I had planned to review recent earnings reports and discuss master limited partnerships in this issue. But the explosion of the Horizon rig and the ongoing efforts to stem a major oil spill in the Gulf of Mexico are the most important stories affecting the global energy markets; it would be irresponsible not to address these events in detail.

It might seem callous to identify opportunities to profit from this deadly disaster. However, panic and lead to overreaction in markets. And extremes of sentiment typically offer investors opportunities that would never occur in normal trading environments. That’s the case with current events in the Gulf.

In This Issue

The Stories

The devastating oil spill in the Gulf of Mexico has roiled the energy sector, and panic breeds opportunity for savvy investors. I discuss the likely winners and losers among contract drillers and subsea equipment companies. See On the Horizon.  

Over the long term, oil-services companies stand to benefit from the end of easy oil. I examine the near-term implications of the Horizon disaster for the industry. See Oil-Services Companies.

Three producers have a stake in the Macondo well; the time is ripe to buy one of these stocks. See The Producers. 

The oil spill has broader implications for offshore drilling in US waters and oil and natural gas prices. See The Big Picture.

The TES indexes indicate that refiners are up and coal stocks are down. Here’s what it all means. See The TES Indexes.

The Stocks

Cameron International Corp (NYSE: CAM)–Buy @ 45, Stop @ 32
Seadrill (NYSE: SDRL)–Buy @ 29, Stop @ 16.25
Diamond Offshore Drilling (NYSE: DO)–Sell in How They Rate
Noble Corp (NYSE: NE)–Buy @ 50, Stop @ 30
Schlumberger (NYSE: SLB)–Buy @ 83
Anadarko Petroleum Corp (NYSE: APC)–Buy @ 70, Stop @ 45

One of the key themes underpinning this advisory is that the world is running out of easy-to-produce oil, forcing companies to target more complex and expensive-to-produce fields to fill the supply gap. Deepwater oilfields such as the Macondo prospect that BP (NYSE: BP) was drilling in the Gulf of Mexico are a perfect example of “hard oil.”

Completing wells in the deepwater isn’t a simple matter of a producer drilling a well with its own crew, engineers and equipment. The list of companies involved includes drilling contractors that provide rigs, several partner producers, myriad service companies involved in all aspects of drilling and testing the well, and equipment manufacturing firms that produce the pipes and subsea wellheads used to control and manage the flow of hydrocarbons. 

Whenever a disaster such as the recent oil spill in the Gulf of Mexico occurs, the mass media tends to gloss over these complexities to drive home the sensationalist headline about a rig exploding and causing an ecological disaster. Most stories about the incident have focused on one of three topics: assigning blame, the political fallout or the environmental damage being wrought.

It’s unlikely the general public would be interested in a story about the potential reasons the blowout preventer (BOP) used on the well failed to activate and prevent the uncontrolled flow of hydrocarbons into the Gulf.

However, this lack of general understanding and detail offers myriad opportunities to investors; sensationalist headlines tend to produce panic–in this case, stocks associated in any capacity with the Macondo well  have taken a hit. Companies involved in this disaster fall into three categories: Those with real liability risk; those with some risk exposure but whose stocks have sold off indiscriminately; and some that likely will benefit significantly from the disaster and coming regulatory changes.

With fear in the driver’s seat, it’s time to look for investment opportunities emerging from the Horizon disaster. To determine the winners and losers, we’ll need to analyze what happened, the companies involved and what’s likely to happen going forward.

On April 20 the deepwater Horizon, a fifth-generation deepwater semisubmersible rig, exploded in the Gulf of Mexico (GOM), killing 11 people on board the rig at the time. Roughly two days later, the rig sank. It now sits on the floor of the Gulf of Mexico, about 1,500 feet from the well it was drilling at the time of the explosion.

The Macondo well, known as MC252, is said to have “blown out,” and hydrocarbons are gushing out of the well uncontrollably. Operators don’t literally pump oil from a well when it’s first produced; in primary production, the natural underground geologic pressures force the oil through the reservoir and into the well. In a deepwater well of this nature, underground pressures are likely on the order of 8,000 to 10,000 pounds per square inch. This natural pressure is forcing the oil out of the field and into the Gulf of Mexico at a rate of about 5,000 barrels of oil per day.

BP has assumed the immediate financial responsibility for the costs associated with cleanup and stemming the flow of oil. This is normal because BP is the operator of the field; however, this does not necessarily mean that BP ultimately will be held totally responsible or liable for the damage. Just because BP is taking charge doesn’t mean we can forget about the other firms involved with the well.

The Horizon rig was built by Hyundai Heavy Industries (Seoul: 009540) in 2001 and is owned by Transocean (NYSE: RIG). This model is dynamically positioned and capable of drilling in waters up to 8,000-feet (2438 meters) deep to a total well depth of about 30,000 feet. Here’s a photograph of what the rig looked like before it was destroyed.

