Editor’s Note: Because there are five Wednesdays in August, the next issue of The Energy Strategist will be delivered on Aug. 25. During this production break, Elliott will issue Flash Alerts as needed to keep readers apprised of key developments affecting Portfolio recommendations and global energy markets.

With the media frenzy surrounding the US debt ceiling and EU sovereign-debt crisis, investors can be forgiven for failing to notice how strong US corporate earnings have been this quarter.

Despite fears that a slowing economy would lead to a disappointing earnings season, thus far 77 percent of S&P 500 companies have reported quarterly results that beat Wall Street’s profit outlook. Meanwhile, 72 percent of these firms topped analysts’ consensus estimate. All 10 S&P 500 economic sectors have managed to grow revenue from the second quarter of last year, though telecommunications stocks have posted negative earnings growth.

The market has become obsessed with reading the economy’s tea leaves and fretting over crises (both real and imagined) that could tip the global economy into recession. When macro issues rule the tape, it’s difficult to focus on industry- or stock-specific stories.  

The Energy Strategist has always sought to strike a balance between analyzing global macroeconomic trends and individual stories within the energy patch.

This earnings season is no different. In addition to updating our macroeconomic outlook, we’ll scrutinize second-quarter results from Wildcatters Portfolio holdings Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT) and dissect each management team’s comments. We’ll also put a handful of other Portfolio holdings under the microscope. After all, once macroeconomic trends recede to the background, you’ll need to know which names are best-positioned to take advantage of emerging trends.

In This Isssue

The Stories

Bigger-picture concerns about slowing economic growth and the EU sovereign-debt crisis have overshadowed the strong second-quarter results posted by many of our Portfolio holdings. Elliott revisits his economic outlook in light of recent developments. See The Big Caveat.

Second-quarter results and subsequent comments from Schlumberger and Weatheford International suggest that demand in the companies’ international markets may have turned the corner. See Serving Up Profits.

There’s more to the model Portfolios than oil-services names. We review second-quarter earnings and comments from a handful of our other holdings. See Other Noteworthy Results.

Want to know what to buy now? Check out the Fresh Money Buys list. See Fresh Money Buys.

The Stocks

The Big Caveat

Economists often use the Latin phrase ceteris paribus, or “other things being equal.” This disclaimer indicates that your analysis or prediction assumes that everything else remains the same. Unfortunately, the real world follows a Heraclitian logic and rarely stands still for our benefit; change is the only constant in the unceasingly complex global economy. Relationships between economic conditions and the stock, bond, currency and commodity markets aren’t as straightforward and deterministic as some might imagine.

Plenty of people claim to be able to predict the economy’s ups and downs. In the late 1980s, plenty of newsletter editors made their names forecasting the 1987 crash. If I told you their names now, you probably wouldn’t recognize them, but these gurus were once considered infallible.

More recently, plenty of pundits and formerly obscure economists rose to stardom after they “foresaw” the 2008-09 financial crisis. But here’s a dirty, little secret: Most of these supposed clairvoyants have made the same predictions for years. A broken clock is right twice a day; if you make the same call for long enough, you’re bound get lucky at some point.

I won’t lie to you. I don’t have a crystal ball that enables me to infallibly predict the global economy’s fate. As longtime readers can attest, I readily admit when my forecasts are incorrect. I also regularly revisit my assumptions when conditions on the ground change.

My economic outlook hinges on a handful of economic indicators that have proved their worth time and time again. These indicators aren’t infallible, but I’ve found that a consistent approach to monitoring economic trends is far more effective than cherry-picking data series to support a preconceived notion. Economic forecasting is an exercise in probabilities. The global economy’s interrelationships are too complex to be distilled into any series of equations.

Fortunately, you don’t have to time inflection points in the economy or stock market precisely to succeed as an investor. The market is a forward-looking system that comprises a mass network of human emotions and decisions–needless to say, its outlook is often cloudy.

The recent boom-and-bust cycle is a case in point. If you failed to position your portfolio against the Great Recession until six months after it began in 2008, you still would have avoided the brunt of the subsequent market implosion. If you were three or four months late calling the market bottom and economic rebound in 2009, you still would have caught the meat of the bull-market rally.

In short, the challenge isn’t to predict economic inflection points; the real money is made by recognizing these changes once they occur and positioning your portfolio accordingly.

During this earnings season, management teams from many of the companies we follow have stated that their outlook remains positive–provided that the economy doesn’t slip into recession. Management teams remain cautiously optimistic about their business prospects, but the big picture remains a cause for concern.

Here’s my updated economic outlook.

The US and other developed economies have been mired in a soft patch since April or May. Incoming economic data have yet to provide concrete signs that this malaise has dissipated.

Some of this weakness stems from temporary factors: Oil and commodity prices spiked in early 2011; adverse weather weighed on business conditions in parts of the US; and the magnitude-9.0 earthquake that hit Japan’s Tohoku region in March disrupted global supply chains. These transitory factors should recede in August or September, setting the stage for a welcome uptick in economic growth.

Despite the recent spate of weak economic data, there’s only a 10 to 20 percent probability that the US will slip into recession. Inflation appears to have peaked in emerging markets, enabling China, India and other fast-growing nations to stop hiking interest rates in an effort to cool their overheated economies. Strong global growth should support rising energy demand.

