales are for land rigs; offshore drilling rigs account for 86 percent of the business. Meanwhile, North American sales account for just 25 percent of the unit’s revenues; much of these North American sales would be to operators in the offshore Gulf.

The beauty of this revenue mix is that it represents the most defensive, downturn-resistant segment of the oil market. Big deepwater drilling projects are largely the province of large integrated oil companies (IOC) and national oil companies (NOC). IOCs such as ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) have plenty of cash on their balance sheets to fund planned projects and have no near-term needs to access still-shaky credit markets.

IOCs also tend to take a fairly long-term view on major projects. These are multibillion-dollar, multiyear deals that tend not to get canceled due to temporary dips in commodity prices. In most cases these firms are locked into their rig contracts, and there’s no easy way for them to break these arrangements.

NOCs are potentially an even more stable source of demand for deepwater projects, and the most exciting market in this regard is Brazil. I highlighted the exciting finds in Brazil’s Santos Basin in the March 5, 2008 TES, The Final Frontier.

To drill all its exciting prospects, Brazil’s NOC Petrobras (NYSE: PBR) has announced it will need as many as 40 technologically complex deepwater-capable rigs. The company signed up for 12 rigs late last year and, therefore, has as many as 28 new rigs to acquire to develop these fields. Petrobras has also announced a USD174 billion, five-year budget to develop these exciting plays, up by more than 50 percent from its prior budget in light of new finds in the region.

Petrobras shows no real signs on pulling back its commitment to produce these plays. Brazil’s deepwater Santos Basin plays are a long-term strategic national asset. While producing these fields would be, at best, weakly profitable with the current price of crude and gas, remember these fields won’t be producing major volumes until after 2012.

Brazil is taking the long-term (and I believe low-risk) bet that crude oil prices will average much higher in coming years than the current quote.

Bottom line: National Oilwell believes that Brazil could represent USD3 billion to USD4 billion in incremental revenue for 2009 alone. That’s a huge number when you consider that the company’s total 2008 revenue was about USD13.5 billion.

Two final points about National Oilwell are worth noting. First, the company has a gigantic USD11.1 billion backlog of unfilled orders that will keep it busy through 2009, regardless of drilling activity and the path of commodity prices. That backlog has soared from less than USD1 billion just four years ago. The backlog is off only slightly from record levels of USD11.8 billion recorded at the end of the third quarter in 2008. In fact, the fourth quarter was the first quarter in the last 14 where National’s backlog fell; the company completed nearly USD1.5 billion in projects from its backlog and booked less than USD800 million in new orders.

Even if the firm’s rig technology backlog continues to shrink at a similar pace throughout 2009, the company has plenty of work to do.

Finally, National Oilwell’s balance sheet is nearly flawless. The company had more than USD1.5 billion in cash on the books at the end of 2008 and just USD874 million in debt, most of it due during the 2011 to 2015 period; there’s little near-term financing risk.

The company took on an additional USD3 billion in debt via a bank credit line when it purchased Grant Prideco. Impressively, National paid down that debt from cash flow and now has a USD3 billion undrawn line that could be brought to bear as needed.

Trading at less than 9 times 2009 earnings estimates and with one of the most stable earnings profiles in the energy patch, new Wildcatters Portfolio addition National Oilwell Varco is a buy under 36. I recommend a stop-loss at 22 to protect downside.

Dril-Quip (NYSE: DRQ)–Dril-Quip is a far smaller firm than National Oilwell, but it’s levered to the same attractive deepwater and overseas markets. Also like National, Dril-Quip has a clean balance sheet, giving it plenty of flexibility despite still-weak credit markets.

Dril-Quip has two divisions: Drilling Equipment and Services. The former accounts for about 85 percent of revenues and is the main division of interest from an investing standpoint. The company’s drilling equipment segment mainly manufactures subsea products used primarily in deepwater offshore field developments.

Many investors seem to believe that in a deepwater field, all the equipment used to control a well is located on a floating production platform. But that’s just not the case–producers install equipment directly on the seafloor, and this equipment is aptly named subsea equipment.

Subsea trees are key pieces of equipment used in all deepwater oil and gas developments. The term “tree” is short for Christmas tree. When onshore wells are completed and ready for production, producers install a network of valves and pipes on top of each well. The general shape of this equipment is vaguely reminiscent of a Christmas tree, hence the term.