Source: Transocean

I provided a great deal of background information about the contract drilling industry in the June 17, 2009, issue The Drilling Dozen. But here’s a quick executive summary.

Drilling contractors are not in the business of exploring for oil and natural gas or producing hydrocarbons. Instead, contractors like Transocean simply lease their rigs to producers for a daily lease fee. In this case, BP leased the rig to drill in the Gulf of Mexico for an indexed day rate of approximately $500,000. The rig was first leased to BP in September 2007 as part of a three-year deal, but the parties extended that contract through September 2013.

As you can see from the picture, semisubmersible rigs are floating rigs that are towed into place prior to drilling and lack legs that touch the seafloor.

Once in place, the rig’s lower pontoons are flooded with water, submerging the lower half of the rig for stability in rough seas. The rig is moored, and computer controlled thrusters help to maintain the exact position, a system known as dynamic positioning.

In this case, the Horizon was drilling BP’s Macondo prospect well in about 5,000 feet of water, roughly 40 miles off the Louisiana coast. The total length of the well was around 18,000 feet below the seafloor. Although BP is the operator, it owns only 65 percent of the prospect. Wildcatters Portfolio holding Anadarko Petroleum Corp (NYSE: APC) has a 25 percent stake, and Japan’s Mitsui (NasdaqGS: MITSY) owns a 10 percent stake.

Transocean has confirmed that the Horizon rig’s insured value is $560 million; insurance will likely compensate the firm for the loss of the rig and potential costs of removing the wreckage.

A drilling contractor supplies both the rig and some of the crew involved in the drilling of a well. But an operating deepwater rig usually houses personnel from several different companies, including engineers and rig workers from the producer(s), services companies and drilling contractor. The Horizon had quarters for 130 people, and reports indicate a crew of 126 was onboard at the time of the blowout and explosion.

There has been some conjecture in the popular media that this accident would involve significant liability for Transocean. BP’s CEO Tony Hayward also tried to deflect some criticism by noting that the blowout preventer (BOP) the company leased from Transocean failed to work properly and prevent the spill. But Transocean isn’t likely to face much liability, and any expenses it will face would largely be covered by the company’s $950 million umbrella insurance policy.

In a typical deepwater drilling contract, the producer assumes responsibility for blowouts and any hydrocarbons that leak from the well, as well as any damage done to the field as a result of drilling. No drilling contractor would take on these enormous liabilities.

The drilling contractor is responsible for any spills from the rig itself–for example, leakage from onboard fuel or mud tanks. Drilling mud often contains oil and other chemicals that would need to be cleaned up if spilled. Often, even in cases of negligence, the drilling contractor’s total liability is contractually capped by the producer.

And keep in mind that BP contracted for the Horizon rig in 2007, when oil prices were on the rise, the supply of deepwater rigs was tight and the credit crunch hadn’t took hold in a meaningful way. The two parties agreed on a day rate of $500,000–relatively high for this class of rig and further indication that the Horizon was in demand at the time.

Why does this matter? Transocean was likely in the driver’s seat when it negotiated the contract for the Horizon rig. It’s unlikely that Transocean would agree to a lease without strict protection against spills and blowout liabilities, especially in such a strong market,

This brings me to what will end up being one of the most important issues to emerge from the accident: The failure of the blowout preventer (BOP) used while drilling the Macondo well. 

A BOP is a large, heavy device that’s installed directly on the seafloor above a deepwater well during the drilling process and removed after the well is completed. The BOP is an emergency mechanism that, once activated, seals off a well and prevents hydrocarbons from escaping by ramming a rod with a rubber seal into the well. These devices include several backup mechanisms.

The BOP can be activated via electrical and/or hydraulic controls installed on the rig itself. In addition, some BOPs are designed to activate immediately under certain circumstances–for example, when the BOP loses communication from the surface. According to reports, the BOP on the Macondo well had this auto-activation function; it should have sealed the well once the explosion at the surface interrupted the connection with the BOP.

If the BOP had functioned, oil would have been trapped inside the well and wouldn’t be flowing out of the drill pipe and well. One of the first measures BP took to seal the well was to try to activate the BOP using remotely operated vehicles. Thus far these efforts have failed to stem the oil flowing from the well, though BP will likely continue this approach.

Because the BOP’s failure allowed the spill to occur, much of the investigation will likely focus on why the device failed and who is liable for that failure.

This is a far more complex issue than one might imagine, but it’s essential to remember that the BOP is considered part of the rig. Transocean’s Horizon rig included a 15,000-psi BOP manufactured and designed by Cameron International (NYSE: CAM). BOPs are typically purchased at the same time as the rig itself; the Horizon was built in 2001, so the BOP was about 10 years old.

