Financial markets are subject to tides and waves. The tides represent long-term trends and cycles that can last for many years; the waves are short-term moves that, for all their violence, fail to change the overall course of the tide.

Investors must never forget that energy markets are inherently cyclical. For much of the 1980s and ’90s, energy commodities and related stocks struggled against weak fundamentals. Temporary catalysts–for example, the spike in oil prices that overlapped with the first Gulf War–provided an occasional short-term boost, but by and large the group muddled along.

But 2002 marked the beginning of a new bull market for energy, akin to the salad years of the 1960s and ’70s. Global energy consumption has soared, led by robust demand growth in emerging markets–a structural trend that shows no sign of letting up. At the same time, declining production from many of the world’s largest fields has constrained supply, forcing operators to tap increasingly complex and expensive-to-produce reserves located in ever-deeper waters.

Though among the most severe corrections in history, 2008-09 collapse in commodities prices and energy-related stocks stemmed from the global financial crisis and didn’t change the sector’s positive fundamentals. The bull market for energy remains intact. But although price of crude oil has recovered quickly since early 2009, the psychological damage inflicted by this traumatic period has taken longer to repair.

This painful experience made energy outfits more reluctant to increase spending on exploration and production (E&P). The industry’s E&P expenditures plummeted by more than 20 percent in 2009 but only bounced back by 10 percent in 2010.

With oil prices above $90 per barrel and likely to top $100 early in the new year, this conservatism is quickly coming to an end. Most estimates call for E&P spending to jump 15 percent or more from 2010 levels and reach an all-time high. The consensus expectation looks conservative when you consider that integrated oil giant Chevron (NYSE: CVX) announced a 2011 capital spending budget of $26 billion, 20 percent more than it spent in 2010. 

Expect producers to invest massive amounts of cash next year in an effort to replace dwindling reserves and boost production. Oil services companies, contract drillers and equipment providers leveraged to spending on exploration stand to reap the rewards of this massive influx of cash.

In the aftermath of the financial crisis and collapse in oil prices, producers deemed exploratory drilling a discretionary expense, cutting this budget sharply and focusing capital expenditures on maintaining and developing existing fields. But operators have only two options to build reserves and grow production: acquisitions or exploration. Expect spending on exploration to ramp up substantially in 2011, with much of the benefits redounding to deepwater drillers and providers of seismic services.

In This Issue

The Stories

Contract drillers stand to reap the rewards from increased investment in deepwater exploration and production. See Go Deep. 

After reining in spending on exploration, all indications suggest that producers will ramp up exploratory activities in 2011. Seismic services account for roughly one-quarter of all exploration-related expenditures. Here are our top picks in this niche. See Seismic Services.

Want to know which stocks to buy now? Check out the updated Fresh Money Buys list. See Fresh Money Buys.

The Stocks

Seadrill (NYSE: SDRL)–Buy < 35
Diamond Offshore Drilling (NYSE: DO)–Sell Short > 60
Schlumberger (NYSEL: SLB)–Buy < 90
Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY)–Buy < USD16
Weatherford International (NYSE: WFT)–Buy < 26
Baker Hughes (NYSE: BHI)–Buy < 60
Compagnie Generale de Geophysique Veritas (Paris: GA, NYSE: CGV)–Buy in Energy Watch List
ION Geophysical Corp (NYSE: IO)–Buy in Energy Watch List

Go Deep

Seadrill (NYSE: SDRL) is a deepwater-focused contract driller. Seadrill and competitors such as Transocean (NYSE: RIG), Noble Corp (NYSE: NE) and Diamond Offshore Drilling (NYSE: DO) don’t explore for or produce oil and natural gas; rather, these firms lease drilling rigs to major producers for a daily fee, or day rate.

There are three major reasons to buy Seadrill.

First, the company has the newest and most advanced fleet of any major contract driller. Second, Seadrill’s rigs are primarily booked under long-term contracts at attractive rates, providing a guaranteed backlog of cash flow and limiting exposure to fluctuating commodity prices.

