Recent quarterly earnings releases from the energy patch provide further evidence that the group is in the early stages of a new up-cycle.

As I’ve written for the past several months, business appears to have troughed for most oil and gas services and equipment companies appears in either the second or third quarter. If prior industry upturns are any guide, investors are in the midst of the cycle’s sweet spot–an excellent opportunity to establish or build positions in our Portfolio recommendations.

With crude oil near USD80 a barrel, it’s amazing how many bears continue to call for a price collapse, citing US inventory and demand statistics. Although these pessimistic pundits have pursued the same specious logic that prompted them to misdiagnose the rally in oil prices that occurred in 2005 to 2006, the fact remains that the importance of US demand to global oil consumption is on the wane. One can no longer analyze global oil markets solely through US inventory reports, a correlation that continues to deteriorate as demand from emerging economies expands.

In this issue I reiterate my call for crude oil to top USD100 next year and reach new highs in 2011. I also offer a detailed rundown of my favorite oil-levered recommendations.

In This Issue

Over the past few issues I’ve sketched out three investment themes. I briefly revisit these key trends and introduce a new feature to The Energy Strategist: A table of all the picks that I discuss in the issue and updated advice on each recommendation. See Stick to the Themes.

I explain why oil prices will hit USD100 a barrel in 2010 and new highs in 2011. See Oil’s Rally Is for Real.

The oil-levered stocks in the TES Portfolios have performed well. I recommend booking profits in a few names and recommend a new oil and gas equipment stock that offers attractive upside. See Playing Oil.

Stick to the Themes

In the September 23 issue, I detailed three core investment themes that should generate ample returns for investors over the next few quarters: the end of easy oil, the 2010 natural gas rally and king coal.

Thus far my related picks have performed well, but I see plenty of additional upside ahead and my enthusiasm is undimmed.

I have received e-mails from several subscribers asking for a brief rundown of the major recommendations, new and existing, that will be discussed in each issue of the newsletter.  Here’s a summary of the buy recommendations highlighted in this issue, their recent performance and my current advice.


Source: The Energy Strategist

In this issue I examine the prospects for my oil-levered recommendations in light of recent news and corporate earnings releases. The next installment of The Energy Strategist will examine the coal markets and provide in-depth analysis of related Portfolio holdings.

For a succinct rundown of the logic behind all three investment themes, please refer to Top Three Energy Themes.

Oil’s Rally is for Real

A sizeable population of pundits is permanently bearish on crude oil prices. Earlier this year, when oil still hovered around USD40 a barrel, plenty of bears predicted that oil prices would slump to USD20 a barrel by the end of 2009.

And even as oil prices headed higher in the spring, several of these prominent bears continued to fight the tape, claiming that the “fundamentals” didn’t support the rally in oil prices. As the rally continued some of the most prominent bearish arguments attributed the rise in oil prices to a weak dollar and/or the nefarious machinations of a group of speculators on the NYMEX futures market.

And this isn’t a recent phenomenon. The Energy Strategist turns 5 years old next March; in the first month of its publication, I was invited on a radio show to discuss energy prices. I spent most of the twenty-minute segment debating the path of oil prices with the host, who maintained that US oil supply and demand conditions didn’t support crude prices above USD50 a barrel–a level that was considered elevated at the time. 

I’m not trying to disparage these analysts–many oil bears are otherwise astute market observers. But I do think it’s worth examining the reasons that crude oil bears have been almost uniformly wrong about oil prices in recent years.

On the demand side of the equation, the answer is simple: an overemphasis on US oil demand and inventories.


Source: BP Statistical Review of World Energy 2009

This graph depicts US oil demand as a percent of global demand. Although the US remains the world’s largest single consumer, using more than 19 million barrels of oil per day in 2008, America’s importance to the global crude oil market has roughly halved since 1965 and hit a new low in 2008. In 1965 the US economy consumed more than one out of every three barrels of oil used worldwide, compared to about one out of every five today.

And this trend is projected to continue for the foreseeable future. According to the US Energy Information Administration (EIA), total global demand for oil is set to jump more than 21 million barrels per day by 2030. Of that total, North American demand will grow only 1 million barrels per day, while demand from developing Asian countries is expected to increase over 14 million barrels per day.

As longtime readers are aware, I doubt that global oil production will ever rise 21.4 million barrels per day from current levels. Even with record-high investment in exploration and development from 2006 to 2008, global oil production expanded less than 350,000 barrels per day for two primary reasons: the increasing complexity of bringing new production on-stream and declining production from mature fields. That being said, I do think the EIA is directionally correct about the source of marginal demand.

For many years, analysts could legitimately analyze global crude oil fundamentals by keeping a close eye on US demand and inventory statistics. When US oil demand slowed and inventories began to build, it was a good indication that oil prices were vulnerable to a decline. Those who continue to view the global oil market through this prism monitor the data depicted in the graph below.