BOPs usually come with a short-term warranty; this particular BOP is well passed its warranty. The drilling contractor–in this case Transocean–would be responsible for the ongoing maintenance, testing and servicing of the BOP.

It’s likely that the initial violent blowout and explosion destroyed the surface controls of the BOP or the cables connecting those controls on the rig with the seafloor; this damage would have prevented the BOP from being activated manually from the surface. Some reports suggest that rig workers tried to activate the BOP from the surface before evacuating the burning rig. It’s also possible the BOP itself was damaged in some way during the explosion, causing the automatic activation of the BOP to fail. If that’s what happened, Transocean is unlikely to be at fault for the failed BOP.

Because BOPs are subject to regular inspection, testing and maintenance, it’s unlikely that the unit simply wasn’t in working order. And because the BOP was a decade old, any material defects likely would have been discovered at some point.

Although I doubt Transocean was liable for the failure of the BOP, this is the one way the company could incur major financial liability for the disaster. That being said, the BOP definitely didn’t cause the disaster, nor would it have prevented the fire and explosion; rather, the failure of the BOP allowed the oil to escape into the Gulf. Even if Transocean were found liable for improperly maintaining the BOP, it wouldn’t bear full responsibility for the accident.

Cameron International, on the other hand, appears to be totally in the clear. The BOP in question is 10 years old, and the rig and BOP have been used to drill several other wells. Over the years these units have undergone countless tests and maintenance checks; any significant manufacturing defects would have been found. Transocean would be liable for any shortfalls in maintenance, not Cameron International.

In fact, the disaster in the Gulf of Mexico is likely to have positive ramifications for Cameron International, as the political fallout could usher in stringent regulations governing BOPs, subsea equipment and redundant safety systems on rigs. Age limits on BOPs and other key equipment are another possibility.

Such an outcome would be consistent with past experience in the energy industry. After the Exxon Valdez spill, the government pushed oil companies to use double-hull tankers and phase out single hulls. And after the accident at the Sago coal mine in 2005, the government required companies to use better seals in underground mines and undergo additional safety inspections. Finally, after one rig broke free of its moorings during the vicious hurricane season of 2005, the government made safety regulations governing mooring rigs in foul weather more stringent.

Because Cameron International is one of the world’s top producers of BOPs, it would benefit substantially from any regulations that require drilling contractors to upgrade equipment or replace it more frequently. The firm would also benefit if contractors have BOP manufacturers perform routine maintenance on the equipment to ensure quality control.

Longtime readers know that I’m bullish on the subsea-equipment companies such as Cameron International, FMC Technologies (NYSE: FTI) and former Portfolio recommendation Dril-Quip (NYSE: DRQ) and have sought an opportunity to jump into the group at an attractive price. That opportunity has arrived. Cameron International Corp, the latest addition to the Wildcatters Portfolio, is a buy under 45 with a stop at 32.  

A brief review of Cameron International’s operations and growth prospects is in order. The company divides its business into three main segments: drilling and production systems (65 percent of revenues), valves and measurement (23 percent) and compression systems (12 percent).

The all-important drilling and production systems (DPS) division focuses on a wide variety of products used to control underground pressures and the flow of oil or gas from wells. Examples include both surface and subsea wellheads, risers used to transport oil and gas from subsea wells to the surface and, of course, blowout preventers (BOPs).

DPS involves both long-cycle and short-cycle businesses. Short-cycle businesses consist of equipment orders that are extremely sensitive to the rig count; for example, orders for surface wellheads in North America rise and fall quickly depending on commodity prices and drilling activity.

In its first quarter conference call, management estimated that roughly 20 percent of Cameron’s total revenue base comes from short-cycle businesses.

Long-cycle businesses are mainly backlog businesses. A large national oil company such as Wildcatters recommendation Petrobras (NYSE: PBR A) might put out a tender to buy hundreds of subsea trees to support a multi-year deepwater drilling and development program.

Trees are the network of valves, pipes and hydraulic equipment placed on a completed deepwater well to control the flow of oil and gas; the term “tree” is actually short for “Christmas tree” because the basic shape of this equipment is vaguely reminiscent of a holiday tree. Several companies would compete for such an order, and the company or companies that win the bid would then add these orders to the backlog.

Spending on major projects of the sort Petrobras has undertaken in recent years isn’t particularly sensitive to commodity prices. Cameron and its peers pursue major deals that can involve billions in capital investment over the span of several years.

In a normal cycle, the short-cycle businesses will be first to improve as oil and gas prices rise. Once major operators gain confidence in the sustainability of higher commodity prices, they invest in major new projects. The pick-up in international spending ultimately drives growth in Cameron’s long-cycle businesses.

A collapse in commodity prices from mid-2008 to early 2009 and global credit crunch resulted in a down-cycle for all oilfield equipment companies, including Cameron. Short-cycle business lines suffered horribly as North American drilling activity fell sharply, crimping demand for surface wellheads and trees.