Moreover, many pundits have confused weak economic growth with an outright contraction. Many of these commentators are repeat offenders who in summer 2010 warned that the US would spiral into a double-dip recession.

In July the Institute for Supply Management’s Purchasing Managers Index (PMI) for Manufacturing slipped to 50.9 percent and the Non-Manufacturing version fell to 52.7, suggesting that activity slowed in both the service and non-service segments of economy. At the same time, PMI readings above 50 suggest expansion. Historically, levels of 45 to 47 have indicated an outright contraction.

Meanwhile, the market ignored the better-than-expected automobile sale data released this week. This rebound in sales suggests that the manufacturing PMI may have bottomed now that the supply-chain constraints stemming from the Tohoku earthquake have abated.

We also continue to monitor the Conference Board’s Index of Leading Economic Indicators (LEI); three consecutive monthly declines usually indicate that the US economy may be slipping into recession. Thus far in 2011, the LEI has posted only one month-over-month decline.

The Bureau of Labor Statistics’ June Employment Situation report fell well short of analysts’ expectations, and the disappointment weighed heavily on investor sentiment. But initial jobless claims have trended lower since May, and figures from ADP Employer Services estimate that the US economy added 114,000 jobs in July.

Global credit markets remain a concern, though the EU sovereign-debt crisis has yet to affect the US corporate bond market. The EU has demonstrated a willingness to take any steps necessary to prevent fiscal conditions in Italy–and, to a lesser extent, Spain–from deteriorating to the point that they have in Greece, Portugal and Ireland.

Although Italy’s debt-to-gross domestic product (GDP) ratio is 120 percent, in 2010 the government ran a deficit that amounted to 4.6 percent of GDP–well below Greece’s deficit of 10.5 of GDP or the US deficit of 9.1 percent of GDP.

Moreover, Italy continues to make headway on reducing its deficit. A new austerity budget that includes roughly EUR45 billion (USD65 billion) in cuts has the support of both the center-right government and its main opposition. In fact, the size of the budget cuts increased to EUR45 from EUR40 as the proposal was debated in the Italian senate.

The package calls for reductions to housing and alternative energy-related credits, additional payments for health care services and changes to the retirement age. If Italy enacts these measures and follows through with their implementation, concerns about the country’s ability to service its debts should subside.

Italy aims to balance the budget by 2014, but some critics have lambasted the government for pushing back the most onerous cuts and tax increases until 2013.

Because Italy runs a smaller budget deficit than its troubled peers, any reductions in government spending won’t damage the economy to the extent that Greece, Ireland and Portugal’s austerity programs have devastated their domestic economies.

For example, Greece’s efforts to reduce government spending and increase tax revenue enabled the country to secure much-needed bailouts from the EU and International Monetary Fund. But this tough medicine also mired the economy in a severe depression; economists expect Greece’s GDP to shrink by almost 4.5 percent in 2011, further pressuring the government’s tax receipts.

Meanwhile, Italy’s economy continues to grow, albeit at a snail’s pace. The nation’s GDP expanded by about 1.3 percent in 2010 and should increase by another 1 percent in 2011. If the recent global economic slowdown proves temporary, Italy’s economy should be able grow by 1.25 percent in 2012.

Italy can also access the public bond markets–admittedly at elevated interest rates–a privilege that Greece no longer enjoys. In mid-July, the Italian government placed EUR5 billion worth of new debt, including 15-year bonds that yielded 5.9 percent–3 percent more than the yield on an equivalent bond issued by the German government. At the same time, the higher yields attracted 1.5 times more bids than the amount of bonds that the Italian government issued.

Let’s turn our attention to the hullaballoo surrounding US debt ceiling. Although the media presented the situation as a crisis that would have wreaked havoc on the global economy, the incident was politics as usual. The Aug. 2 deadline crated a heightened sense of urgency, but the US was never in real danger of a default– no matter what the editorials said. If this political theater raised legitimate questions about US credibility, then why are the yields on US Treasury bonds near multi-month lows?

We will continue to monitor incoming economic data for signs of weakness or strength and will issue Flash Alerts to keep you apprised of any critical developments. But the recent patch of economic weakness is part and parcel with the halting economic recovery that began in mid-2009. If economic growth picks up in August and September, this is an excellent opportunity to buy well-placed energy stocks.

Serving Up Profits

Schlumberger (NYSE: SLB)

Key Takeaways:

• Demand in the North American market continues to strengthen, enabling Schlumberger to raise prices in many key service lines.

• Management downplayed concerns about excess capacity in the US pressure pumping market–a theme in prior conference calls.

• Rising demand in the Eastern Hemisphere bodes well for profit margins and pricing power. Management was upbeat about conditions in international markets.

• Producers continue to invest heavily in exploration, a boon for providers of geophysical services.

During Schlumberger’s conference call to discuss second-quarter results, management outlined the case for continued strength in North America and rising demand for oil services in international markets. The company’s executive team tends to be more conservative in its bigger-picture outlook than its peers, so management’s upbeat comments–arguably the most optimistic in three years–carry even more weight.

The North American market for energy services has been a pocket of strength for the Big Four services firms–Baker Hughes (NYSE: BHI), Halliburton (NYSE: HAL), Schlumberger and Weatherford International–for well over a year. In fact, robust demand for pressure pumping and other key services in onshore shale oil and natural-gas plays has enabled providers to raise prices substantially.

