Oil services stocks have endured a tough run over the past year. The Philadelphia Stock Exchange Oil Service Sector Index (OSX) has given up 9.3 percent over the trailing 12 months, compared to the S&P 500’s 3.7 percent gain.

The OSX hit its 52-week high in early April 2011–about a month before the S&P 500 reached its peak–and posted its biggest losses between early August and early October, when concerns about the global economy were at a fever pitch. This trading pattern hardly comes as a surprise: Investors have long regarded oil services stocks as cyclical names that underperform when economic growth slows.

But this latest pullback reflects market perception rather than business realities. Consider trends in the US (left-hand axis) and international rig counts (right-hand axis), which measure the number of active drilling units.

Source: Bloomberg

Oil and gas producers slashed drilling activity sharply between late 2008 and mid-2009 because the credit crunch and global economic downturn sent oil prices plummeting to less than $40 per barrel. But the rapid recovery in US and international drilling activity has surprised many analysts. Today, the US rig count hovers around its peak, while the international rig count has eclipsed its 2008 high.

In other words, producers have expanded their drilling programs since the boom of summer 2008, when oil fetched almost $150 per barrel and natural gas prices hovered near record highs in both the US and international markets.

Oil services firms’ earnings are sensitive to commodity prices: Higher oil and gas prices incentivize exploration and exploration (E&P) companies of all sizes to invest in finding and developing oil and gas fields.

At current levels, oil and international gas prices continue to support investment in exploration and production.

Source: Bloomberg

The price of West Texas Intermediate crude oil has rallied from year-ago levels, while Brent crude oil remained above $100 per barrel despite concerns about global economic growth and the ongoing EU sovereign-debt crisis.

At the same time, North American natural gas prices have tumbled to record lows this winter, a downdraft that I predicted in Step Off the Gas. We expect North American natural gas prices to remain depressed for at least the next two to three years, as frenzied drilling activity in the nation’s prolific shale oil and gas plays should keep the market oversupplied.

However, supply and demand conditions are far more sanguine in international markets. Demand for natural gas remains elevated after the Fukushima Daiichi disaster. Most of Japan’s nuclear power plants are still off-line, while Germany has accelerated plans to shutter its reactors. To keep the lights on, both nations will need to step up imports of natural gas.

As you can see, London-traded natural gas futures have pulled back from their 2011 high but still trade at almost four times North American natural gas prices. In Asia, rising gas consumption in China and Japan has pushed the spot price of liquefied natural gas well into double digits.

Against this backdrop, exploration and production companies of all sizes have expanded their capital budgets for 2012–a huge tailwind for oil services companies.

Nevertheless, shares of the Big Four services companies–Halliburton (NYSE: HAL) and Growth Portfolio holdings Baker Hughes (NYSE: BHI), Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT)–have lagged since spring 2011 and trade at multiples that are more appropriate for a recession.

Source: Bloomberg

This graph tracks the average price-to-book value for the big four services firms over the past decade. To facilitate comparison, the graph includes lines that are one standard deviation above and one standard deviation below the group’s mean price-to-book ratio. These standard deviations roughly delineate when shares of the Big Four are undervalued or overvalued.

Although all four stocks have appreciated substantially from their 2009 lows, the current price-to-book ratio is on par with valuations last seen in late 2008 and early 2009, when oil prices plummeted to less than $40 per barrel and producers slashed spending on new projects.

During the 2004-08 bull market for energy commodities, shares of the Big Four often traded at roughly five times book value. The stocks would need to more than double in price to reach this valuation.

At these levels and at this stage in the cycle, shares of the Big Four appear grossly undervalued. But valuation alone is poor justification for an investment: Some stocks are inexpensive for a reason, and as John Maynard Keynes famously wrote, “The market can remain irrational a lot longer than you can remain solvent.”

Shares of the Big Four need a catalyst that will attract investors. Industry fundamentals have improved, but investors continue to shun cyclical names in these uncertain times. Although the EU continues to take two steps backward for every one step forward in addressing the sovereign-debt crisis, policymakers appear to understand the risk to the global economy and ultimately should move to stabilize the situation in the fiscally weak Club Med nations.

Such a development should prompt investors to emphasize the realities of a strengthening US economy, a Chinese economy on course for sustainable growth and a tightening supply-demand balance in global crude oil markets. All these factors should precipitate a re-rating of the Big Four and other hard-hit energy names.

During each quarterly earnings season, The Energy Strategist scrutinizes the Big Four’s results and subsequent conference calls. Due diligence is a big part of this routine: The Growth Portfolio includes exposure to three of the Big Four services firms, a positioning that stands to benefit over the long term from the end of easy oil.

The investment thesis is simple: Emerging economies continue to drive global oil demand to new highs, while production from the world’s largest and cheapest-to-produce fields continues to dwindle. As these fields mature, E&P firms must target reserves in shale formations, the deepwater and Canada’s oil sands to offset declining output. Extracting oil from these complex fields requires much more spending on services and equipment than flowing crude from Saudi Arabia’s giant Ghawar field.

Equally important, the Big Four services firms operate in oil- and gas-producing regions throughout the world, providing them with unparalleled insight into developing trends in the energy patch. Three key themes emerged during Baker Hughes, Halliburton and Schlumberger’s recent conference calls to discuss fourth-quarter results.

• Uncertainty in North America. Halliburton’s relatively weak showing in the fourth quarter raises questions about whether drilling activity and profit margins in North America will moderate after several blowout years.
• International recovery? E&P activity has accelerated in international markets, but intensifying competition between the Big Four kept a lid on pricing power in 2011.
• Deepwater Growth. The discovery of massive fields in the deepwater has increased demand for drilling rigs, services and equipment. All three management teams indicated that deepwater activity is poised to accelerate.

In this issue, we’ll explore each of these themes and highlight related investment opportunities.

The Stories

1. With natural gas prices likely to remain depressed for at least the next two to three years, producers have scaled back drilling in the Haynesville Shale and other dry-gas plays in favor of the Eagle Ford Shale and other liquids-rich basins. The implications of this strategy shift for overall drilling activity and margins on pressure pumping are unclear at this juncture. See Whither North America?

2. Although the international rig count remains elevated and oil prices support developmental drilling, intense price competition on large-scale projects has limited margin growth for oil services firms. See Over There.

3. The boom in deepwater drilling should pay off for these Portfolio holdings. See Going Deep.

4. Elliott drops three stocks from his Best Buy list and adds four new names. These picks are his favorite stocks in the current environment. See Best Buys.

The Stocks

Baker Hughes (NYSE: BHI)–Hold in Growth Portfolio
Schlumberger (NYSE: SLB)–Buy < 100 in Growth Portfolio
Weatherford International (NYSE: WFT)–Buy < 17.50 in Growth Portfolio
Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY)–Buy < USD17.50 in Aggressive Portfolio
SeaDrill (NYSE: SDRL)–Buy < 45 in Aggressive Portfolio
Pacific Drilling (NYSE: PACD)–Buy < 11 in Aggressive Portfolio
Mid-Con Energy Partners LP (NSDQ: MCEP)–Buy < 24 in Growth Portfolio
Diamond Offshore Drilling (NYSE: DO)–Cover Short for 6.3% Loss in Hedges Portfolio
Knightsbridge Tankers (NSDQ: VLCCF)–Hold in Aggressive Portfolio