Finally, this reliable stream of cash flow enables the company to pay a sizable quarterly dividend of $0.65 per share, equivalent to an annualized yield of about 8 percent at the stock’s current price. Future dividend growth could be an important upside catalyst for the stock, especially given demand for income-paying stocks; the company has the scope to boost its quarterly payout to about $0.75 by the end of 2011.

Seadrill owns 10 semisubmersible drilling rigs and six drillships. Thirteen of these vessels already operate under long-term leases; three more are under construction at Asian shipyards, with one slated for delivery at year-end and the remaining two expected to arrive in the first half of 2013.

Semisubmersible rigs are large platforms attached to hollow chambers that resemble pontoons.  The rigs are towed to a drilling location, and the pontoons are flooded with water so that the rig is partially submerged, providing stability in rough seas. A drillship, on the other hand, can travel to the drilling site under its own power. These pictures of Seadrill’s West Hercules semisubmersible rig and West Capella drillship will clarify this difference.

Source: Seadrill

The table below lists all the rigs in Seadrill’s fleet, each rig’s capabilities and the day rates Seadrill receives from its customers. 

Source: Seadrill

Seadrill’s average operating rig is less than five years old. Built in 1986, the West Alpha is the company’s oldest unit and is under contract in Norway at a day rate of $488,000 through June 2012. The company’s second-oldest rigs, both of which were built in 2000, are also under contract; the West Venture is booked through the end of 2012, while the West Navigator’s contract expires at the end of 2015.

The 10 remaining active rigs were built between 2008 and 2010 and are equipped with the advanced features that operators demand. These ultra-deepwater rigs can drill in water that’s more than 10,000 feet deep and can complete wells more than 6 miles in length. These high-specification units also feature expanded decks, hooks and hoists capable of handling more weight, and advanced blowout preventers (BOP) that shut off the well in the event of an emergency.

Transocean boasts the biggest ultra-deepwater fleet , but the average age of its 26 rigs is 15 years old. Noble Corp boasts seven ultra-deepwater rigs in its stable, but their average age is 14 years old. Diamond Offshore Drilling, which we recommend selling short in the model Portfolios, owns four deepwater rigs whose average age is 26 years old.

Youth trumps experience when it comes to drilling rigs; older units aren’t up to the rigors of increasingly complex E&P operations taking place in the deepest waters. For example, the massive Tupi field offshore Brazil requires equipment capable of drilling through thick layers of salt and withstanding the extraordinarily higher pressures and temperatures within the reservoir itself. To produce these plays, operators need state-of-the-art rigs; in many cases, using an older, less-capable rig isn’t an option.

In addition, the Macondo incident will spark a raft of new regulations in the Gulf of Mexico and, to a lesser extent, other markets around the world. These new rules should require modern, higher-specification rig equipment. Much of the focus has centered on blowout preventers in the wake of the Macondo disaster. Had the BOP on Transocean’s Deepwater Horizon rig worked properly, it could have stanched the flow from the blown-out well and prevented what became the largest oil spill in US history.

US regulators will likely mandate that operators in the Gulf use larger, more powerful BOPs that can handle much higher pressures. Regulations will also require more frequent third-party inspections of BOPs, which could force operators to upgrade and replace BOPs more frequently.

Such a rule would pose major problems to contract drillers with older fleets; many of these rigs lack the deck space to accommodate a modern BOP. Rig owners typically order a BOP at the same time as the rig itself. Whereas the infamous blowout preventer on Transocean’s Deepwater Horizon was about 10 years old, most of Seadrill’s rigs are outfitted with newer models.

Seadrill and other contractors have noted a bifurcation in the rig market: Producers prefer newer rigs and are willing to pay a substantial premium to secure their services. To worsen matters for contract drillers with older vessels, the Macondo disaster has further upset the supply-demand balance. Many of the rigs working in the Gulf were older models. As operators relocate these rigs to new markets, they’re forced to compete for contracts with less-capable rigs.

In contrast, Seadrill’s only rig in the Gulf of Mexico is an ultra-deepwater drillship built in 2008, a vessel that would command an attractive day rate in any number of markets.