The critical process of hydraulic fracturing–an innovation that enables producers to tap oil and gas reserves trapped in tight reservoir rocks–would be impossible without pressure pumping.

Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, ceramic material or sand coated with ceramic material–ensures that these passages remain open.

Over the past year, producers have ramped up drilling activity in these unconventional fields, focusing oil-rich plays such as the Bakken Shale of North Dakota and regions that contain substantial amounts of high-value natural gas liquids (NGL). Rising output from shale oil and gas fields translates into increased demand for pressure pumping and other services. At times, producers have reported waiting at least 90 days for hydraulic fracture because of capacity constraints. Insufficient pressure pumping supply and rapidly growing demand equals higher prices for service providers. (See Rough Guide to Shale Oil for more details on these trends.)

Although Schlumberger has benefited from robust demand for pressure pumping, the company’s management has adopted a far more cautious outlook regarding the sustainability of the up-cycle. Former Schlumberger CEO Andrew Gould, who retired on Aug. 1, had previously suggested that overzealous capacity additions could outstrip demand for pressure pumping. Management’s comments during the Q-and-A portion of the company’s July 22 conference call indicate that the firm has modified its outlook:

Analyst: Many of your big competitors are adding frac[turing] equipment in North America as quickly as they can. How would you say your equipment adding strategy differs from them?

Andrew Gould: I don’t think it does. But I’ll let Paal comment on that.

Paal Kibsgaard: No, I think while we generally believe that there is opportunity to bring service intensity down from this brute force approach we have to shale development, we are still pursuing both sides of the equation there, right? So while we continue to promote the workflow that I alluded to in my comments, we are also adding significant horsepower this year into our pressure pumping business. So as I mentioned in my commentary, we added in the first half of this year, more horsepower than we’ve done in any full year previously. And I think that just basically signals that we are part of this thing as well.

The analyst’s question reflects the company’s traditional business mix–Halliburton (49 percent of 2010 revenue) and Baker Hughes (50 percent) have more exposure to North America than Schlumberger (21 percent)–and former skepticism toward the sustainabiity of pricing gains in the pressure pumping market.

CEO Paal Kibsgaard’s response indicates that Schlumberger has changed tack. The company added more pressure pumping capacity in the first six months of 2011 than it has over any full year. This about-face suggests that management expects drilling activity in liquids-rich shale plays to justify further investment.

At the same time, Kibsgaard mentions efforts to reduce the service intensity of these shale fields–likely an allusion to the firm’s HiWay fracturing and shale reservoir modeling technologies. Schlumberger’s technology helps operators to identify the most productive portions of each horizontal well, reducing the number of fracturing stages and boosting profit margins. Not only does the producer save money on water and proppant with this approach, but wells can also be fractured much more quickly.

In his prepared comments, Kibsgaard noted that Schlumberger has performed more than 1,200 HiWay fracturing stages worldwide and that this approach has saved 60,000 tons of proppant relative to conventional drilling techniques. Fifteen producers have adopted Schlumberger’s HiWay technology thus far. Many of these customers operate in the Eagle Ford Shale, a field in South Texas that contains windows of crude oil, natural gas and natural gas liquids (NGL).

HiWay and similar technologies cut drilling costs and allow operators to better understand how oil, gas and fracturing fluids move through the fields they produce. Over time this could go a long way toward reducing populist fears about fracturing.

Not only is Schlumberger on board with the North American pressure pumping pricing cycle, but management also expressed confidence in potential pricing upside for other services related to unconventional drilling. In particular, the firm highlighted growing demand for its drilling and measurement (D&M) services and emphasized the potential to push through price increases and boost profit margins.

D&M encompasses a wide range of services, from directional drilling to cementing, mud logging and supplying drilling fluids.

Schlumberger acquired its directional drilling capabilities from its acquisition of Smith International. By deviating the wellbore from its downward path (i.e., drilling directionally), operators can target the most productive zones of a particular reservoir and improve their wellhead economics.

Cementing supports and protects the well cashing, a thick steel pipe that’s installed to isolate certain parts of a well prevent leakage and environmental contamination. For example, if you drill a 10,000-foot oil well through an area that contains water at 2,000 feet, the casing would prevent this underground aquifer from gushing into the well. Selecting the proper cement for each unique job is a critical task that can have disastrous consequences. Some industry insiders have suggested that a shoddy cementing job contributed to the blowout of the Macondo well and the worst-ever oil spill in the US Gulf of Mexico.   

Schlumberger’s M-I SWACO division specializes in formulating drilling-fluid systems and additives that are pumped into a well as its being drilled. The pressure of the drilling “mud” that’s injected into the well counteracts the geological pressure of the oil and gas in the field, preventing a blowout, or the uncontrolled flow of oil and gas into the well. The composition and weight of the drilling fluid used depends on the type of reservoir and the pressure and temperature of hydrocarbons in the field.

The drilling mud circulates through the well and then returns via the annulus, or the empty space outside the drilling pipe. As mud returns to the surface, the operator can analyze its contents to hone its understanding of the reservoir rock and the hydrocarbons contained therein. This process is known as mud logging.

