Over the past few months, the energy sector has pulled back substantially, reflecting concerns that the EU sovereign-debt crisis and slowing economic growth in the developed world will erode international oil prices.
The trauma of the credit crunch and Great Recession, which catalyzed a stunning year-over-year decline in primary energy demand, has stuck with investors and reminded them that macro challenges can temporarily overwhelm long-term supply and demand trends.

A media that focuses on the worst-case scenario rather than likely outcomes hasn’t helped matters.

Although these macro risks warrant close scrutiny, the tight supply-demand balance in global oil markets suggests that the price of Brent crude oil should remain at levels that incentivize investment in exploration and production (E&P).

Given the potentially severe repercussions of a major sovereign default, we expect EU finance ministers to push for a solution that will prevent Greece and Italy from defaulting on their sovereign bonds. Meanwhile, recent data points from the US suggest that the world’s largest economy has continued to grow, albeit at a slow rate. Our economic model currently pegs the likelihood of the US lapsing into recession over the next six months at one in three.

Many industry observers and participants say that producers tend to rein in activity and investment when Brent crude oil prices dip below $80 per barrel. Although this international oil benchmark has pulled back from its April high of $127 per barrel to roughly $110 per barrel, the price of West Texas Intermediate (WTI) crude is at greater risk of breaching this threshold because of logistical constraints. (See Why US Gasoline Prices Remain Elevated.)

Energy investors seeking to position their portfolios for a decline in global oil demand should consider bulking up on shares of international oil companies such as Chevron Corp (NYSE: CVX) and ExxonMobil Corp (NYSE: XOM), both of which offer solid yields and tend to outperform during periods of weakness.

We also favor dividend-paying companies with exposure to spending by the Super Oils and national oil companies (NOC). Whereas independent E&P outfits tend to adjust their spending based on cash flow, the majors and NOCs have bulletproof balance sheets and usually take a longer view on oil and natural gas prices. These behemoths also tend to pursue complex, multiyear projects because the scope of their operations makes it difficult to move the needle on reserve replacement.

Although the group has been out of favor, some offshore contract drillers offer an attractive combination of defensive qualities and exposure to long-term growth trends. The key is identifying names that have exposure to the business lines that offer the most upside.

Contract drillers supply energy producers with both rigs and the basic equipment and personnel needed to sink an oil or natural gas well. Producers pay a daily fee to lease these rigs. Day rates are the main source of revenue for contract drillers and bear no direct relationship to the value of the oil or natural gas extracted from these wells.

The supply and demand picture for offshore rigs varies substantially based on a unit’s age and capabilities. In the wake of the Macondo oil spill, operators prefer modern rigs that include advanced safety features and additional space to accommodate newer blowout preventers. In both the deepwater (water depths of 4,500 feet to 7.500 feet) and midwater markets (1,500 feet to 4,500 feet), high-specification rigs generally command higher day rates than their older peers.

Meanwhile, the ultra-deepwater (water depths in excess of 7,500 feet) segment of the market continues to offer the highest day rtes and the most upside Atwood Oceanics (NYSE: ATW), Ensco (NYSE: ESV) Noble Corp (NYSE: NE), SeaDrill (NYSE: SDRL) and Transocean (NYSE: RIG) all noted an uptick in tendering activity and inquiries during their second-quarter conference calls. Many of these management teams predicted that day rates would once again eclipse $500 per day in the second half of 2011.

The head of Transocean–which boasts the industry’s largest fleet of offshore drilling rigs–neatly summed up this bullish outlook at the recent Barclays Capital CEO Energy-Power Conference:

[We have] lots of optimism about the strength of the ultra-deepwater market. It is, for all intents and purposes, sold out in 2011 and continuing demand this year on into next year. So the customers are already talking about 2012 availability and starting to think about 2013 availability…Utilization today is over 95 percent, and that’s always a positive signal for the contractors. The pace of tendering has improved, there are more discussions going on today. Day rates are improving and short-term availability is decreasing. So these are all very, very positive signs for the ultra-deepwater market.

Of the major contract drillers, SeaDrill’s management sounded the most bullish about the near-term prospects for the ultra-deepwater market, noting that the company will hold back two newly built rigs in anticipation of higher day rates.

Management teams also regard the recent uptick in permit approvals for deepwater drilling in the Gulf of Mexico as an encouraging development.