Source: EIA

This graph tracks total US inventories of crude oil and refined products from 1990 to present. There’s a good deal of seasonal variation in inventories of crude and refined products, but a quick glance at the graph reveals a few overarching patterns.

Note that oil inventories remained relatively high from 1990 to 1994. Over this period, oil price generally trended lower, falling from USD40 a barrel around the time of the first Gulf War to lows in the mid-teens in early 1994.

From mid-1994 to 1997, US oil and refined product inventories generally tightened. Over this period, crude oil prices strengthened from the mid-teens up to the high USD20s in early 1997.

The following year marked the beginning of a new cycle. A sharp increase in inventories in 1997 and 1998 pushed oil down to as low as USD10 a barrel at the end of 1998. From 1999 to 2000 inventories generally trended lower, pushing oil prices above USD30 a barrel.

When you examine the oil market through this lens, it’s easy to see why some pundits have remained downbeat on oil prices throughout the historic advance that occurred from 2002 to 2008. Oil inventories built sharply from 2003 to 2004 through mid-2006–the pattern over this period is eerily similar to the build in inventories that occurred in 1997 and 1998. In fact, inventories peaked at roughly the same level in1998 and 2006.

But oil prices didn’t react in the same fashion during these seemingly analogous periods. In fact, the price action was almost a mirror opposite: Whereas oil prices halved between 1997 and 1998, the commodity’s price more than doubled from early 2004 to the highs achieved in 2006. And the rally accelerated as inventories tightened from 2006 to mid-2008.

The relationship between US inventories and oil prices has continued to deteriorate over the past year and a half. The big run-up in crude inventories from mid-2008 through early 2009 appeared to validate the oil bears’ thesis; inventories rose sharply, and crude prices fell precipitously during the financial crisis. But in 2009 oil has soared to over $80 a barrel, even as inventories continue to hover just off 20-year highs.

The relationship between US oil inventories and global crude oil prices is broken for the simple reason that most of the marginal growth in oil demand is coming from the developing world. Viewing US oil supply and demand numbers in a vacuum no longer suffices as an accurate proxy for movements in global oil markets. Nevertheless, a number of bearish analysts continue to trumpet the inconsistencies between US inventories and global prices as unsustainable and the precursor to a major collapse–the same mistake they made in 2005 and 2006.

Weekly inventory releases from the EIA are widely watched and can move oil prices in the near term. Last week, for example, a larger-than-expected build-up in crude oil and refined products inventories sent prices tumbling. But don’t be duped: Global oil market fundamentals aren’t weak; US oil fundamentals are weak.


Source: IEA

The above graph tracks the International Energy Agency’s (IEA) estimates of global oil demand for 2009 and 2010. The blue bars represent oil demand for 2009; the purple bars depict demand estimates for 2010, which the IEA began publishing in July of this year.

Estimates for 2009 have made a roundtrip this year. Back in January, the IEA projected that oil demand would total 85.3 million barrels per day this year. But as economic indicators worsened in the first quarter, the agency steadily revised its estimates down to a low of 83.2 million barrels per day in May.

However, as global economic data showed concrete signs of improvement over the summer, the IEA steadily revised its estimates higher; in its November report, the agency hiked 2009 demand estimates by another 200,000 barrels per day, to 84.8 million barrels per day–the highest estimate since January.

The trend in 2010 estimates evinces a similar pattern. Since July, the IEA has hiked 2010 global oil demand estimates by 1 million barrels per day to 86.2 million barrels per day. That is, the agency now expects that global oil demand will grow about 1.5 million barrels per day in 2010–similar to levels last seen in 2008.

As you may have surmised, most of this growth is projected to come from the developing world–not the US and Western Europe.


Source: IEA

To create the above graph, I compared the IEA’s 2009 demand forecasts in May and October of this year. The key point to note is that the IEA has not revised North American demand estimates higher since May, the most bearish monthly report issued by the agency this year; subsequent revisions reflect expectations that oil consumption will increase in Asia-Pacific markets.

Analysts who focus on US inventory statistics pin their conclusions on the only region where oil demand isn’t growing.

The main driver of increased oil demand estimates from the IEA is revisions to global Gross Domestic Product (GDP). My graph below offers a look at historical GDP growth and projections for the future.


Source: IMF, IEA, BP Statistical Review of World Energy 2009

In this graph the blue bars represent global GDP growth, the purple bars represent GDP growth in the developing world, and the yellow bars represent growth in global oil demand. I’ve also included the International Monetary Fund’s (IMF) projections for future GDP growth.

As you can see, emerging markets have been the engine of global growth since 2000. Even in 2009, when overall GDP contracted, emerging markets have managed to generate positive growth.

Growth in these key emerging markets is expected to accelerate into 2010, pulling along the global economy. IMF estimates predict that GDP growth in emerging markets will accelerate through 2014, powering global economic growth in excess of 4 percent from 2011 to 2014. Global growth of that magnitude is historically consistent with annualized growth in oil demand of around 1.5 to 2 percent, though a big rise in oil prices could temper demand a bit.