This discussion of Schlumberger’s roster of drilling-related services is illustrative rather than exhaustive. The is the key takeaway from management’s discussion of the North American market: Emerging pricing power in service lines besides pressure pumping suggests that drilling activity remains strong and producers have begun to hit capacity constraints. In other words, services firms aren’t always available immediately to perform these tasks. A tightening market for other services explains why Schlumberger had decided to bet on a continued up-cycle in North America.

The North American oil-services market would go into overdrive if exploration and production (E&P) activity picked up in the deepwater Gulf of Mexico. Such a development would be welcome news for the oil-services industry in general and Schlumberger in particular because of its traditional competitive strength in deepwater drilling. In this regard, rumblings about a potential lease sale in the deepwater Gulf of Mexico are an encouraging sign.

With demand on the upswing for oil and natural gas services on the upswing in international markets, the Big Four could soon be firing on all cylinders. The industry serves three geographic end-markets: North America, Latin America and the Eastern Hemisphere, which includes Europe, North Africa, the Middle East and Asia Pacific. Markets in the Eastern Hemisphere have lagged in recent quarters, offsetting robust demand in North America and Latin America.

Elevated oil and international natural gas prices have encouraged major integrated oil companies and state-owned entities to step up drilling activity and investment throughout the Eastern Hemisphere. However, up until recently, overcapacity has prevented oil-services firms from pushing the line on pricing. To worsen matters, many of the big services firms have built a substantial presence in the Middle East and other key markets–a major fixed cost.     

These challenges have prompted some of Schlumberger’s competitors to bid on projects at prices that don’t guarantee long-term profits. For a time, the industry appeared bent on winning new work at any cost with scant regard for the long-term consequences. Profit margins would continue to languish in this cutthroat and irrational competitive environment until the supply-demand balance at least normalized.

It’s been a waiting game. For the past several quarters, the major oil services firms have offered anecdotal evidence that pricing power in the East Hemisphere had begun to turn the corner. The consensus outlook from most of the Big Four called for pricing to improve at some point in late 2011 or early 2012.   

Schlumberger’s second-quarter results suggest that the waiting game may be over. Demand for the company’s services improved significantly toward the end of this three-month period, and management suggested that this momentum had continued into the third quarter.

During the Q-and-A session that followed management’s prepared remarks, former CEO Andrew Gould and his successor Paal Kibsgaard addressed the sustainability of these pricing improvements:

Analyst: Just wanted to follow up as it relates to the revenue and margin improvement sequentially we saw in Eastern Hemisphere in 2Q. Is that mostly just a snap-back as guys you see it from the seasonal declines in the first quarter, or have we started to see some of the improving operating fundamentals really creep into results yet? I guess my first question. And then second, given the pricing and mixing outlook, I think the expectation has been kind of a back half of ’11 to be more of a volume-led margin expansion story. I’m just curious if there’s anything that you guys see in Eastern Hemisphere as far as a sharper margin inflection in the back half of the year, or is that still pretty much a 2012 story?

Andrew Gould: No, I think I was quite clear in the commentary that it’s not general yet, but individually on small contracts, pricing improvements have begun. And I think that–I don’t see any reason why that would go away now, Bill. Now, there is a snap-back effect partly in MEA, of the Australia and Egypt. But it’s not significant in the overall picture. And, yes, you have definite activity pickup. And what I would point out to you is that, we pointed out at the beginning, is that a lot of the pickup was in characterization. And therefore that tells you that a lot of the pickup is the beginning of some of these exploration campaigns that we’ve been waiting for.

Paal Kibsgaard: And maybe just adding to, that I agree with what Andrew is saying. I think if you look at the sequential margins overseas, there’s really two main components. One is that the volume is actually going up. And the way we’re set up with our timeframe and our infrastructure, we are actually able to leverage the volume and the fixed costs we have to generate good pull-through, even on relatively flat pricing, right? That’s No. 1. And No. 2, as Andrew alluded to, the part of the company that grew very well was the Reservoir Characterization, where the average margins are obviously higher than for the other two product groups.

In this excerpt, Schlumberger’s management team makes it clear that the recent improvement in operating fundamentals is more than just a rebound from normal seasonal declines. More important, the company has been able to hike prices on smaller contracts, suggesting that the supply-demand balance has tightened considerably in the Eastern Hemisphere.

The industry often regains pricing power on smaller contracts in the earlier stages of the recovery cycle because the competition for larger contracts is more intense and operators expect to receive a volume-based discount. It might take a quarter or two, but this pricing power eventually will spread to larger projects.

Schlumberger’s unique product mix also contributed to the uptick in its international profit margins. The major oil-services companies operate offer many of the same basic product lines, but each has a reputation for performing certain kinds of work. Schlumberger is best-known for its technological innovations and the strength of its exploration-related services.

The company’s commitment to research and development has produced a steady stream of cutting-edge technologies that give the oil-services giant a leg up when bidding on major contracts and enable the firm to charge more than its peers. Without giving away too many details, management indicated that 2011 and 2012 will be big years for new products and services related to drilling efficiency–a key to controlling costs. We expect these product introductions to help Schlumberger win market share as demand ramps up.

Schlumberger replaced competitors on 47 jobs in the second quarter, as producers opted to jettison low-cost providers that failed to perform the requested services at the desired level of qualit. Project delays stemming from inferior work can cost an operator far more than any price discount. Operators appear increasingly willing to pay for superior performance.