Although spending on deepwater and international developments proved more resilient, these orders also slowed as oil tumbled from nearly $150 a barrel to the mid-$30s. Several major international oil projects were delayed, including a few in the Middle East. And even as oil prices headed higher into mid-2009, big international oil companies were reluctant to accelerate spending plans; these firms needed to be confident in the sustainability of the commodity price recovery.

Cameron reported first-quarter earnings on April 29, and based on those results, the cyclical pattern appears to have turned for the better once again. Short-cycle businesses in North America exceeded management’s prior expectations after a larger-than-anticipated jump in the North American active drilling rig count. Drilling activity picked up despite weak gas prices–primarily because of a big jump in activity targeting crude oil and natural gas liquids (NGLs). I explained this phenomenon at great length in the most recent issue of The Energy Letter, Why Some Natural Gas Is Worth $7.28.

Although Cameron’s short-cycle businesses exceeded expectations, management continues to base its guidance on the assumption that the US rig count will decline by 200 rigs in the second half of the year. This is a conservative assumption, and management admitted as much, noting that results are tracking toward the top end of its guidance in North America. The chief financial officer also acknowledged that the low end of its prior guidance was probably out of the question. 

Although improvement in the firm’s short-cycle business is positive, the turn in long-cycle segments is decidedly more important. Management’s comments in the first-quarter conference call suggest a growing confidence that long-cycle businesses will turn in the second half of 2010. Here’s CFO Charles Sledge’s take on the prospects for deepwater tree orders in the back half of the year:

…going forward I think we’re probably pretty close to the bottom and troughing in each individual business unit. But you will hav, within drilling and production systems the significant amount for subsea revenue that’ll come Q2 through Q4 [the second through the fourth quarter]. Again we said that subsea will be up 50 percent year-on-year. It wasn’t up that much in the first quarter so you can see it’s back-end loaded…

Management went on to state that it has seen a big uptick in tendering activity for deepwater-related orders. The company specifically noted strength in the deepwater off West Africa and its strong position in Brazil, where it boasts 1,000 local employees.

Consensus expectations call for global subsea tree orders of about 400 this year. Management indicated that it expects the annualized run rate over the next 18 months to exceed that estimate.

Valves and measurement (VM) is another major segment for Cameron. As the name implies, VM includes a number of products used to control and measure the flow of natural gas and oil through pipelines. This segment is also a combination of short- and long-cycle businesses.

Management noted that its VM division is tracking better than expectations. The company’s prior guidance was for flat revenues in VM this year; as of its first-quarter call, management has increased that to a year-over-year increase of 10 to 15 percent.

Cameron is a great company with outstanding leverage to the long-term growth in deepwater drilling, a key play on my “end of easy oil” thesis. With the stock trading at a discount because of unreasonable fears about its exposure to the Horizon disaster, now is an outstanding time to buy Cameron under 45 with a stop at 32.

As I stated earlier, I don’t believe Transocean will have to pay any liabilities related to the accident beyond the deductibles on its insurance policies. Based on that assessment, the roughly $6 billion drop in Transocean’s market capitalization since the middle of April represents a major overreaction to the Horizon incident.

Nonetheless, I am not adding Transocean to the model Portfolios at this time; Gushers recommendation Seadrill (NYSE: SDRL) is a superior alternative that may benefit from the Horizon disaster.

Seadrill switched its listing from the Oslo Stock Exchange to the New York Stock Exchange (NYSE) in mid-April, a move that dramatically increases the company’s visibility and its ability to use its stock as currency for acquisitions. 

The firm has a long history of growth via acquisitions, including its ongoing bid to take full control of Scorpion Offshore (Oslo: SCORE), a company that focuses on shallow-water jackup rigs used in international markets. Day rates for jackup rigs appear to be improving after a slowdown in 2008-09; in fact, Seadrill recently leased one of its jackup rigs to Statoil (NYSE: STO) for $650 million. This five-year deal equates to a day rate of around $350,000–a high rate for that class of rig.

Seadrill makes no secret that it plans to expand in deepwater markets. CEO Alf Thorkildsen recently noted that the company is interested in acquiring firms with exposure to the deepwater Golden Triangle–Brazil, West Africa and the deepwater Gulf of Mexico. The Oct. 7, 2009, issue The Golden Triangle features an in-depth discussion of these plays.

And Seadrill already has an enviable backlog of contracts covering its existing deepwater rigs. Here’s a look at Seadrill’s current deepwater fleet, minus jackups.

Source: Seadrill

As you can see, Seadrill’s fleet is extremely young. With the exception of a single rig, all of Seadrill’s rigs were built after 2000, and the vast majority were built in 2008 and 2009 or are still under construction. All of the equipment on these rigs is relatively new.