Seadrill also owns about 20 shallow-water jackup rigs and 17 tender rigs that support offshore drilling operations. Neither jackups nor tender rigs receive day rates that are as high as what the company receives for its deepwater fleet. In addition, operators tend to lease jackups for shorter periods.

Newer jackup rigs also command a premium from producers, and Seadrill boasts the world’s largest fleet of jackups built after 2000. Seadrill, Rowan (NYSE: RDC) and other jackup owners have noted an uptick in demand higher-specification models. As of December 2010, 96 percent of jackup rigs built in the past decade were under contract, compared to a utilization rate of just 62 percent for older rigs.

With a backlog of over $8.5 billion in contracts covering its deepwater rigs, $2 billion covering its jackups and $1.5 billion for its tender rigs, Seadrill will enjoy a highly reliable stream of cash flow over the next few years. Better still, the company put a handful of new rigs to work in 2010 and will receive three newly built rigs over the next few years. This revenue growth should enable Seadrill to boost the quarterly dividend to as much as $0.75 per quarter by the end of 2011.

Management continues to make all the right moves. A few years ago high demand for new rigs enabled shipbuilders to increase prices. But this pricing power evaporated after commodity prices collapsed in 2008 and early 2009. These days, shipyards have cut prices aggressively to win business.

Seadrill took advantage of slack business, purchasing two new ultra-deepwater drillships for less than $600 million apiece. Seadrill also has the option to purchase two additional drillships at this favorable price, which management estimates is as much as $200 million less than prevailing prices at the top of the market.

The company has pursued a similar strategy with its portfolio of jackup rigs, ordering new units and purchasing more recent models in the secondary market. In fact, management has noted that ordering new jackup rigs and leasing them under long-term contracts generates superior returns to purchasing another contract driller outright.

With an in-demand fleet, a growing 8 percent yield and opportunities to increase revenue through new rig construction, Seadrill is the best-placed contract driller in my coverage universe. Buy Seadrill under 35.

Diamond Offshore Drilling and its aging fleet are at the other end of this bifurcated market. The stock has traditionally traded at a premium to its peers because of its outsized dividend yield. That advantage will continue to dissipate in coming years, as its older fleet will weigh on cash flow and revenue.

Already, the stock’s yield is less than half that of Seadrill’s. Expect income-oriented investors to continue to reallocate capital to Seadrill from Diamond Offshore Drilling.

Diamond Offshore Drilling’s shares have underperformed its peers this year, up only 19 percent from their summertime lows. Seadrill’s stock, on the other hand, has nearly doubled in price over the same period.

I expect a rising tide to lift all oil-related stocks in 2011–even weaker names such as Diamond Offshore Drilling will trade sideways or eke out a gain. Selling Diamond Offshore short provides a bit of insurance against any broader pullback or correction that might occur over the next 12 months. This short position is for investors looking to hedge a portfolio with significant exposure to energy stocks. If you fit into this category, short Diamond Offshore Drilling above 60.

Seismic Services

Seismic services involve the use of sound and pressure waves to map underground rock formations that could contain oil and natural gas. As with most energy-related services, seismic work has become increasingly complex and technologically advanced in recent years.

Drilling deepwater wells is extraordinarily expensive. Day rates for the rig alone can top $600,000 per day, and a single well can take 90 or more days to drill. In addition to the rig and crew, producers must pay services firms to handle a host of tasks, including drilling, logging and testing the well and managing the drilling fluid. Drilling alone can cost well north of $1 million per day.

Given this expense, it’s no surprise that seismic services account for roughly one-quarter of all spending on exploration; high-quality seismic information enables producers to identify the areas in a basin that are most prospective for hydrocarbons.

Trial and error is part of the energy business. However, producers in the deepwater are willing to invest in high-quality data to avoid dry holes, or wells with no commercial value.

And the need for seismic work doesn’t disappear the minute a new field is identified and drilled. Companies increasingly rely on seismic data to determine how best to develop a field over time and exactly where to sink wells.

Seismic services fall into two basic categories: multi-client seismic and contract. Multi-client seismic work is a database of seismic information that’s sold to more than one operator. For example, if a producer is interested in bidding on a deepwater block in the Gulf of Mexico, it would order seismic data on that block to determine whether and how much it will bid. Producers also use the data to pinpoint areas of interest for drilling or a more detailed survey.