In the early stages of a recovery cycle, producers usually try to squeeze as much output as possible out of their existing fields to take advantage of rising oil prices. They may also begin to develop fields they’ve already discovered. Once management teams gain confidence that oil prices have stabilized at levels that incentivize further investment, producers plow money into exploring for new oil and natural-gas fields to develop. Among the Big Four, Schlumberger’s product mix offers the best exposure a recovery in spending on exploration. (We analyzed this market at length in the Dec. 22, 2010, issue Here Comes the Spending.)

This trend appears to gaining strength. Former CEO Andrew Gould discussed this recovery at length during the company’s July 22 conference call, highlighting the uptick in demand for seismic services:

[T]he distinguishing factor of Schlumberger is Reservoir Characterization. It was very clear in this quarter that an acceleration in the exploration cycle is such that that is going to be a distinguishing part of the company. And if we look at the level of demand for seismic over the last few months and the global demand for seismic, coupled with some form of return in the Gulf of Mexico – and there have been encouraging noises out of Washington about holding a lease sale – that makes the seismic business look a lot better than it did even three months ago.

And the second thing is that there have never been so many deepwater rigs on order. So to the extent that we have exploration success in deepwater–and there’s no reason to believe we won’t have reasonable success. I think that the exploration cycle can be a lot more sustained than it was last time, when it was abruptly terminated by the financial crisis and by the Macondo incident. So I think that’s the first thing.

And the second thing, as I’ve said forever–a long, long time, ever since I took over–to renew the production base when we’re close to 90 million barrels a day, is just going to take a lot more CapEx [capital expenditures] than it did–and OpEx [operating expenses], by the way– than it did when the world was even at 80 million. So to the extent that, as you say, if you exclude the macroeconomic risks, which are not inconsiderable at this point in time, I’m back to my sort of theme of stronger for longer.

In this except, Gould explains why the company’s reservoir characterization business may be approaching an important inflection point, noting the broad demand for seismic services in international markets and increasing optimism about a potential recovery in the US Gulf of Mexico.

A year ago, the panic surrounding the Macondo oil spill prompted many analysts to claim that the accident marked the end of deepwater drilling in the Gulf. Over the ensuing months, reports have suggested that the damage from the spill hasn’t reached the levels that many had expected. Moreover, the risk-reward equation has shifted: Consumers are willing to accept the risks of deepwater drilling in the Gulf because of the region’s growing importance to the nation’s oil supply.

Gould’s comments about the structural trends that underpin this upswing are even more important. His assessment of these market dynamics reflects our long-held thesis on the end of easy oil. According to Gould, declining output from mature fields will force producers to spend more money than in the previous cycle–and that’s just to maintain global oil production of 90 million barrels per day.

In its discussion of the turnaround in the Eastern Hemisphere, management highlighted bullish developments in two markets: Iraq and Saudi Arabia.

The company’s operations in Iraq managed to generate more than $100 million in quarterly revenue, while profit margins have approach the average level in the Middle East and Asia. The latter is a key development because many analysts expected these operations to offer subpar margins; services firms had bid aggressively to win contracts in this rapidly growing market.

Meanwhile, the development of Saudi Aramco’s massive Manifa field should continue to ramp up in the back half of the year. .

Bearing in mind the macroeconomic caveats discussed in the first section, the global services cycle is entering a sweet spot roughly a quarter earlier than most analysts had predicted at the beginning of the year. This bullish development pushes the oil-services in the model Portfolios to the top of my buy list. Take advantage of weakness in the broader market and buy Schlumberger under 100.

Seismic Services and Reservoir Description

Schlumberger’s positive comments about spending on exploration and its WesternGeco seismic services division bodes well for the global seismic industry as a whole. Gushers Portfolio recommendation Petroleum Geo-Services (Oslo: PGS; OTC: PGSVY) represents our purest play on this trend. 

Although the stock has sold off in recent days, this pullback reflects spillover selling from the broader market retrenchment rather than stock-specific factors. In fact, Petroleum Geo-Services reported second-quarter sales of $326.6 million, well ahead of analysts’ consensus expectations for $294. The company also exceeded earnings estimates by a significant margin, and management expressed increased confidence in its full-year profit targets issued earlier this year.

In a conference call to discuss second-quarter results, Petroleum Geo-Services offered a similar assessment of prevailing business conditions, noting an uptick in demand for multi-client seismic (MCS) services had enabled the company to post record-high MCS sales. Management also “good and increasing demand globally” for MCS. Activity was particularly robust in the North Sea.

Seismic services fall into two basic categories: multi-client and contract work. Services firms market some databases of seismic information to multiple clients. 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 should bid. Producers also use the data to pinpoint prospective areas for test drilling.

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.

Over time, Petroleum Geo expects strength in MCS to bleed into the contract segment. 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, exploration and production firms usually order detailed seismic data to delineate the most promising drilling prospects.

This progression makes sense, as producers first need multi-client data to identify promising prospects before acquiring in-depth data to guide field development.

The lone disappointment in Petroleum Geo-Services’ second-quarter results stemmed from the rising cost of marine fuel, which ate into some of the price increases the company has won in recent quarters. These price hikes only have a delayed effect on the firm’s profit margins. Petroleum Geo-Services usually books projects about six months in advance; higher prices on jobs booked today won’t be apparent until early 2012.