This year marks the only year on the chart where global GDP growth is expected to be negative. Prior to 2009, the years of slowest growth were 1999 and 2001. In both cases, oil demand grew as global GDP growth reaccelerated–exactly what the IEA expects to occur 2010.

The key factor to consider is that emerging economies are far more oil-intensive than the US and Western Europe. Consider the following graph.


Source: IMF, BP Statistical Review of World Energy 2009

To calculate the data depicted in this graph, I dividend each country’s GDP by the total amount of oil consumed annually. The higher the number, the higher the country’s GDP relative to the amount of oil consumed. In other words, when this number is on the high side it implies that a country uses oil more efficiently–that is, it generates more economic activity per barrel of oil consumed.

As you can see, every dollar of GDP growth China generates contributes more to global oil demand than the same dollar of GDP growth in a developed country. Accordingly, because emerging markets are expected to generate considerable economic growth in the coming years, demand for oil should expand rapidly.

None of this means that investors should ignore weekly releases on US oil inventories. However, these statistics illustrate why weak US oil demand growth and high North American oil inventories aren’t necessarily inconsistent with rising oil prices.

Supply is an equally important factor to consider. As I’ve written about oil production and my “end of easy oil” thesis on numerous occasions, I won’t belabor the point here. Suffice it to say that the world’s easy-to-exploit onshore oilfields are mature and their production is on the wane. Needless to say, companies are increasingly targeting oilfields that are more complex and expensive to produce–for example, deposits located in oil sands or deepwater fields. To incentivize production from these fields, oil prices will need to remain elevated for a prolonged period.

In the September 23 issue, Top Three Energy Themes, and in the October 7 issue, The Golden Triangle, I outlined the logic behind the end of easy oil. More recently, in “Second Chance to Buy,” I explained why companies’ continued reluctance to spend money on exploration and development will likely accelerate next year’s rally in global oil prices.

Periodic corrections aside, I expect oil prices to exceed USD100 per barrel in the first half of 2010 and reach new highs in 2011.

Playing Oil

Apart from 2009, the two years with the weakest global oil demand growth were 1998 and 2001. In both 1999 and 2002, global oil consumption reaccelerated sharply. The result: in 1999 and 2002, the Philadelphia Oil Services Index rallied, returning 68 and 0.1 percent, respectively. 

Although a 0.1 percent gain in 2002 might not seem particularly solid at first blush, the S&P 500 plummeted more than 22 percent that year–within that context, energy stocks dramatically outperformed.

Next year’s dramatic rebound in global oil demand should power an impressive rally in stocks leveraged to oil and my end of easy oil theme. It’s not at all unreasonable to expect gains of 50 to 100 percent next year. The catalysts will be three-fold: continued strength in oil demand from emerging markets; a cyclical recovery in US and EU oil demand; and continued weak supply growth, especially outside of OPEC.

Here’s a rundown of my favorite plays on the rebound in oil demand.

Anadarko Petroleum (NYSE: APC) — I first highlighted Anadarko in Top Three Energy Themes and provided additional details about the firm’s key deepwater plays in the October 7 issue, The Golden Triangle.

Anadarko has historically focused on natural gas production, primarily in the Rocky Mountains. But in recent quarters the company has shifted its attention to crude oil and natural gas liquids (NGLs). Last quarter, NGLs and crude oil comprised 42 percent of Anadarko’s production, compared to 37 percent in the second quarter.

In the third quarter, Anadarko produced a record 57 million barrels of oil equivalent, up roughly 7 percent from the previous year. The main drivers of Anadarko’s production growth were strong output from its plays in the Rockies and the Gulf of Mexico. But even within the traditionally gas-focused Rockies management the company targeted plays such as Greater Natural Buttes in Utah and Wattenburg in Colorado–deposits that generate significant quantities of NGLs along with natural gas.

NGLs are hydrocarbons such as propane, butane, ethane and natural gasoline that are produced with gas but typically fetch prices that are more closely tied to crude oil; producing a higher quantity of NGLs enables companies to benefit from crude oil’s huge price premium to gas.

But the real catalyst for Anadarko’s stock isn’t the firm’s continued success with current production. In the instance the carrot for investors is the company’s massive drilling and exploration program in the Deepwater Golden Triangle: the deepwater fields off Brazil’s coast, the Gulf of Mexico and the waters off the coast of West Africa.

In the fourth quarter of 2009, Anadarko five wells slated for exploration: the 31,000-foot Rickenbacker well in the Keathley Canyon, off the Gulf of Mexico (see the October 7 issue for a map); the 21,000-foot Lucius play in the Keathley; the 16,000-foot Itaipu well in Brazil’s pre-salt; the Windjammer well off the Mozambique’s coast; and the Mecupa well in Mozambique proper. Positive well results from any one of these fields could be a potential upside catalyst for Anadarko’s stock.