In the wake of the Horizon tragedy, it’s not difficult to envision a scenario where producers prefer newer drilling equipment. And the government may mandate that rigs operating in the Gulf of Mexico include modern equipment. Such a shift would benefit Seadrill.

Also note that most of Seadrill’s deepwater fleet consists of advanced rigs capable of drilling long wells in extremely deep water; the firm’s rigs are suitable for just about any job a producer would care to pursue. Several of the rigs have already been contracted by Petrobras to operate in the deepwater off Brazil’s coast.

Finally, Seadrill has outstanding contract coverage. Most of its existing rigs are booked under long-term deals at day rates that are close to or higher than the going rate in this environment. These contracts represent billions of dollars of cash flow that’s virtually locked in and guaranteed–after all, few would question the credit quality Petrobras, ExxonMobil (NYSE: XOM) and other key customers.

Better yet, shareholders will benefit from Seadrill’s backlog because the company pays out most of its cash as a dividend. The quarterly payout currently stands at USD0.55, roughly equivalent to a 9 percent yield at current prices.

The acquisition of Scorpion Offshore and the completion of two rigs under construction could spell significant upside for the dividend payout. By my estimates, Seadrill could pay as much as USD0.70 per quarter in a year’s time; the stock could easily it $40 in that event.

With a solid dividend yield, upside from new contracts and a young deepwater fleet, Seadrill is a better buy than Transocean–and there’s no need to worry about Horizon-related liability. Buy Seadrill under 29 with a stop at 16.25.

Diamond Offshore Drilling (NYSE: DO), the other major driller that pays a significant dividend yield, is the big loser among the drillers.

Diamond Offshore classifies the lion’s share of its quarterly payout as a special dividend. Management recently cut that special payout; this year the stock is likely to offer a lower yield than Seadrill. Shares of Diamond Offshore have underperformed of late. It wouldn’t surprise me if income-oriented investors are shifting cash Seadrill.

I could accept Diamond’s lower yield if the company had a superior fleet or better growth prospects, the company’s rigs are generally far older, less capable and don’t have the same backlog of contracts that Seadrill rigs enjoy. And Diamond has significant exposure to the deepwater Gulf of Mexico, the market most likely to suffer an interruption in activity as a result of the Horizon disaster. I am downgrading Diamond Offshore Drilling to a sell in How They Rate.

My final contract drilling recommendation in the Wildcatters Portfolios holding Noble Corp (NYSE: NE). Noble owns 63 offshore drilling rigs, a combination of deepwater and jackup units. The company has a history of solid cost control and conservative management; in fact, Noble lowered its full-year cost guidance when reporting earnings in late April.

And with day rates on jackup rigs stabilizing, earnings should get a boost from its shallow-water business into the second half of 2010.

On a valuation basis, Noble’s stock is among the cheapest of the major diversified contract drillers and a solid long-term play. Buy Noble Corp under 50 with a stop at 30.

Oil Services

A handful of services firms involved with the Horizon well development. The firm most closely associated with the accident is Halliburton (NYSE: HAL), a company I don’t currently recommend in the model Portfolios. To a lesser extent, Wildcatters Portfolio bellwether Schlumberger (NYSE: SLB) and its takeover target, Smith International (NYSE: SII), were also involved with the well.

The involvement and potential liability of the services firms is complex. Halliburton confirmed that approximately 20 hours before the blowout it had installed and cemented in place the production casing, the final step in a well’s construction. In this case, BP was planning to temporarily plug and seal the well.

You might not know it from the mainstream media stories, but Macondo was a significant discovery well–that’s why natural pressures continue to force oil from the well. When an operator makes a discovery of this nature, the standard practice is to temporarily plug the well and move on to the next prospect.

Once the operator decides how it plans to produce a new field and the timing of that development, it might unseal the well and start production. Alternatively, the producer might decide that it’s better off drilling a new well to produce the field more efficiently.

In the case of Macondo, BP drilled the well to establish whether hydrocarbons were present; the company intended to announce the discovery and plug the well until it decided how to develop the field.

Recall that oil isn’t found underground in a giant lake but inside the pores, cracks and crevices of a reservoir rock. The pressure of the oil underground forces the oil through the rock and into the well.

Oil drillers pass through multiple layers of rock before encountering the targeted oil-bearing formation. Some of these layers may contain water, natural gas or other gases–substances that shouldn’t enter the well. Accordingly, producers install a thick metal pipe known as casing and use cement to fix it in place. Here’s a basic diagram showing how this works.

Source: Schlumberger

This image provides a stylized depiction of how casing is installed to isolate the well from surrounding rock formations. 

This casing works both ways, preventing fluids from underground formations from moving into the well and hydrocarbons in the well from moving into other rock formations.  This process is the key to ensuring that neither the well nor the surrounding environment are contaminated.