With the supply-demand balance in the market for seismic services finally tightening, Petroleum Geo-Services’ American depositary receipt rates a buy under USD17.50.

Wildcatters Portfolio holding Core Laboratories (NYSE: CLB) also stands to benefit from increased spending on exploration and renewed interest in deepwater drilling. The company specialize in reservoir description, a niche business that involves analyzing core samples from oil and gas fields to evaluate their productivity and identify the best production methods.

The firm generates about two-thirds of its revenue outside North America, and its business is heavily skewed toward oil projects. Core Laboratories posted solid second-quarter results, beating analysts’ consensus estimate on the top and bottom lines. Management also raised its full-year earnings estimate. The stock has performed well in a weak market, a sign of future strength. Buy Core Laboratories up to 115.

Weatherford International (NYSE: WFT)

• The outlook for the Eastern Hemisphere has improved dramatically over the past three months and pricing power is returning.

• Weatherford’s strength in artificial lift will be a tailwind for the stock.

• North Africa remains a short-term obstacle, but management noted that activity has increased in Algeria.

Wildcatters Portfolio holding Weatherford International reported strong second-quarter results–welcome news after several embarrassing fumbles. Although the stock has lagged its peers thus far in 2011, investor sentiment toward the name remains overly negative given the cyclical recovery underway in the international demand for oil services.

Management’s missteps over the past year have undermined its credibility, but investors investors shouldn’t forget that the stock outperformed in the last big oil services up-cycle. CEO Bernard Duroc-Danner and his team have delivered value over the long term and have years of experience.

Meanwhile, strengthening demand for its core services and growing confidence in the firm’s ability to execute should be enough to prompt a dramatic re-rating of the stock over the coming year.

During Weatherford International’s conference call to discuss second-quarter results, management echoed Schlumberger’s comments about improving volumes and pricing in the Eastern Hemisphere. The firm also noted that pricing in North America is beginning to improve in businesses other than pressure pumping.

Weatherford International has earned a reputation for its expertise in producing oil and gas from mature fields. To this end, management and analysts focused on the prospects for the company’s artificial-lift business during the July 26 conference call. .

Artificial lift encompasses a number of different services that enhance output as an oil or natural-gas field matures. In the early stages of a field’s life cycle, geological pressures push oil from the reservoir rock, into a well and to the surface. Depending on the type of field being drilled and the quality and pressure characteristics of a reservoir, primary production can continue for years or just for a few months. Once output slows, operators can use a handful of methods to bolster production.

One example of artificial-lift technology is the horse-head pumps that dot the landscape in mature oil-producing regions such as Southern California.

Source: Weatherford International

The electric submersible pump–which is installed at the bottom of a well and pumps oil to the surface–also falls into this category.

Artificial lift is an attractive business to be in from a long-term perspective because most of the world’s largest and most-prolific oil fields are in decline. Producers continue to deploy artificial- lift techniques as a way of reducing output declines from these fields. Duroc-Danner explained his bullish outlook for artificial lift in North America during the company’s recent conference call:

Analyst: [B]ack to your comment, Bernard, with regard to the North American outlook and I think justifiably talking about a series of product lines which have yet to really inflect and should be coming down the road, especially lift. One thing that I’m sort of curious about is revenue per well opportunity on this backlog of new generation wells that are building, costing call it $5 million to $10 million per well to drill and complete versus what used to be a million dollar well to drill and complete. Have you thought about the revenue per well differential, if you will, on this new generation well that’s being drilled today versus what used to be the case?

Bernard J. Duroc-Danner: Yes, I–well, I have. It’s a complicated question because of the–it depends, as in everything else in our business, depends on the well, depends on the reservoir, depends on location. But maybe what follows will be helpful. Roughly 25% of what North America sells, top line, is artificial lift for us.

What we–so you can derive the numbers. What we are noticing is that on–not only on the wet shales but also what we call tight oil and also tired oil being developed with different approaches are using the lessons learnt from the experience from shales. We’re noticing that the billings and the equipment specification for artificial lift is more than two times what it normally is.

Duroc-Danner’s comment suggests that a recovery in the artificial-lift business–which tends to pick up a few quarters after services related to primary drilling–provides an opportunity to grow North American profit margins. That’s because operators often wait a few months for a well’s initial production to decline before pursuing artificial-lift technologies.

According to Weatherford International’s CEO, wells drilled in oil and NGL-rich shale plays and longer horizontal wells in mature fields such as the Permian Basin generate twice the artificial- lift sales as traditional North American wells. Expect robust drilling activity in these unconventional plays to support fast-rising demand for artificial lift.

The company also has managed to push through two rounds of price increases on its artificial-lift services. But the full benefits of these price hikes won’t be apparent until the company works through its lower-margin backlog. Over time, expect profitability in the firm’s artificial-lift segment to improve dramatically.

Weatherford International’s exposure to North Africa has also weighed on the company in recent quarters because of disruptions in Algeria, Libya and Egypt.

Although the firm’s Libyan operations will remain on ice until the country’s internecine civil war ends and political stability returns, activity in Algeria has ramped up and management expects a number of delayed projects to materialize in late 2011 or early 2012.

These developments prompted management to boost its guidance for 2011, though these estimates still appear conservative. Provided it can continue to execute and the macroeconomic situation doesn’t deteriorate, Weatherford International’s stock should be able outperform its peers over the balance of the year. Buy Weatherford International under 28.