Subsea trees are infinitely more complex. Such installations include equipment that allows producers to control the flow of oil and natural gas remotely from the surface. In addition, subsea trees have to be able to handle the extremes of pressure, temperature and other harsh environmental conditions consistent with deepwater oil and gas plays.

As the name suggests, subsea risers are a sort of pipe that acts as a conduit between subsea wells and surface production and drilling equipment. Obviously, risers are required during the drilling process and to actually bring produced oil and gas to the surface.

Dril-Quip does have some exposure to the shallow-water and onshore drilling markets. But these businesses are tiny in comparison to its deepwater exposure. Moreover, about 70 percent of revenue comes from outside the US; North American sales mainly consist of sales into projects in the Gulf of Mexico. These end-markets largely insulate Dril-Quip from the dramatic decline witnessed in North American drilling activity.

In addition, like National Oilwell most of Dril-Quip’s customer base consists of IOCs or NOCs. These firms are likely to continue spending no matter the short-term path of oil and gas prices.

And check out my chart below.

Source: Dril-Quip Public Filings

Dril-Quip’s backlog has increased steadily in recent quarters, from less than USD100 million in early 2004 to more than USD600 million as of the end of 2008.

Dril-Quip has continued signing some sizeable deals since the end of 2008, including a recent two-year, USD80 million deal to supply subsea wellhead systems to BP (NYSE: BP). These systems will be used in the deepwater Gulf and are designed to handle pressures of 15,000 to 20,000 pounds per square inch. This deal will involve booking an immediate USD26 million to its first quarter backlog, with the rest to be booked over the remainder of the two-year term. BP also has an option to extend the deal into a third year.

Just as with National Oilwell, Brazil could be a major growth area over the next few years. The nation’s big plans for deepwater plays spell rising demand for subsea equipment that will likely translate into significant order flow for Dril-Quip.

But even based on the current backlog, Dril-Quip only expects to fill about 65 percent of its year-end 2008 backlog by the end of this year. That backlog represents a steady stream of revenue for the firm.

Long-time TES readers are probably wondering why I’m recommending Dril-Quip rather than Cameron International (NYSE: CAM) or FMC Technologies (NYSE: FTI), two larger manufacturers of subsea trees and equipment. I’ve recommended both in TES before, and both ended up being profitable investments. I still rate both companies “buys” in my coverage universe.

My rationale for recommending Dril-Quip is two-fold. First, the company is far smaller than Cameron or FMC, with a USD1.2 billion market capitalization compared to USD4.8 for Cameron and USD4 billion for FMC. Because smaller stocks have a tendency to move quicker than their larger brethren, this means that as interest in the energy services and equipment stocks leveraged to deepwater picks up, Dril-Quip stands to see more upside.

Another advantage of Dril-Quip’s size is that it can feed off the table scraps. While FMC and Cameron duke it out over who gets the most awards for subsea trees, Dril-Quip can quietly pick up subsea wellhead orders for USD50 million or USD100 million; these might be tiny deals for Cameron, but they’re needle-movers for Dril-Quip.

Second, Cameron has far more leverage to onshore trees and equipment than Dril-Quip; the firm has more exposure to the declining US rig count. Meanwhile, FMC Technologies is more expensive on a forward price-to-earnings basis.

I like both FMC Technologies and Cameron International as long-term plays on the deepwater drilling cycle, but I prefer Dril-Quip as a play for the Portfolio right now. I’m adding Dril-Quip to the aggressive growth Gushers Portfolio as a buy under 35 with a stop at 21.

Seadrill (OTC: SDRLF) and Transocean (NYSE: RIG)–Contract drillers are in the business of leasing rigs to operators for a fixed fee known as a day-rate. There are really three offshore contract drilling markets to watch: jackups, midwater floaters and deepwater rigs. To make a long story short, the first two markets are either showing outright weakness already or showing signs of softening. The final market, the market for deepwater rigs, has remained resilient. I explained the reasons for this resilience above.

As for jackups and midwater floaters, consider that many of these rigs are currently being employed by smaller independent producers rather than big NOCs or IOCs. Such producers are more likely to delay or cancel projects. And these producers are more sensitive to commodity price volatility.

The two drillers in my coverage universe with the most direct leverage to deepwater rigs are Norway-based Seadrill and US deepwater giant Transocean.

Transocean is the world’s largest offshore drilling company, with a total of 136 rigs as well as 10 rigs under construction. Roughly 68 of those rigs are semisubmersibles or drilliships, and 39 are ultra-deepwater or deepwater rigs capable of drilling many of the complex plays being targeted around the world today. The company has a further 29 midwater floater rigs capable of drilling in waters up to 4,000 feet. All 10 rigs the company has under construction are deepwater rigs, with eight qualifying as ultra-deepwater rigs.