Production casing is the casing installed in the well around the section that contains the targeted oil or natural gas. Producers perforate this casing by detonating explosive charges when they’re ready to put the well into production. This area is shown as the perforated interval on the diagram.

Services firms typically perform the casing, cementing and completion of wells. In the case of Macondo, Halliburton handled this work.

After Halliburton installed that production casing and tested it to make sure it was properly placed, the next step would have been to place a series of concrete plugs in the well to prevent hydrocarbons from gushing to the surface. These concrete plugs would be drilled out when BP decided to produce the well.

This is where accounts of the accident diverge. According to a Halliburton press release, the company finished the installation and testing of the production casing but had not yet plugged the well. Some reports contend that Halliburton had completed both the production casing and the cement plugs for the well.

These discrepancies open up alternative conclusions about what potentially caused the blowout. If the cement plugs were installed, then it’s possible those plugs failed unexpectedly. This could happen if, for example, Halliburton didn’t use the correct cement mixture in the well.

Services firms sign contracts with producers that limit their liability in the event of an accident, but Halliburton might have some liability if the investigation proves that the firm was negligent in the way it performed its duties. In practice, this would be a tough case to prove; the explosion and blowout likely destroyed the cement blocks in the well.

If, as Halliburton contends, the cement plugs were not installed, the fault may lie with the mud system. I’ve explained the concept of a circulating mud system before in this publication, but here’s a review.

The term “drilling mud” traces its origins to the early days of the oil business, when producers literally used mud as a drilling fluid; legend has it  that producers in Texas forced cattle to walk through standing water to create drilling mud. Nowadays, the composition of mud is far different, though the basic purpose is unchanged.

As I noted earlier, oil and gas in a well is under extreme geologic pressure. In the case of Macondo, this pressure was probably on the order of 8,000 to 10,000 pounds per square inch (psi). Atmospheric pressure is 14 psi. By drilling a well the producer creates a conduit between the high pressure reservoir and the low pressure surface. The rest is simply physics: The oil moves from an area of high pressure to an area of low pressure.

To counteract this effect during the drilling process, producers pump drilling mud under high pressure into the well. The pressure of this mud acts as a counterbalance to the pressure of hydrocarbons in the reservoir, preventing a blowout while drilling. The mud is literally pumped down the well-pipe, through the drill bit at the end of the well and back up the annulus, the open space created outside the drill pipe. Once on the surface, the mud can be analyzed and ultimately recycled down the well.

In addition to providing a counterbalance to the geologic pressure of the field, the mud also sweeps up rock shavings created during the drilling process and cools and lubricates the drill bit.

The weight of the drilling mud is a key consideration, and designing drilling mud for a particular field is a complex and highly scientific task. If the mud is too heavy and dense, it will slow the drilling process and may move out of the well and into the formation, harming the field’s productivity. And if the mud is too light, the well can “kick”–a sort of mini blowout where some of the oil or gas in the field actually overcomes the pressure of the mud and moves into the well and to the surface.

If you’ve ever been SCUBA diving, you know that one of the first things you learn is not to hold your breath. That’s because air in your body is compressed to the pressure of the water when you’re beneath the surface. As you move up toward the surface, that pressure drops and the air bubble in your body expands; if you held your breath and surfaced quickly, that air bubble could expand rapidly with obvious consequences.

Now imagine an even more extreme scenario. A bubble of natural gas at 10,000 psi enters a well and begins to rise toward the surface. As pressures diminish, the gas bubble expands. In this case, the producer could face a large volume of gas traveling up out of the well at high speed–it’s not hard to imagine a situation where that gas bubble would ignite and explode.

If Halliburton truly did not finish plugging the well, BP still would have been using circulating mud to balance the pressure of the hydrocarbons in the field. Because the initial fire on the Horizon was clearly fueled by hydrocarbons from the well, the explosion may have stemmed from insufficient mud weight or pressure that allowed a gas bubble to explode through the top of the well.

Because the potential for kicks and the mud weight is constantly monitored during the drilling process, it’s not clear how that would have occurred. But it’s not impossible for a gas bubble to move into a well undetected and surprise rig workers at the surface.

Halliburton didn’t supply the drilling fluids for this play–this responsibility fell to the leader in the fluids business, MI-SWACO, a joint venture between Schlumberger and Smith International. Full control of this joint venture is likely one of the major drivers of Schlumberger’s pending takeover of Smith.

Last year MI-SWACO received 77 percent of all awards related to the deepwater fluids business. As you can imagine, drilling fluids is a key service related to deepwater wells and offers attractive growth prospects and profit margins.

The fallout for MI-SWACO will likely be limited. The joint venture’s contract with BP would have been written so that the operator has liability for blowouts and MI-SWACO’s liability would be covered by insurance.