Other Noteworthy Results

When we added BG Group (LSE: BG/, OTC: BRGYY) to the Wildcatters Portfolio in the March 23 issue, we focused on how the company’s extensive assets and operations related to liquefied natural gas (LNG) stood to benefit from tightening in global natural gas markets.

In the second quarter, revenue from BG Group’s LNG operations (about 34 percent of the firm’s overall sales) increased by 2 percent from year-ago levels, led by the firms shipping and marketing operations. Management noted that 84 percent of its LNG cargos were diverted from the US (the market of last resort) to international customers, compared to only 64 percent in the second quarter of 2010. LNG Demand was particularly robust in South America and the Asia-Pacific region. This performance prompted management to suggest that the segment’s full-year operating profit would likely come in at the upper range of USD1.9 to USD2.2 billion, up 42 percent from the prior year.

Knighted CEO Frank Chapman also reiterated its bullish take on tightening global LNG markets during a conference call to discuss second-quarter results:

I think that the situation in Japan has not really affected significantly our trading. So it will be something which is not the cause of this year’s overarching LNG performance, but it will make–and has made–the environment in which we’re working somewhat tighter. So it’s an incremental contributor to performance rather than something which shaped the overall annual performance.

What is evident however is that the catastrophic situation that has occurred in Japan and the follow-on policies that are being implemented by various governments around the world, who are now changing their plans, not to use further nuclear, means that the overall picture is tightening and is causing particularly Asia-Pacific customers to come back to the table somewhat earlier than hitherto planned, in order to engage and start to consider their next tranches of long-term supply. So that is completely evident from the interaction that we’re having with a broad spectrum of customers, particularly in Asia-Pacific.

Chapman’s assessment of global LNG markets roughly corresponds to our original investment thesis, though we expected the company to enjoy a bit more near-term upside from an uptick in Japanese demand.

As we explained in The Fallout and Less Uncertainty for Nuclear Power, Germany’s response to the tragedy at Japan’s Fukushima Dai-ichi nuclear power facility plant bode well for global LNG demand. Germany plans to decommission all 17 of its nuclear power plants by 2022, a move that will strain regional electricity supplies and increase Continental demand for LNG. The German government has already shuttered seven of the nation’s nuclear reactors–about 41 percent of its nuclear power capacity and 11 percent of its overall generation capacity–tightening global LNG markets.

Meanwhile, Asia-Pacific LNG demand is poised for substantial long-term growth–and you don’t have to take Sir Francis Chapman’s word for it.

The Chinese government’s long-term plans call for natural gas to account for 10 percent of the country’s energy mix, one-third of which will be imported via pipelines or LNG. Natural gas has been growing in popularity in China, particularly in power-generation facilities located near major cities. Concerns about air quality mean that many of the high-rise residences constructed during China’s recent housing boom are equipped for piped gas. Further migration to urban areas will only increase demand.

LNG imports will be part of the solution. In December 2010 Chinese LNG imports topped 1,000 metric tons, five times their December 2008 level and a new all-time high. China’s first re-gasification terminal opened in Guangdong province in 2006, and the country currently boasts three import facilities. But that capacity is slated to expand substantially over the next decade. Check out the table below.

Source: Reuters

Although the growth prospects for BG Group’s LNG operations remain intact, the exploration and production (E&P) segment enabled the company to beat Wall Street’s estimates for second-quarter earnings and revenue. A 3 percent increase in the company’s hydrocarbon production, coupled with higher commodity prices, propelled the E&P division’s revenue to USD2.8 billion, up 35 percent from the previous year. The company’s realized natural gas prices jumped by 23 percent from the prior year, while its average realized oil price surged by 55 percent.  Meanwhile, lower exploration costs bolstered operating profits to USD1.4 billion, a 90 percent increase from year-ago levels.

But the big news from the quarter focused on the company’s operations offshore Brazil. Results from appraisal drilling and real-time production data prompted the company to double its reserve and resources estimate for its licensed blocks in the Santos Basin to 6 to 8 million barrels of oil equivalent. Management also noted evidence of “an incredible level of connectivity” within the Lula field, a discovery that should enable the company to hit its production target while drilling fewer wells and bodes well for the amount of oil and gas the company will recover during its 27-year license.

Meanwhile, now that the firm’s first floating, production, storage and offloading (FPSO) vessel is operating in the Santos Basin, the firm will be able to hone its production techniques to reduce costs and boost ultimate recovery rates. BG Group and its partners have 11 additional FPSOs on order and will expect to add an additional two units in coming quarters. In total, these 13 FPSO represent total productive capacity of 23 million barrels of oil equivalent per day.

Management also emphasized that 2011 is a transitional year for the company’s E&P division and noted that the firm’s hydrocarbobon output should grow at a compound annualized rate in the double-digits as new projects come online between 2012 and 2020. This production growth, combined with a tightening supply-demand balance in global LNG markets, should be a boon for BG Group.

Take advantage of weakness in the broader market and buy BG Group under GBp1,650 on the London Stock Exchange. BG Group’s American depositary receipt (ADR) rates a buy up to USD133 in the over-the-counter market. 