Transocean also has a sizeable fleet of shallow-water jackup rigs, including 10 jackups capable of drilling in harsh environments such as rough seas, and 55 standard jackups.

In its fourth quarter 2008 earnings report, Transocean stated that it’s seeing considerable weakness in its jackup business in all parts of the world, including Africa and the Middle East, markets that initially appeared to be holding up relatively well. Transocean has idled several jackup rigs, and more such moves are likely.

Transocean also has two midwater floaters that have already been idled, and it has indicated more rigs are likely to suffer the same fate. If there’s no demand, management has indicated it would cold-stack some of these rigs; in other words, it will put the rigs in a form of longer-term storage to cut ongoing costs.

The real value in Transocean is its massive deepwater fleet, which has, for the most part, already been contracted under long-term deals to major IOCs and NOCs. In fact, all 10 of the rigs Transocean already has under construction have been contracted for work as soon as they’re completed and put into service.

Management has said that some of the deepwater producers have lost their sense of “urgency” in terms of signing up new rigs. However, the company sees continued strength in this market, particularly in Brazil and India, where NOCs are pursuing major deepwater projects of strategic importance.

Transocean has a USD39 billion backlog of rig contracts. These consist mainly of deepwater rigs that have already been contracted under firm deals but haven’t yet completed their prescribed work. That backlog is off about USD2 billion from the levels the company reported last quarter but represents a solid base of revenues for Transocean regardless of the path of commodity prices.

Given this huge base of locked-in cash flow, the company has been repurchasing stock and paying down debt. Many investors and analysts on the company’s February conference call seemed to be pushing for Transocean to pay some sort of dividend, but management appears reluctant to take that route right now.

Transocean is a stable story in that its cash flows are locked in under long-term deals. However, there isn’t much of a near-term upside catalyst, as its deepwater rigs are all heavily contracted and the near-term newsflow is more likely to consist of bad news about jackup and midwater floater demand. Transocean is a buy in How They Rate, but I’m not adding it to the Portfolio at this time. I prefer National Oilwell and Dril-Quip, which have the potential for near-term positive newsflow in the form of new contract awards.

Seadrill is in many ways a similar story. The company has 14 floater rigs, 13 of which are highly capable deepwater or ultra-deepwater rigs. Seadrill also has a jackup fleet totaling 12 rigs and a tender fleet of 17 rigs. Tenders are simply rigs used to support other rigs by, for example, carrying and storing equipment.

Seadrill’s deepwater rigs are largely contracted under favorable deals at attractive day-rates. Because Seadrill was later in contracting many of its rigs it has, as a rule, obtained higher day-rates for its deepwater rigs than Transocean. The company has a total of USD12.7 billion in backlog, a sizeable sum for a relatively small company.

Two main problems over the past six months have hit the stock. First, the company took on considerable debt to fund its newbuild drilling rig program and still has a sizable debt burden. Companies with a heavy debt burden have significantly underperformed since last fall’s credit crunch. As credit markets have eased somewhat lately, this has become a less severe headwind. Given Seadrill’s massive backlog of locked-in deepwater contracts, the firm’s debts look manageable, but it remains a psychological risk in the current market environment.

Second, many of Seadrill’s major shareholders and management team used what are known as total return swaps (TRS) contracts to leverage their positions in Seadrill and other stocks. This made those holders a great deal of money during the bull market for the stock that ended last summer. But during the fall months, with the stock plunging alongside the energy sector at large, these TRS holders began to lose money and were forced to sell down their stakes in Seadrill to raise cash and pay off their leveraged plays on the stock. This exacerbated the selling intensity late last year. I suspect the TRS issue has passed, as Seadrill’s stock has stabilized over the past three months.

Seadrill is a buy in my aggressive Gushers Portfolio. As concerns about Seadrill’s debt burden abate, the stock should continue to recover.

Weatherford International (NYSE: WFT)–Wildcatters Portfolio recommendation Weatherford has been hit, with  all other services firms, by falling commodity prices and weak drilling activity in many markets around the world, particularly North America, Russia and the North Sea.

But there are potential upside catalysts for Weatherford when it reports earnings April 20. One is the company’s Chicontepec deal in Mexico. This deal has been controversial in the analyst community and among the other large services firms. Basically, Chicontepec is a multi-year deal involving many wells and related project management; many believe that Weatherford bid too aggressively on this deal. That sentiment seems to be shared by at least one member of Schlumberger’s (NYSE: SLB) management team who made a thinly veiled comment about this project in a conference call a few quarters ago.