And although MI-SWACO provided the fluids, the drilling mud is usually designed in close cooperation with the producer. That would almost certainly be the case in this instance, as BP is an experienced operator in the Gulf of Mexico. This limited exposure would explain why shares of Schlumberger and Smith International didn’t suffer as much as Halliburton’s stock in the wake of the disaster.

That being said, investors should take advantage of any weakness in shares of Schlumberger, a must-own name in the oil-services space.

Schlumberger reported blowout earnings in late April, results that would have been the big story in the energy markets over the past couple of weeks if the Horizon disaster hadn’t grabbed the headlines.

Longtime subscribers know that I pay close attention to Schlumberger’s quarterly results and conference call. The firm has its hands in just about every imaginable oil and gas-producing region of the world, and its management usually offers a broad overview of market conditions when it releases earnings.

I’ll save a more detailed overview of Schlumberger’s results for the next issue of The Energy Strategist. Here are some highlights.

Schlumberger’s management and CEO Andrew Gould have a long history of maintaining a conservative outlook. The company held true to form when it released fourth-quarter results earlier this year, noting signs of firming up in its business but stopping short of predicting a more significant upturn. It now appears that even Schlumberger is gaining confidence in the outlook.

Here’s the first question asked during the company’s first-quarter conference call and Gould’s response:

Analyst: Andrew [Gould], you–earlier in the year you did express optimism, but then you sort of dialed the numbers back a little bit for 2010 indicating that maybe the Street had got a little bit too optimistic. Do we interpret sort of your uptick in outlook to mean that 2010 numbers may now have some upside room? And can you talk a little bit about exactly what you’re seeing that gives you sort of the increased confidence over the past month or two?

Andrew Gould: Firstly, I feel pretty comfortable with the sort of overall consensus where it is now, Dan. And secondly, we are seeing clear signs of increases in activity in the North Sea. I mean, you can count them. And similarly, we’re seeing the results of some of the exploration campaigns in Latin America, which are leading to very high quality revenue for us, particularly in the wireline and testing.

And similarly I’ve always thought that some of the idle rig slots in West Africa would get picked up if the oil price was higher than people were planning and that’s exactly what seems to be happening. So it’s just–it’s confirmation that’s come through in the last 3 months of what I was alluding to in January.

Gould’s response confirms that some of the positive developments management had expected began at the beginning of the year began to show up in actual results. Thanks to the stabilization of oil prices near recent highs, producers are confident enough in their outlook to open their purse strings and spend more on exploration and development.

It’s also worth noting that Gould sounded an incrementally more positive note on North American activity. Although he still sounded fairly cautious about natural gas, Gould commented that drilling activity targeting oil and liquids in North America had the potential to remain robust.

All told, a broader market correction and concerns about the Horizon accident are obscuring Schlumberger’s strong first-quarter performance. Schlumberger rates a buy under 85.

The Producers

The most obvious and direct financial impact of the spill is on the producers: BP, Anadarko Petroleum Corp and Mitsui. BP is the operator and owns 65 percent of the well; it will likely bear the brunt of any liability.

I discussed Anadarko’s situation in a Flash Alert earlier this week. With a 25 percent stake in the well, the company has some exposure. That being said, shares of Anadarko have given up as much as $15 since mid-April; based on current prices, the accident has taken around $6 billion out of Anadarko’s market value.

If we assume that this $6 billion represents 25 percent of Anadarko’s clean-up liability, the accident would cost around $24 billion in total. That’s around three or four times the most extreme estimates I’ve seen as to the total cost of clean-up. And, unlike BP, Anadarko isn’t likely to face much of a reputational hit because it wasn’t the operator.

Bottom line: The reaction in Anadarko is overdone, and this looks like an outstanding time to buy the stock. Buy Anadarko Petroleum Corp under 70 with a stop at 45.

I suspect that the decline in BP’s stock price is overdone, as panic-driven situations invariably go too far. However, the risk is significantly higher for BP than for Anadarko; I’d rather play it relatively safe and buy the latter.

The Big Picture

The political fallout from the spill is likely to be three-fold: more stringent regulation on drilling in the Gulf; a delay in opening up new areas for offshore drilling; and a potential halt to auctioning more leases in the Gulf of Mexico.

The Obama administration had proposed opening new offshore areas of the US to drilling and exploration in coming years. Since the accident, President Obama and senior administration officials have indicated that the plan won’t go ahead until a full investigation of this spill is completed. This is hardly a surprise and is a reasonable response to the recent tragedy.

But a delay in opening up new regions for drilling shouldn’t have a meaningful affect on the sector. Even if the US opened up these lands today, it would still take around five years before the policy shift produced additional drilling activity. None of the services firms got much of a boost when the President announced the intention to open up new regions for drilling; the delay shouldn’t have a negative impact on share prices.

On the other hand, any to delay planned auctions in areas that are already open for exploration would be harmful. (The next lease sale in the Gulf is scheduled for late summer). But new lease sales also don’t result in an immediate uptick in drilling activity; a delay, even one that lasts several months, wouldn’t have a meaningful impact on service and drilling activity in the Gulf.