Next year Anadarko plans to drill two to six exploration wells off the coast of West Africa–that’s in addition to ongoing appraisal and development wells planned off the coast of Ghana.  

In addition to this exploration program, Anadarko plans to continue appraisal drilling around some of its more recent discoveries in all three legs of the deepwater Golden Triangle. Anadarko is one of the purest plays on the growth of deepwater. Buy Anadarko under USD70.

EOG Resources (NYSE: EOG) — EOG Resources is traditionally regarded as a US-focused producer of natural gas. However, like Anadarko, the company’s recent activity has focused on boosting production of crude oil and natural gas liquids (NGLs).

For several quarters management has forecasted that the firm’s production would be roughly an even split between natural gas and liquids; in EOG’s November 6 conference call, management revised that estimate to sometime between 2011 and 2012. In 2010 EOG expects oil and NGLs to account for 44 percent of its production mix, up from 36 percent in 2009. Overall EOG is looking to grow its liquids production an astounding 50 percent in 2010, while boosting gas output by just 3 percent. This strategy should pay off for EOG, as crude oil currently offers a far superior return on investment to natural gas.

EOG’s outlook for the North American gas market is broadly in-line with my own; management stated that it expects its natural gas business to begin the year weak but end the year strong. As a result, EOG’s plan to produce 3 percent more gas in 2010 consists of flat production year-over-year in the first half of the year, followed by 6 percent annualized growth in the second half. Much of this additional production will come from the Haynesville Shale of Louisiana and East Texas, one of the cheapest-to-produce and most prolific fields in the US.

EOG boasts an impressive slate of unconventional oil-focused plays in the US. The most unique is a field EOG calls its Barnett Combo play, located in the northern reaches of the Barnett Shale play near Fort Worth Texas. Most of the Barnett produces gas, but EOG has identified a swath of 90,000 acres that produces oil.

EOG made a 7,800-acre acquisition during the quarter, and management believes it has acquired the majority of the productive acreage. Now that the property is secured, the executive team provided detailed information on the Barnett Combo play for the first time.

In the eastern half of the play, the productive layer of shale is about 700 to 1,500 feet thick; EOG has sunk cheap-to-drill vertical wells spaced about 20 acres apart. Two of its recent wells in this part of the play showed initial oil production rates of 1,067 and 450 barrels per day, along with as much as 2.1 million cubic feet of NGL-rich natural gas.

In areas where the shale is thinner, EOG is sinking horizontal wells, which drill down to the productive layer of the shale and then penetrate sideways through that layer, exposing more of the well to the oil-producing rock. These wells should produce similar initial production rates to the vertical wells in the Barnett Combo’s thicker sections. All told, EOG believes that with crude oil trading between USD75 and USD80 a barrel, wells in the Barnett Combo should generate about a 70 percent return on investment.

Before I highlight some of EOG’s other plays, it’s important to reiterate that there is a big difference between “shale oil” and “oil shale.” The former refers to conventional crude oil that is trapped in shale rock. Shale oil is produced much like shale gas and other unconventional gas plays.

I’ve written about unconventional plays extensively in the past, but here’s a quick refresher. Natural gas and oil don’t exist underground in some giant cavern or lake; hydrocarbons are found trapped in the pores and cracks of a reservoir rock. A typical conventional reservoir rock is sandstone, which resembles a mass of sand particles stuck together to form a rock. Sandstone has many pores that are capable of holding hydrocarbons. In other words, sandstone has favorable porosity.

Typically these pores are interconnected, allowing oil and gas to travel easily through the rock. Such rocks have a high degree of permeability. When a producer drills a well in a conventional field, oil and gas travel through the reservoir rock and into the well, powered mainly by geologic pressures.

Shale fields and other unconventional fields aren’t especially permeable; while there may be plenty of oil and/or gas trapped in the rock, there are no channels through which that oil or gas can travel. Even in shale fields where there’s plenty of geologic pressure, the hydrocarbons are effectively locked in place.

Producers have developed two major technologies in recent years to unlock oil- and gas-rich shale: horizontal drilling and fracturing. The first technology is self-explanatory: Horizontal wells are drilled down and sideways to expose more of the well to productive reservoir layers.

Fracturing is a process by which producers actually pump a liquid into a shale reservoir at such tremendous pressures that it cracks the reservoir rock. This creates channels through which hydrocarbons can travel–in other words, fracturing improves permeability. EOG’s management noted that the oil the company produces from its shale oil plays is typically of equivalent or better quality than West Texas Intermediate (WTI), the most widely quoted benchmark of US crude. 

Oil shale refers to a solid or near-solid form of crude that’s primarily found in Colorado and parts of Alberta, Canada. This shale involves complex production techniques; typically, large heaters are used to liquefy the crude before it’s pumped to the surface. Like crude produced from the oil sands, oil shale must undergo additional refining before it’s ready for use. Shale oil is extremely profitable to produce at current prices and is a major area of growth for EOG; oil shale is a much more expensive resource.