The good news about Chicontepec is that it’s an extremely important deal for Mexico’s Pemex from a strategic perspective, and the NOC is highly likely to go ahead with this project regardless of the commodity price environment. Thus, this deal represents a reliable source of revenue and growth in a service market where growth is hard to come by.

Weatherford’s execution in Mexico has been solid so far, and the firm still says it’s going to make money on the Chicontepec deal. I suspect management will be peppered with questions about the deal, and if it appears the project is going as planned, the stock should react positively.

Another potential catalyst: Iraq. Oil-related revenues are absolutely crucial to Iraq’s budget and fiscal stability. After years of underinvestment in basic infrastructure and maintenance, let alone new field development, Iraq’s oil industry is in tatters. However, there are signs of change afoot, and the country is supposed to begin more aggressive development of key fields this year. The goal is to increase production from the current 2.5 million barrel-a-day capacity to 6 million barrels a day by 2013.

Although that seems more than aggressive, it certainly suggests that Iraq plans a massive wave of development in coming years. Weatherford has contracts to perform work in the Rumaila North and Zubair oilfields. Given the likely explosion of contracts in this country, Weatherford should be well-placed to win deals. And, as with Mexico, Iraq oilfield developments would be of national strategic importance and, therefore, not sensitive to near-term commodity pressures. Buy Weatherford International under 17.50.

Schlumberger (NYSE: SLB)–I can’t conclude a discussion of oil services and equipment names without at least mentioning the world’s largest services company, Schlumberger. Undoubtedly, Schlumberger will indicate weakness in some of its key markets when it reports earnings April 24. However, with the stock around USD40 per share, it’s already pricing in a lot of bad news.

Schlumberger has the most impressive line of high-tech services offerings leveraged to the long term “end of easy oil” thesis. Although the stock lacks near-term catalysts other than a general recovery in the group, Schlumberger remains a long-term, must-own name.

Hercules Offshore (NSDQ: HERO)–Hercules is a shallow-water drilling contractor in the Gulf of Mexico that we used to recommend in The Energy Strategist. We were stopped out of the stock last year at much higher prices.

I have, however, heard from a few subscribers who held on and are looking for advice on the stock. I’ll now track Hercules once again in How They Rate. Here’s my rationale for rating it a hold.

Hercules faces a tough 2009, by far the toughest year in its short history as a publicly traded company. The firm owns commodity jackup rigs that operate in the Gulf of Mexico, one of the most negatively affected markets in the world by the commodity corrections and drilling slowdown. The exodus of rigs from the region in recent years will ultimately help to stabilize rates in the region and improve business conditions, but not until natural gas prices rebound from current depressed levels.

Another headwind is proposed tax and royalty changes in the Obama budget that would make it less attractive to drill in this region. I discussed this issue at some length in the March 4, 2009 TES, Big Budget Blues.

Hercules is likely to see many of its rigs idled, and those that do find work will likely earn rates that barely cover cash costs of operating rigs. Management has stated that if the environment is as bad as it’s projecting, Hercules will likely be in breach of debt covenants by the end of this year. Management is seeking to revise these terms.

Given management’s long history in the business and strong track record, I believe that the banks will renegotiate covenants with Hercules. After all, a failure to do so would result in bankruptcy, an outcome the banks probably want to avoid; selling the rigs in a depressed market isn’t likely to result in much of a return of their capital.

I’m also looking for Hercules’ business to show signs of a turn when gas prices recover; as readers know, I’m looking for that to happen before the end of 2009.

That makes Hercules a sort of call option. I’d put bankruptcy odds at less than 20 percent over the next year and a half. Meanwhile, if Hercules does successfully renegotiate covenants or gas prices recover more quickly than expected, the stock could trade back to the USD7 to USD10 range.

Finally, I’m awaiting with bated breath the release of the Energy Information Administration’s (EIA) Report 914, which was due for release yesterday but hasn’t yet been posted to the agency’s website. This report shows the EIA’s estimates of natural gas production in the US. This month’s report should give us our first look at January production numbers.

I’m looking for further signs of falling production due to the massive decline in the gas-directed rig count. A large drop in production would lend support to my thesis that gas production will soon begin falling faster than demand and will push up prices. I’ll provide and update when Report 914 is released.

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