Since the Bureau of Ocean Energy Management issued the first post-moratorium deepwater drilling permit on Feb. 28, 2011, and the first permit for new deepwater exploration in March, the agency has struggled to make a dent in its backlog of applications–largely because of a lack of resources. At the same time, the recent spate of approvals suggest that operators have grown accustom to the permitting process and new requirements.

With few ultra-deepwater rigs in the Gulf of Mexico, the region could offer elevated day rates in the near term. Some management teams suggested an acceleration of activity in the Gulf could help the market absorb newly built rigs slated for delivery in 2013–a cloud that had hung over the industry. SeaDrill CEO Alf Thorkildsen was particularly bullish on this score during the company’s conference call to discuss second-quarter earnings:

What I see is that the demand side in 2011 is very strong. That will have a spillover effect into 2012. We see extension of contracts, we see new contracts and most importantly is that there are significant discovery both in Africa and in Brazil particularly which is of interest. We have not seen the effect yet on Gulf of Mexico, but I am also very optimistic going forward into that market. The permits are still not up to the same level as before Macondo, but we see that there is an increase in permits and we know that it is a very prospective deepwater area and I am therefore somewhat more optimistic that we will have a better balance between supply and demand for all the newbuilds in 2013.

Companies also noted that conditions were improving in the market for high-specification jack-up rigs that operate in shallower waters, particularly in the Gulf of Arabia and Southeast Asia. Demand for harsh-environment rigs also remains robust.

In response to these trends, some of the industry’s leading contract drillers have sought to lower the age of their fleets and build their exposure to the ultra-deepwater market through acquisitions and investment in newly built rigs.

Transocean in late August acquired Aker Drilling in an all-cash deal worth $1.46 billion–a 96 percent premium to Aker’s market value. The deal nets Transocean two harsh-environment, ultra-deepwater rigs and two new drillships slated for delivery in 2013. In February 2011, Ensco acquired Pride International for $7.6 billion in cash and stock. The transaction expanded Ensco’s fleet by more than 60 percent and included 21 deepwater units.

Investors should take advantage of recent weakness in the broad market to lock in elevated yields on contractor drillers with the youngest fleets and the most exposure to the ultra-deepwater market. We would steer clear of names with older fleets.

Upcoming Webcast on American Wealth: Under Siege

On Sept. 27, economic experts Roger Conrad and Elliott Gue will be joined by David Dittman to discuss the current global economic situation and provide some investment solutions. To attend this important investment webcast is free of charge, but you must register to access this valuable information. Click here to register!

Meet Elliott at the Summit

Don’t miss out on this unique opportunity to hear Elliott Gue, Roger Conrad, Yiannis Mostrous, Benjamin Shepherd, David Dittman and Jim Fink share their latest insights on the markets and economy. Join these investing experts at Investing Daily’s 2012 Wealth Summit at the luxurious Four Seasons Hotel in Palm Beach, FL on May 4-5, 2012.

With the US economy likely to grow at a lackluster pace over the next few years, expect the stock market to suffer through a period of extreme volatility as investors adjust to the new normal. The EU’s ongoing sovereign-debt crisis will also continue to enervate investors. Throw in “Black Swan” events such as the civil war in Libya, and it’s easy to see why investors are on edge. A fearmongering media that focuses on worst-case scenarios rather than the likely outcomes doesn’t help matters.

But Investing Daily’s 2011 Wealth Summit will give you the edge in these uncertain times. This year’s event will focus on winning investment strategies that generate profits in both up and down markets. To learn more about this must-attend Wealth Summit, go to InvestingSummit.com or call 1-800-832-2330 for more details.

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Here’s what you could miss out on if you don’t add your name to our priority waiting list for new members. Wealth Society subscribers receive every advisory Investing Daily publishes, a treasure trove of market intelligence and profitable insights that will help your portfolio thrive in both bear and bull markets. Members also enjoy personal email and phone access to the industry’s top investing minds and have the opportunity to attend quarterly conference calls and regular dinners hosted by our analysts. The Wealth Society also comes together each year at a luxury resort–an event that’s included FREE with your membership.

To put your name on the priority waiting list for Wealth Society membership, click here or call 1-800-832-2330.

Running with Da’ Bears and Da’ Bulls

Bears and bulls alike are invited to join Elliott Gue and Roger Conrad at the Hilton Chicago Hotel for The World MoneyShow. The events get underway on Oct. 20 and last until Oct. 22. As this new era of investing unfolds, smart investors know it’s imperative to stay informed and educated. Planning to join me in Chicago? Click here or call 800-970-4355 and refer to priority code 023653 to register as a guest of The Energy Strategist.