The Bakken shale offers an even higher return on investment than the Barnett Combo play. In the North Dakotan core of this play, wells produce at an initial rate of about 1,000 barrels per day and produce an after-tax return on investment of 100 percent. Wells drilled just outside the core region offer lower initial production–500 to 900 barrels per day– but still produce a solid 35 percent return.

Other emerging oil plays include the Cleveland oil play in the Texas Panhandle and the Waskada oil project in Manitoba. Management noted that these plays yield after-tax returns of between 35 and 70 percent but offered less additional information–likely because the company is pursuing additional acreage and doesn’t want to tip its hand.

Although production from the aforementioned wells pales in comparison to some overseas wells, investors should consider that they’re among the most productive new wells drilled onshore in North American in decades. At the same time, don’t fall for the hype you’ll hear spouted from some commentators–the Bakken and Barnett Combo plays will never produce enough oil to make the US energy independent. But these plays certainly will flow enough oil to keep EOG’s production and bottom line growing for years to come. Buy EOG under 100.

Hess Corporation (NYSE: HES) — Hess reported strong third-quarter results and raised its total 2009 production guidance from a range of 390,000 to 400,000 barrels per day to 400,000 to 410,000 barrels per day. Production was up 16 percent compared to the same quarter last year. Most of the growth stemmed from a new field in the Gulf of Mexico and an easy year-over-year comparison because of hurricane damage in the year-ago quarter.

One concern that weighs on Hess’ stock is that the company may need to borrow more money or issue shares to fund its ambitious drilling program over the next few years. But given rising commodity prices and healthier debt and equity markets, management maintains that the firm should be able to finance planned growth from operational cash flow. This is a big positive.

What bothers me about Hess and the main reason I cut the stock to a hold back in the September 23 issue, Top Three Energy Themes, is the lack of near-term catalysts for the shares. The most widely-watched exploration plays in Hess’s portfolio are deepwater fields in Ghana and Brazil, but the company likely won’t drill new wells in these fields until late 2010, at the earliest. By comparison, Anadarko has more deepwater well results scheduled for early 2010 that should push the stock higher.

Granted, Hess has a big drilling program underway in the Bakken shale; however, we already have sufficient exposure to this play through EOG Resources. I am selling Hess from the Wildcatters Portfolio and booking an overall gain of about 21.7 percent on the position. Investors should consider reallocating a portion of the proceeds to my other oil-focused plays.

Noble Corporation (NYSE: NE) — Noble Corporation is a contract driller that I recommended in the June 17 issue, The Drilling Dozen. If you’re unfamiliar with the drilling business, that issue includes a detailed primer.

Noble owns a mixed fleet of rigs that includes deepwater floater rigs and international shallow-water jackups. There’s little new to note about Noble’s deepwater floaters, as these rigs are all booked on long-term contracts at fixed day rates; this fleet offers a stable, reliable source of cash flow regardless of commodity prices and drilling activity.

Heading into the quarter, Noble had just one floater due to come off contract in 2010, the Nobel Paul Romano. However, the producer that had been leasing that rig–Marathon Oil (NYSE: MRO)–agreed to a deal that will allow it to keep the rig for an additional 120 to 150 days at a day-rate of $375,000, a reduction from the prior day-rate of more than $480,000 a day.

The Paul Romano is a semisubmersible rig capable of drilling in water up to about 6,000 feet. It’s technically a deepwater rig but was rebuilt about a decade ago and lacks many modern capabilities.

The contract extension with Marathon will keep the rig locked up until next summer, and management noted it’s looking at several potential contracts for the rig. This will be an interesting story to keep an eye on in early 2010–if Noble is able to contract the rig at more than $375,000 to $400,000, that could be a sign that demand for rigs of that class is improving.

The more important near-term catalyst for Noble will be its international jackups. These rigs tend to be contracted under shorter-term deals, and day-rates suffered considerably amid the weak commodity price environment of late 2008 and early 2009.

But Noble noted signs of a turn in the industry as a whole. In particular, Noble stated that international jackups have continued to find work in the $85,000 to $115,000 day-rate range; however, three rigs in Iran recently fetched $177,000 per day, and one went to work in Sudan at $180,000 per day. Sanctions against both of these countries mean that most contractors, Noble included, are prohibited from bidding on these deals. As a result, these rates are far higher than what prevails in competitive markets. Nonetheless, that both countries were willing to take on the rigs suggests that commodity prices are high enough to yield a profit.

Noble also noted that several of its largest jackup customers were looking to either maintain their rig counts or put more rigs to work. Better still, the utilization rate of the international jackup fleet remains near 80 percent even though four newly built rigs went to work in the third quarter. Noble’s management noted that if commodity prices hover around current levels, the utilization rate for jackups would actually increase. As the utilization moves above 80 percent, day-rates should begin to inch higher–a real catalyst for Noble’s stock. Buy Noble under 50.