Sometimes seismic firms shoot multi-client seismic surveys on a speculative basis, marketing the data to producers after the fact. More often, seismic-services firms secure deals to sell the data to at least a few clients to offset the cost of acquiring this information and make up the balance afterward. In strong markets, an operator oftentimes can pre-fund more than 100 percent of the acquisition cost, guaranteeing a profit.

Increased spending on multi-client projects and rising levels of pre-funding are bullish indicators for providers of geophysical services.

In a contract situation, the service provider shoots a seismic survey at the request of a single operator or group of clients, charging a fee for each square mile or kilometer. Rates vary depending on the type of ship and technology used to acquire the data. After leasing acreage, E&P firms usually order detailed seismic data to delineate the most promising drilling prospects.

Modern seismic data offers a three-dimensional (3-D) image of the formations in a particular field. Computers and sophisticated data analyses enable companies to identify the most prospective regions and plan where to sink their wells. Four-dimensional (4-D) seismic data includes a time element, allowing operators to monitor how hydrocarbons move through a field as it’s in production.

Land-based collection of geophysical data is also advancing, especially in onshore shale plays. But much of the innovation–and demand growth–in recent years has occurred in offshore data acquisition, especially in the deepwater.  

Here’s how service providers gather seismic data offshore. Specially equipped ships tow streamers up to 10 kilometers (6.25 miles) in length and use advanced air guns to discharge sound and pressure waves. These emissions, which bounce off formations under the seafloor, are received by hydrophones attached to the streamers. From this data, powerful software extrapolates an image of these formations. In general, the more streamers attached to a ship, the more data it can collect and the faster it can perform surveys.

Wildcatters Portfolio holding Schlumberger (NYSEL: SLB), whose WesternGeco subsidiary is one of the world’s leading providers of geophysical services, provides the model Portfolios with exposure to this business. The company is the only major services firm with significant seismic operations. Over the past few years WesternGeco has accounted for roughly 10 to 13 percent of Schlumberger’s total revenue.

Spending on seismic data is discretionary and cyclical, hinging on exploration budgets and commodity prices. Accordingly, the cyclical swings in this business line tend to be more profound than in its other service lines.

Source: Bloomberg

Revenue from geophysical services grew more quickly than sales of other oil field services during the 2005-06 exploration boom. But when commodity prices tanked in 2008-09, this business deteriorated far more than the company’s other operating segments.

An oversupply of ships has also weighed on seismic surveyors. During the last exploration boom, companies ordered new vessels to meet growing demand for seismic services. Many of these ships were delivered in 2009-10, intensifying the industry’s pain.

But the energy industry is on the cusp of another exploration boom that should last at least two to three years. Revenue from seismic surveying should accelerate. Schlumberger’s third-quarter earnings and conference call showed signs of this nascent recovery.

Management highlighted high-level seismic work the company performed in the North Sea, West Africa, the Red Sea, Brazil and the Gulf of Mexico, suggesting that demand had increased for wide and multi-azimuth seismic data acquisition.

CEO Andrew Gould made a particularly instructive comment during Q-and-A portion of the company’s conference call to discuss third-quarter results:

Nothing is ever is ever sure on Gulf of Mexico multi-clients until the quarter ends, but the level of inquiries is encouraging. And, as we have mentioned before, I think that some of our customers are going to spend a little bit of the money they didn’t spend on drilling in improving their data portfolio….

What I’m trying to communicate is that the spread of wide or multi-azimuth outside the Gulf of Mexico is going to soak up capacity….I don’t know whether that’s going to be sufficient to move pricing in 2011, but…I think it is going to be sufficient to absorb capacity, which seems to be becoming a fear that you hear around the community. I actually think that there will be enough work to absorb most of the boat capacity. If, of course, work starts again in the Gulf of Mexico, then it would have an almost immediate effect, I think, on pricing. But I’m not going to predict that at this stage.