The most harmful policy would be if the government tried to stop activity on leases that have already been awarded. Such a move would almost certainly face legal challenges and is highly unlikely. But would hit drilling activity and development work in the Gulf, a negative for service and contract drilling firms.

However, the decline in activity would be offset somewhat by a surge in oil prices. A stop to deepwater drilling activity in the Gulf would ignite fears of a global oil crunch; don’t forget that the US is the world’s third-largest oil producer. An interruption to Gulf Coast supplies would be akin to a multi-month hurricane hitting the Gulf; oil and refined product inventories would tighten, and crude prices would likely surge to around $100 a barrel. The jump in energy prices would prompt the administration to reverse the policy quickly and would likely power a rally in energy stocks across the board. Bottom line: It’s not going to happen.

However, changes in regulations of leasing activity that serve to reduce drilling activity or make operating in the Gulf more expensive will have a negative impact on supply–good news for energy prices.

The TES Indexes

Last issue I introduced nine TES Indexes covering individual industries in the energy patch. Here’s a review of the indexes’ recent performance.

Source: Bloomberg, The Energy Strategist

As you might expect, a broader pullback in the market and event risk related to the Horizon accident have weighed on energy-related groups. A correction in the S&P 500 is only natural amid the ongoing rally; given the improving drilling environment, I regard any pullback as an opportunity to buy our Portfolio recommendations.

The opening on May 5 brought some highly unusual volatility to a number of stocks, particularly master limited partnerships (MLP). Those dips were primarily technical in nature; the market hit some stops, and there was some panic in the morning given steep losses in European markets overnight. That all of these names recovered quickly suggests it wasn’t a fundamental issue.

Two indexes do stand out in the table above: coal and refiners. Shares of North American refiners are rallying in a weak market primarily because of growing evidence that US oil demand is recovering.

In addition, these stocks have traded at depressed levels that already reflected a terrible profit environment. Signs of an uptick in profitability have sent the sector sharply higher. Gushers Portfolio holding Valero Energy Corp (NYSE: VLO) is my favorite play in the refining industry. I added Valero as a trade on a seasonal improvement in refining margins, and the stock has done well; I will look to sell it into strength over the next month or so.

The big driver in the coal markets, particularly international coal markets, appears to be a proposed “super tax” on miners in Australia of 40 percent. This would impact Gushers Portfolio holding Peabody Energy (NYSE: BTU) directly because of its mining interests in Australia. It would also impact mine equipment manufacturer Bucyrus (NSDQ: BUCY), as higher taxes might spell less demand for mining equipment.

The super tax appears to be a populist move on the part of Prime Minister Kevin Rudd’s government. Rudd defended the tax earlier this week, noting that many of the nation’s largest miners–including BHP Billiton (NYSE: BHP) and Rio Tinto (NYSE: RTP)–are heavily owned by foreigners. According to this logic, the miners’ record profits don’t benefit the general population. Polls indicate that the tax is relatively popular with the general Australian population, and Rudd faces an election this coming October. Let’s face it–politics and populism are a global phenomenon.

Rudd’s basic argument doesn’t hold water. The mining industry accounts for an outsized proportion of Australia’s gross domestic product and created gobs of new jobs in recent years. The quick rebound in profits for the industry in early 2009, powered by strong Chinese demand, helped Australia economy has outperformed during trying times. It’s unreasonable to claim that the industry’s growth hasn’t benefited Australia.

The threat of higher taxes isn’t good news for the global mining industry, but the knee-jerk negative reaction to a populist tax is overdone.

For one, the measure still has to clear Australia’s Senate, where Rudd does not have majority; the Senate is facing heavy lobbying efforts by the nation’s mining industry. The industry gave a hostile reception to Prime Minister Rudd at a recent conference, and several companies have suggested they would expand overseas investment or simply cut back spending.

And even if this tax passed, the measure would not go into effect until 2012–plenty of time to make changes or soften the blow. In addition, the proposal would replace some taxes currently levied on the industry at the state level; the increase isn’t quite as big as the headline number suggests.

Let’s shift from politics to the dynamics of the coal market. Indonesia is the only country that can approach Australia in terms of thermal coal exports, but local infrastructure isn’t sufficient to support growing demand. And Australia is the established leader in terms of metallurgical coal used in steelmaking; many of the big miners would simply pass on higher costs to coal buyers like China and India.

Finally, one must question the logic behind this pullback in coal-levered stocks. The so-called super tax has been part of Rudd’s platform for some time–does a known policy initiative constitute news?

Bottom line: The mining tax isn’t a positive but is not a reason to sell Australia-leveraged coal stocks. The tax also likely spells higher commodity and raw materials costs worldwide.