Petrobras A (NYSE: PBR A) — I outlined my investment thesis for Petrobras at great length in the October 7 issue, The Golden Triangle, so I won’t rehash those arguments here.

Suffice it to say that Petrobras’ management noted some progress on drilling the company’s core deepwater plays. The firm has ramped up its extended well test on the Tupi field to 20,000 barrels per day and completed a fourth well in the field that further confirmed its reserve estimates of 5 to 8 billion barrels.

Petrobras plans to sink exploratory wells in several pre-salt deepwater plays, including a total of three wells in blocks BMS-9, BMS-11 and BMS-10. Positive results from these exploration wells could be a significant catalyst for the stock.

As I noted in the October 7 issue, the new Brazilian oil laws are generally neutral to positive for Petrobras. However, the law still has to clear several hurdles in Brazil’s two-house legislature. The law isn’t likely to be passed until sometime in the second half of 2010; the legislative changes shouldn’t have any near-term bearing on the performance of Petrobras. Buy the Petrobras’ A-class shares under 50.

Suncor (NYSE: SU) — Oil sand behemoth Suncor’s third-quarter earnings release was generally solid, though so there’s still a fair amount of white noise because the firm completed its mega-merger with Petro-Canada on August 1.

Suncor’s management noted during the third-quarter conference call that it had expected the merger to save $300 million in annual expenses and produce $1 billion in capital efficiencies. But the company now expects to exceed those targets–a positive sign. Whenever a company is involved in a big merger, there’s a risk that expected synergies won’t materialize.

As I’ve noted in previous issues, Suncor plans to sell off many legacy Petro-Canada assets to focus on its core oil-sands operations. Management expects to raise about $4 billion from these sales, with most of the divestments occurring in 2010. Operations on the block include natural gas fields, North Sea assets and some of the company’s operations in Trinidad and Tobago.

The company offered some additional guidance on planned 2010 production in an operational and capital spending update a few days after it released its quarterly earnings results. Suncor’s long-term strategic goal is to grow its oil-sands production 10 to 12 percent on an annualized basis.

The company’s next major projects include Firebag stages 3 and 4, which are slated to produce first oil in the second quarter of 2011 and the fourth quarter of 2012, respectively. Each stage adds roughly another 68,000 barrels per day of bitumen production to the company’s current base of around 300,000 to 350,000 barrels per day. These production figures do not include Suncor’s 12 percent interest in the Syncrude oil- sands joint venture.

Looking out past 2012, Suncor has a large number of projects under consideration. The list includes two additional stages to the Firebag oil sands project and the massive Voyageur project that Suncor mothballed earlier this year due to weak commodity prices.

Bottom line: Suncor is one of the most heavily oil-focused producers in my coverage universe and is one of only a handful worldwide that could post robust production growth over the next several years. And this new oil production should come on-stream during a period of rapidly rising oil prices. Suncor rates a buy under 43.

Seadrill (Oslo: SDRL; OTC: SDRLF) — Seadrill is a contract driller that I highlighted at some length in the June 17 issue, The Drilling Dozen. To summarize, Seadrill is a contract driller focused on deepwater and ultra-deepwater rigs.

Seadrill’s stock could benefit from tree massive catalysts that have emerged over the past month:

1. Seadrill re-instated its dividend policy.  Amid the financial crisis of late 2008, Seadrill suspended its dividends to conserve cash. But the company’s financial position has improved markedly over the past year, thanks to USD2.1 billion in new financing and the repayment of a short-term loan of USD1 billion.

In a sign of management’s confidence, the company declared a dividend of 50 cents for the quarter. The ex-dividend date is November 23, and the dividend will be paid on or about December 7. Based on management’s comments it appears that Seadrill intends to reinstate a regular quarterly dividend in 2010 and is targeting 50 cents per share. At the current share price, that would work out to a yield of 8.1 percent.

2. Seadrill is planning to move its primary listing from Norway to the New York Stock Exchange in the first quarter of 2010. Because most individual investors in the US have trouble accessing the Oslo market directly, most buy Seadrill over the counter (OTC) in the US. But only around 13,000 of the company’s OTC shares trade hands each day; although Seadrill’s business prospects are sanguine, the stock that most US investors would purchase isn’t especially liquid.

Look for an explosion in interest in the stock once it lists on the NYSE. Volumes and liquidity will improve immensely once stock becomes readily available to US investors. 

3. Like Noble, Seadrill benefits from a solid backlog of contracts for its deepwater rigs and an improving jackup market.

With a solid fleet of rigs and three clear-cut upside catalysts, Seadrill rates a buy under 27.

Schlumberger (NYSE: SLB) and Weatherford (NYSE: WFT) — As I have explained in prior issues of The Energy Strategist, the big oil-services companies are among my favorite long-term plays on the end of easy oil.

I analyzed both stocks and their recent earnings releases in great detail in the previous issue, Second Chance to Buy. Schlumberger is a buy under 85; Weatherford is a buy under 26.