Gould’s comment about multi-client sales inquiries in the Gulf of Mexico underscores that big operators such as Chevron and ExxonMobil Corp (NYSE: XOM) will be active in the area, regardless of forthcoming regulations. That these firms are looking to buy new seismic data suggests that spending on exploration activity might bounce back relatively quickly.

The other key point in this excerpt is that rising demand for advanced seismic surveying technologies outside the US Gulf of Mexico has alleviated some of the excess capacity in this market. Management emphasized throughout the call that the quality of WesternGeco’s seismic data enables it to win business.

And WesternGeco isn’t Schlumberger’s only operating segment that will benefit from increased spending on exploration. A good rule of thumb is that exploration-related business accounts for as much as 40 percent of Schlumberger’s revenue–by far the highest percentage among the Big Four services firms.

Halliburton (NYSE: HAL), for example, derives roughly 25 percent of its revenue from exploratory services, while Portfolio holdings Weatherford International (NYSE: WFT) and Baker Hughes (NYSE: BHI) generate 15 to 25 percent of sales from these businesses.

A pick-up in exploration will bolster results at all four services firms, but Schlumberger will benefit the most. Schlumberger now rates a buy up to 90.

Meanwhile, Baker Hughes and Weatherford International continue to benefit from increased capital spending in international markets, a trend that should pick up steam in 2011. (See Riding the Services Cycle.) Weatherford International is a buy under 26. I’m raising my buy target on Baker Hughes to 60 to reflect the stock’s strong performance after announcing solid third-quarter results.

Given the bullish outlook for exploration, it’s time to beef up the Portfolio’s direct exposure to geophysical services.

Like WesternGeco, Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY) provides higher-end seismic solutions to deepwater operators, a segment of the market that offers superior returns. The company’s high-density 3-D data products account for 70 percent of new orders, and demand should continue to pick up as E&P firms target increasingly complex deepwater fields.

Brazil, home to some of the biggest offshore discoveries, accounts for 15 percent of the Norwegian firm’s revenue. Petroleum Geo-Services has amassed one of the largest libraries of 3-D seismic data in Brazil, giving it a leg up in this rapidly growing market.

Management’s comments during its conference call to discuss third-quarter results and recent Capital Markets Day echoed those of Schlumberger CEO Andrew Gould. The company expects the surveying market to remain weak because of overcapacity, though this glut should dissipate in 2011 as demand picks up.

Management also expects capacity to expand between 2011 and 2014 but not at a rate that will outstrip growth in demand. Its current forecast calls for streamer capacity to increase 7 percent in 2011, 10 percent in 2012 and 3 percent in 2013 and 2014. That pales in comparison to the growth that occurred during the last production boom.

Most analysts project global E&P spending to rise 10 to 15 percent in 2011. Expenditures on seismic services are expected to jump by nearly 20 percent. I regard these estimates as conservative and expect spending to increase at a faster pace. Nevertheless, in this scenario higher demand should be sufficient to absorb new capacity.

Management’s estimates for Petroleum Geo-Services’ future investment in multi-client seismic (MCS) projects and pre-funding likewise paint a positive picture.

Source: Petroleum Geo-Services

The first graph tracks the company’s MCS investments over the past few years and includes management’s expectations for 2010-11. MCS spending ramped up quickly in 2005-08, the last boom in exploratory services. Investments in MCS shrank in both 2009 and 2010 but are projected to rebound somewhat in 2011.

Source: Petroleum Geo-Services

Meanwhile, Petroleum Geo-Services projects that pre-funding levels will recover to about 100 percent, even though the company plans to spend more money MCS surveys. This could mark the beginning of an uptick in pre-funding and investment in MCS projects–both signs of strength in the seismic market.

Petroleum Geo-Services’ proprietary GeoStreamer platform differentiates the company from the pack. By towing these advanced streamers further beneath the surface, the company reduces noise and weather-related disruptions, providing a sharper image and deeper penetration than conventional techniques. This technology is particularly useful in the North Sea and other markets known for their harsh weather. The company continues to hone this technology to improve accuracy and efficiency.