Valero Energy Corp (NYSE: VLO), the world’s largest independent refiner, operates 15 petroleum refineries–seven on the US Gulf Coast, three in the Midcontinent region, two on the West Coast, one in Canada, one in Aruba and one in the UK–capable of processing a total of 2.9 million barrels per day.

Valero’s refining operations accounted for almost 85 percent of its 2010 revenue, while the firm’s retail operations in the Americas–about 5,800 locations in the US, Aruba and Canada– represented about 11.3 percent of sales last year. The firm’s ethanol production plants in the US Corn Belt generated about 3.7 percent of 2010 revenue. 

Broadly speaking, the refining industry continues to benefit from rising global demand for gasoline, diesel and other refined products as consumption recovers in the developed world and emerging-market demand expands at a rapid rate.

On the supply side, the overcapacity that has plagued refinery operators in the US and Europe continues to ease. Over the past few years, integrated oil companies have sought to rationalize their downstream operations, divesting less profitable refineries in the US in favor of facilities in the Middle East and Asian emerging markets, two regions that offer superior margins and growth prospects.

Meanwhile, independent US refiners have also moved to reduce capacity, selling or closing smaller (and therefore less-efficient) plants on the East Coast–a highly competitive region that lacks access to cheaper domestically produced crude oil. The majority of oil refined at East Coast facilities arrives via tanker from Nigeria, the North Sea and other international locations.

Valero Energy estimates that these moves reduced global spare refining capacity to 5.9 million barrels per day at the end of 2010 from about 7 million barrels per day at the end of 2009. The company also got in on the act, selling its Delaware City and Paulsboro, NJ refineries in 2010.

But the biggest near-term upside catalyst for Valero Energy remains the flexibility of its refineries: About 80 percent of the company’s refinery capacity can process feedstock that trades at a discount to light, sweet crude.

With Mexican oil output stabilizing and rising production of heavy oil from Colombia, the refiner should reap the rewards of attractive spreads on heavy-sour and medium-sour grades of crude relative to light-sweet, waterborne crude oils. In its conference call to discuss second-quarter results, management noted that the discount on Maya heavy-sour crude oil to light Louisiana sweet crude oil increased 21 percent to $14.58 in the second quarter of 2011, up 21 percent from year-ago levels.

Exporting diesel and gasoline from the company’s core operations on the Gulf Coast continued to generate solid profits in the second quarter, benefitting from expanding margins and rising demand in Mexico and Brazil. During Valero Energy’s conference call to discuss second-quarter results, Chief Commercial Officer Joe Gorder told an analyst that this trend should remain in place for some time:

It’s almost getting to be a chorus here instead of a verse that we have got strong exports out of the Gulf Coast. I read an article this morning that Reliance [Reliance Industries (Bombay: 500325)] is moving their barrels now to Asia. Asian demand is still strong and we expected them to come to the states at some point in time. We just haven’t seen it. So you’ve got growth in other parts of the world, which are pulling those barrels. The Gulf Coast refiners, as we’ve said before, are very cost competitive, and you have natural markets for those barrels and those barrels are into Mexico, Central America, South America, and then over to Europe. And I just expect that this is going to be with us for some time.

Meanwhile, 40 percent of the company’s capacity in the Midcontinent region stands to benefit from the widening spread between the price of West Texas Intermediate (WTI) crude (a popular US benchmark) and Brent crude oil (a European benchmark that better reflects trends in global oil demand).

WTI generally commands a slight premium to Brent crude oil, but that relationship has reversed over the past 12 months. Local supply conditions at the physical delivery point in Cushing, Okla. are the culprit: Rising US imports of Canadian oil, higher domestic output from shale oil fields and an uptick in ethanol production have prompted pipeline operators to add new lines or reverse the flow of existing lines to carry crude south to Cushing and other refinery centers.

This shift has not only glutted storage facilities at Cushing, but the reverse pipeline have limited flows out of the hub. When an influx of crude oil overwhelms refining capacity, stockpiles build, and the price of WTI declines. This logistical logjam can only be resolved by the construction of new pipelines to move crude oil from Cushing to the Gulf Coast, an area that’s home to about 30 percent of the nation’s refining capacity. Management expects this tailwind to be in play for another 12 to 18 months.

Recent moves to take advantage of favorable pricing differentials on oil produced in the Eagle Ford Shale of South Texas, arguably the hottest unconventional oil and gas play in the US, should boost in the coming quarter. Management noted that in the second quarter the company increased the use of discounted Eagle Ford crude in its system to 37,000 barrels per day, up from 12,000 barrels per day in the first quarter. The firm also highlighted plans to process 25,000 barrels per day of Eagle Ford crude at its Corpus Christi refinery in the third quarter and 60,000 barrels per day at its Three Rivers Facility by year-end.

On Feb. 27, 2010, we added Valero Energy to the Gushers Portfolio as a shorter-term investment that stood to benefit from improving fundamentals. (See A New Dark Age for Refiners.) The stock has rallied 34 percent since it joined the model Portfolios. Although weakness in US equity markets has eroded our gains, margin improvements could enable the stock to retest its 2011 high. At the same time, concerns about weakening US gasoline and distillate demand amid economic weakness could bea a headwind. Valero Energy Corp continues to rate a hold.

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 18 Fresh Money Buys that includes 16 stocks and two hedges.

I’ve classified each recommendation by risk level–high, low or moderate. 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.