At present Weatherford’s stock is a particularly compelling value because of the market’s overreaction to Pemex’s recent announcements about the Chicontepec play. Consult the previous issue for my in-depth analysis of these developments.

Tenaris (NYSE: TS) — I recommended Tenaris in The Golden Triangle. The company makes oil country tubular goods (OCTG) that are used in the drilling and completion of oil and natural gas wells.

The main driver of demand in OCTG products is drilling activity. With oil and gas prices at sky-high levels in the summer of 2008, global drilling activity was strong; when the financial crises sent commodity prices tumbling, drilling activity declined sharply.

The worst-hit drilling market was North America, where drilling activity is sensitive to gas prices; gas prices sustained a harder hit than oil and have recovered more slowly. But projects were delayed worldwide; after all, just under one year ago, oil prices were in the USD30s, a level where few drilling projects are sufficiently profitable.

It should come as little surprise that the volume of pipes Tenaris sold in the third quarter was much lower than a year ago–the third quarter of 2008 marked the high for commodity prices. Tenaris’ third-quarter sales were off 42 percent from 2008.

High inventories of OCTG are another challenge, especially for Tenaris’ US operations. Currently, there’s roughly 10 months’ worth of OCTG supplies in inventory, compared to four to six months’ worth from 2004 through 2008. But inventories have declined from the beginning of the year. As producers draw down inventories of OCTG rather than order new products, Tenaris’ sales have continued to drop.

But this weakness in OCTG volumes and pricing was common knowledge ahead of Tenaris’ report. In fact, the stock has rallied to a new 52-week high since reporting its results.

The primary reason for this rally is that management made some upbeat comments about a turn in its core business during the third-quarter conference call. Specifically, in international markets (i.e., outside North America), Tenaris noted that its incoming volume of orders began to improve in the third quarter, suggesting that more sales could be in the pipeline.

In particular, Tenaris noted that national oil companies (NOCs) like Saudi Aramco have increased their tender activity and are trying to secure deliveries of new OCTG products for the first quarter of 2010. This trend is also reflected in measures of international drilling activity; much of this drilling is sensitive to oil prices and should pick up amid resurging oil prices.

Better yet, as I explained in the October 7 issue, Tenaris is a leading producer of premium-grade OCTG. Advanced OCTG products are needed to drill deeper wells onshore and in deepwater fields. Tenaris noted that many of the orders it’s received from NOCs are for these higher-margin OCTG products; the focus on drilling complex fields plays directly into Tenaris’ strength as a market leader in premium OCTG.

And signs suggest Tenaris’ business in the US and Canada could be turning around. The US rig count bottomed out over the summer, and much of the (albeit slight) uptick in drilling activity since that then has been concentrated in complex oil and gas shale plays. These plays often require more premium OCTG rather than simple, welded pipes.

Furthermore, the US government recently imposed severe tariffs on Chinese OCTG. The first round of tariffs was designed to offset subsidies the Chinese government grants to domestic OCTG and pipe manufacturers. Chinese pipes compete with Tenaris’ basic offerings; large imports over the past year have contributed to the rise in inventories and falling prices. Although these tariffs likely will increase the costs of producing oil and gas in the US, they’re certainly great news for Tenaris.

Often the most profitable time to hold a stock is when business hits an inflection point and is first bouncing back from a weak period–this is exactly what’s happening to Tenaris right now. The company expects rising sales volumes into early 2010.

With clear signs of a rebound in OCTG demand and a solid franchise in premium OCTG products, Tenaris rates a buy under 45.

Dril-Quip (NYSE: DRQ) — I last detailed Dril-Quip in Top Three Energy Themes. As I explained in that issue, Dril-Quip manufactures subsea products used primarily to develop deepwater fields. That makes the company a pure-play on one of the hottest and most compelling investment themes in the energy patch today, deepwater.

The company’s recent earnings release illustrates why Dril-Quip’s stock has performed so well in recent months. Incredibly, Dril-Quip’s revenues have continued to grow throughout the 2008 financial crisis, the worst global recession in decades and the rollercoaster ride in energy prices.

Dril-Quip books orders for new subsea products into a backlog and then gradually fills those orders over time. Therefore, it’s a good idea to keep your eye on Dril-Quip’s backlog; as long as this book of business continues to grow, the pace of orders for the firm’s products remains robust.

In the third quarter Dril-Quip’s backlog reached $623 million, compared $618 million at the end of the second quarter, $603 million at the end of 2008 and just $528 million at the end of the third quarter of 2008.

Back in late September, I raised my buy target on Dril-Quip to 50 and stated that I could see the stock trading between 60 and 65 by year-end. Dril-Quip has soared over my buy target and is trading just a hair’s breadth away from that 60 to 65 range.

The fundamentals surrounding Dril-Quip remain compelling over the long term, particularly its consistent backlog growth. And despite the recent run-up, the stock now trades at 21.3 times this year’s earnings estimates and 19.6 times 2010 estimates.