About half Petroleum Geo-Services’ vessels are equipped with GeoStreamers, up about one-quarter from a year ago. By the end of 2011 this technology will be deployed on two-thirds of the fleet. All the company’s ships should be outfitted with the technology by some point in 2013.

Management estimates that the company earns a price premium of more than 12 percent when clients opt for GeoStreamer-based solutions rather than conventional products. And this price premium appears to be growing. Customers are willing to pay up for high-quality data, boosting Petroleum Geo-Services’ profit margins.

In another sign of confidence, the company ordered two new state-of-the-art ships that will be ready for deployment in late 2013 and early 2014, suggesting that management expects demand for seismic services to remain robust.

Petroleum Geo-Services’ leadership in 4-D seismic technology also bodes well for future growth. The company is testing seismic equipment that’s permanently installed on the seafloor and provides a detailed glimpse of how the field’s characteristics change over time. This information enables producers to enhance their production methods and maximize ultimate recovery rates.

The company has also solidified its financial position, paying down a significant chunk of its debt and using the proceeds of an equity issue completed earlier this year to partially finance the two new-builds it recently ordered. In recognition of these efforts, Standard & Poor’s on Dec. 2 upgraded the company’s credit rating to BB from BB-.

Plans to pay initiate a dividend in 2012 that will be tied directly to cash flow could also serve as a catalyst for the stock. If the seismic business picks up substantially, Petroleum Geo-Services could surprise the market by declaring a larger-than-expected dividend. Nevertheless, investors shouldn’t bank on receiving an outsized dividend yield.

A pure play on an uptick in spending on exploration, Petroleum Geo-Services is the latest addition to the Gushers Portfolio. Although it’s usually preferable to buy stocks on the local exchange, most subscribers will find it difficult to buy stocks listed in Oslo. The company’s over-the-counter American Depository Receipts (ADR) trade under the symbol “PGSVY” and track the performance of the Oslo-listed shares relatively well. Daily trading volume averages about 30,000 shares, so subscribers should use a limit order to ensure a favorable purchase price.

Petroleum Geo-Services’ ADR shares rate a buy under USD16.

Compagnie Generale de Geophysique Veritas (Paris: GA, NYSE: CGV), or CGG Veritas, is another pure-play on an improving market for seismic surveying. The company operates two business lines: services, which accounts for roughly 75 percent of overall revenue, and equipment, which accounts the remaining 25 percent.

CGG Veritas owns a fleet of seismic ships as well as crews and equipment for performing surveys on land. Like WesternGeco and Petroleum Geo-Services, the company performs contract and multi-client work and offers data processing services to help customers interpret and analyze survey results.

Management has likewise indicated that demand for seismic services appears to be improving. The company’s investments in multi-client projects declined in the third quarter, but pre-funding levels were at 102 percent in the marine division and about 80 percent for land-based projects. Meanwhile, despite spending less on multi-client shoots, sales of marine data were up 29 percent from the year-ago quarter. The firm’s seismic shoots for shale oil and gas plays in the US and Canada are also in high demand, pushing multi-client US land sales to an all-time high in the third quarter.

The firm’s contract business has perked up a bit, though pricing power is still poor. Management noted that its backlog of seismic contracts rose 9 percent in the third quarter to USD1.6 billion and that it had won jobs in onshore Oman and offshore Mexico and India. But pricing levels mean that the firm’s profit margins on offshore contract work are near zero. Because management has already booked much of its available capacity for the first half of 2011, prices won’t recover until the second half.

CGG Veritas also has its sights set on the high-end of the market. Launched in June 2010, BroadSeis utilizes solid streamers to dampen extraneous noise and improve the clarity of the resulting image. The system also includes a mechanism to control the depth of the streamers and a powerful software package to analyze collected data. Demand for CGG Veritas’ high-tech offering should increase as the industry ramps up deepwater E&P.

The company is also at the vanguard of 4-D seismic solutions, having recently installed Optowave, the firm’s reservoir monitoring product, in the North Sea’s Ekofisk field. Collecting and sending data on a periodic basis, this permanent solution enables producers to monitor and enhance production from mature fields.

CGG Veritas’ Sercel division, which manufactures and sells seismic equipment, is a unique business line that boasts market share of 60 to 65 percent. Despite weakness in the seismic services market, Sercel managed to grow its third-quarter revenue 21 percent from a year ago and increase its operating profit margins to 30 percent from 18 percent. Not only is Sercel enjoying increased demand for its products, but this business also enjoys pricing power.

The company’s Unite wireless system for onshore seismic shoots eliminates the need for wires and cables connecting individual data collection devices, reducing setup times and making it easier to acquire data onshore. In the marine segment, the company’s Sentinel streamer posted solid sales growth.

Unfortunately, Sercel accounts for only a quarter of the company’s revenue; the division’s strong performance failed to offset weak pricing for its marine services.

The Sercel division isn’t CGG Veritas’ only distinguishing characteristic: The company’s high cost structure is a concern. But management is implementing a restructuring plan to address these challenges and has emphasized that it expects to close the cost and performance gap over the next two years.

These efforts center upon addressing what management refers to as “the cost of non-quality.” The present-day CGG Veritas is the sum of various acquisitions, including the mega-merger between US-based Veritas and French outfit Compagnie Generale. Although this deal produced the largest pure-play seismic surveyor, the company’s fleet is highly heterogeneous, increasing the cost of upgrades and maintenance. The portfolio also includes a sizeable number of older, less-capable vessels.

CGG Veritas has already taken steps to improve its fleet. Over the past two years the company has decommissioned seven older vessels, leaving only four such ships in its portfolio. This number will decrease by half in 2014. The two remaining ships will be outfitted with modern equipment and deployed for shallow-water shoots. Management is also revitalizing its high-end fleet, jettisoning surplus vessels, upgrading others and purchasing a few new-build ships.

That’s not the only challenge. Whereas most seismic surveyors almost all their fleet, CGG Veritas only owns about 30 percent of this ships it uses, leasing the remained under long-term deals. Management estimates that margins increase 10 to 12 percent on large vessels when the company owns the ship. The company has a plan in place to boost the percentage of owned vessels over the next two to three years.

All told, non-quality issues account for roughly 60 percent of the cost performance gap between CGG Veritas and the rest of the industry. Between fleet improvements and planned cuts to general expenses, the company hopes to increase annual operating income by roughly $150 million.

CGG Veritas boasts solid technology and a market-leading seismic equipment business. But given its cost structure and higher debt levels, the firm isn’t as well-positioned as Petroleum Geo-Services.  

That being said, I’m adding CGG Veritas to the Energy Watch List as a buy. Readers concerned about buying Petroleum Geo-Services over the counter should consider CGG Veritas as an alternative.

My final pick is ION Geophysical Corp (NYSE: IO). The company manufactures and sells data collection equipment for both onshore and offshore seismic shoots, and provides seismic data interpretation services and libraries of multi-client data. Unlike the other names analyzed in this report, ION Geophysical doesn’t have a fleet of ships or dozens of land-based seismic crews; instead, the company provides equipment to third-party contractors. Management estimates that the firm controls about 15 percent of the market for seismic equipment.

ION’s land imaging systems division produces and sells seismic acquisition equipment including vibrator trucks–the trucks that generate the sound and pressure waves–as well as wired and wireless geophone sensors that intercept sound waves bouncing off subsurface features. This division is now part of a joint venture (JV) with BGP, a unit of China National Petroleum Company.

As part of this JV, BGP’s crews will field-test ION Geophysical’s latest technologies. The research and development part of the JV will reside in the US, while much of the manufacturing will shift to China, a move that significantly reduces costs.

The partnership should immediately enhance ION Geophysical’s 20 percent share of the market for land-based seismic devices–BGP plans to buy the majority of its equipment from the JV–and give it an enviable foothold in the Chinese market. If Sinopec and other Chinese operators begin to purchase equipment from the JV, ION Geophysical will take a big step toward management’s lofty goal of tripling its market share within five years.

Unconventional oil and natural gas fields that have been unlocked by horizontal drilling and hydraulic fracturing are a key growth market for the company’s land-based solutions. Hydraulic fracturing involves pumping a liquid under high pressure into the reservoir rock, physically cracking it to create a pathway through which the oil or gas can flow. Seismic imaging enables producers to evaluate the effectiveness of different fracturing technique and makes it easier to gauge how their wells interact with the field’s natural fractures. This sophisticated work requires high-quality seismic data.