FMC Technologies (NYSE: FTI) and Cooper Cameron (NYSE: CAM) are the most comparable companies in my coverage universe. Cooper trades at 18 times 2009 earnings estimates and 19.4 times next year’s estimates; FMC trades at 20.3 times 2009 estimates and 23.3 times next year’s estimates. On a relative basis, Dril-Quip’s valuation doesn’t look completely out of touch with reality given the strength of its business.

But the stock is pricing in significant positive news and has run-up quickly in recent weeks, approaching its all-time highs set in mid-2008. I can see the stock continuing into to trade above 60, but there’s just not enough upside left to maintain my buy recommendation. I am cutting Dril-Quip to a hold as of this issue. I also recommend that investors sell half of their position in Dril-Quip to book a solid gain of over 90 percent from the date of recommendation. Finally, investors should place a stop order at $50.50 to protect their gains.

For example, if you own 100 shares of Dril-Quip, sell 50 shares and hold the remaining 50 shares.

This strategy will allow us to book some impressive gains immediately. Setting the stop will protect an almost 70 percent gain on the remaining half of the position, and we’ll continue to benefit if Dril-Quip rallies to new all-time highs.

Tullow Oil (London: TLW) — I’ve rated Tullow’s shares a hold for some time and last explained my rationale in Top Three Energy Themes. Tullow has announced impressive drilling results from its core operations in Africa. These successes include a series of wells offshore Ghana and elsewhere in West Africa.

Tullow is also a perpetual takeover target; a number of large producers would love to boost their stake in key African oil-producing regions where Tullow has a solid acreage position.

But I see Tullow’s upside limited to 10 to 15 percent from current levels even in the event of a takeover. And the TES Portfolios include ample exposure to the deepwater fields off West Africa via Petrobras and Anadarko. I recommend that readers sell their shares of London-based producer Tullow Oil for a total gain of 167 percent from my recommendation in 2007.

By taking profits in Hess and Tullow and booking partial gains in Dril-Quip, we’re in a good position to boost our oil-related exposure elsewhere in the portfolio.

In this issue, I’m adding Dresser-Rand (NYSE: DRC) to the Wildcatters Portfolio as a buy under 34. Dresser manufactures compressors and turbines, about 90 percent of which are used in the oil and gas industry. Dresser has two reporting segments: new units and sales of parts and maintenance to service existing products. Each segment accounts for roughly half of aggregate sales.

The three largest end-markets for Dresser’s products are as follows: oil and gas production (32 percent of revenue), refining (31 percent of revenue) and gas transmission (17 percent of revenue).

For example, Dresser compressors are used to re-inject gases produced with oil–both natural gas and waste gases like carbon dioxide–back into the oilfield. By re-injecting gases, producers can maintain field pressures and production volumes for a longer period.

In addition, pressures fall as fields grow older, requiring producers to install more compression equipment to maintain production levels. Producers also need compressors to transmit natural gas along pipelines and to pump gas into pressurized storage facilities.

And compression equipment is a key component of liquefied natural gas (LNG) liquefaction trains–compressors are used to super cool natural gas and produce LNG. The same basic equipment also is used to separate natural gas from NGLs during processing. Simply put, Dresser operates in just about every imaginable subsector of the oil and gas industry.

Dresser is a backlog business, so it’s important to keep an eye on the pace of new order bookings as a sign of future growth potential. As you might expect, the pace of new order bookings has slowed markedly over the past year. In the 12 months ended with the third quarter of 2009, total bookings were just shy of $1.8 billion–down by 27 percent over the same period ended one year ago. Bookings in the third quarter were off 60 percent compared to a year prior; although service and maintenance service bookings were off, sales of new units dropped over 80 percent.

Lower commodity prices were the root cause of this slowdown. Companies have delayed large projects such as new refineries, LNG facilities and major oil and gas production projects. As I’ve noted in previous issues, even big, multi-year oil and gas production projects in the Middle East, arguably the world’s most resilient producing market, were canceled or delayed amid the low commodity price environment of early 2009.

But Dresser’s management noted signs that the pace of bookings is on the mend. Specifically, new unit bookings totaled just $79 million in the entire third quarter but at the time of the conference call (October 30), Dresser noted that it had already received $250 million in new orders in the fourth quarter. The list includes new orders for a refinery project in the Middle East, production-related equipment in West Africa and a Chinese LNG Project.

The company expects aftermarket orders to also improve sequentially in the fourth quarter and to continue that improvement into 2010.

Dresser has performed well this year but has lagged many of the oil services and equipment stocks I follow–since late July the stock has traded roughly sideways. But with oil prices at higher levels, companies are considering restarting stalled projects or increasing capital spending plans. It appears that the order cycle has bottomed. Dresser should benefit from accelerating growth into 2010 as the next up-cycle unfolds.

This should catalyze more upside in the stock. There’s also room for Dresser stock to play catch-up with the rest of the oil services and equipment industry into next year as the evidence of the recovery mounts. Buy Dresser Rand under 34.