In marine seismic, ION Geophysical offers a host of advanced streamers and is working on a series of products designed to function in the Arctic, an area that’s expected to attract a great deal of E&P activity in coming years.

In 2008 and 2009, ION Geophysical struggled with a large debt burden and concerns about its long-term financial viability. But the JV gave BGP a 51 percent stake in exchange for a cash infusion that enabled ION to pay down much of its outstanding debt.

The stock trades near a 52-week high and has enjoyed a torrid run since summer, so it could pull back amid a bout of profit-taking. Small-cap stocks such as ION Geophysical are subject to greater volatility, so a routine correction in the energy sector of 5 to 10 percent could send the shares 15 to 20 percent lower.

The stock trades at about 24 times forward earnings, but only a handful of analysts cover the company, and the consensus estimate looks conservative. For a company that’s likely to grow earnings substantially as demand for seismic data recovers, that valuation appears undemanding.

We’ll track ION Geophysical as a buy in the Energy Watch List and will look to add the stock to the model Portfolios in the event of a correction.

Fresh Money Buys

The stocks recommended in the three model Portfolios represent my favorite picks. The three Portfolios are designed to target different levels of risk: Proven Reserves is the most conservative the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays but have the most potential upside.

I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve compiled a list of 15 Fresh Money Buys that includes 13 names and two hedges.

I’ve classified each recommendation by risk level–high, low or moderate–and included a brief rationale for buying each stock. Conservative investors should focus the majority of their assets in low- and moderate-risk plays, while aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset exposure to energy stocks.

Also note that stocks that exceed my buy target for more than two consecutive issues will either be removed from the list or the buy target will be increased. Here’s the list, followed by a short update on company-specific developments.


Source: Bloomberg, The Energy Strategist

Fresh News

Chevron (NYSE: CVX) remains my favorite major oil company, thanks to its strong production growth potential. I consider the stock a core holding, but the Fresh Money Buys list is all about picking the timeliest recommendations in the model Portfolios.

During strong energy markets, majors such as Chevron and ExxonMobil tend to underperform the sector because they have less leverage to commodity prices. With the stock approaching our buy target of 90, now is an opportune time to remove Chevron from the list.

Enterprise Products Partners LP (NYSE: EPD) earlier this month announced the sale of 13.25 million units, including overallotments of 1.725 million units. Take advantage of the usual knee-jerk correction to add to your position at an attractive price.

This offering isn’t truly dilutive because Enterprise will use the capital it raised to build new assets that produce additional distributable cash and allow it to keep boosting its payout. The master limited partnership (MLP) has a long history of increasing its payout every single quarter, including straight through the dark days of the 2008-09 financial crisis. With a yield just under 6 percent, Enterprise Products Partners LP rates a buy under 45.

Coal producers remain one of my favorite groups heading into 2011, and Peabody Energy Corp’s (NYSE: BTU) Australian operations offer exposure to emerging-market Asia’s demand for both thermal and metallurgical coal. I’m raising my buy target on Peabody Energy Corp to 65 from 61.

I outlined my case for buying International Coal at great length in a Flash Alert issued on Dec. 21, 2010. I’m adding the stock to the Fresh Money buys list as of this issue. Buy International Coal up to 8.

Coal-focused MLP Penn Virginia Resource Partners LP (NYSE: PVR) faces some challenges in its midstream gas business. But with the price of natural gas liquids holding steady, I’m raising my target in the stock to 29.

Subsea equipment manufacturer Cameron International (NYSE: CAM) will also benefit from spending in deepwater fields. The firm may also benefit from new deepwater regulations in the Gulf  of Mexico, as it manufactures the high-end blow out preventers that are likely to become mandatory in the region.

Petroleum Geo-Services (OTC: PGSVY), outlined at great length in today’s issue, is another new addition to the Fresh Money Buys list. Buy Petroleukm Geo-Services up to USD16.