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Drilling Down : Crude Oil Stocks Buying Opportunity

Companies / Oil Companies Aug 23, 2007 - 07:34 PM GMT

By: Elliot_H_Gue


Investors swamped my email when news hit that some oil crews were “fleeing” the advance of Mean Dean in the Gulf of Mexico.

These investors have seen some hard bounces of late on the Street's “mechanical” bull, looking for good buys to the upside. Most readers asked me the same question: “I'm tempted by the bargains out there, but this is hurricane season. Should I invest in the energy patch right now?”

Yes, the North American hurricane season is just starting and the opening salvo this year is a category 5. But with or without a hurricane hitting the Gulf, there's one energy service sector that can hand you some mighty interesting plays. And if you're looking for under-appreciated bargains, I have plenty for you to consider.

I always alert my readers when it's time to take money off the table and enjoy their profits. But there's also a time to buy. For the energy service companies below – all drillers – I believe the time is now.

Oil & Gas Drilling: By Land and By Sea

If you're a bargain-hunter, opportunities are out there if you know where to look. Last week's selling is handing us some outstanding buys. The long up-cycle in energy and most other commodities isn't complete. Here are some plays to consider right now:

Bargain Driller # One: This is one opportunity I just can't pass up, a recent addition to my Gushers Portfolio. Headquartered in Bermuda with most operations controlled out of Houston, this company is the world's largest contract land driller with a total of more than 600 land rigs operating worldwide. And, it has a small offshore drilling business and manufactures rigs and equipment.

The stock is trading at a valuation level unseen since 2001, when natural gas prices were under $2 per million British Thermal Units (MMBtu) compared to $6 per MMBtu today.

This company has nimble new management with an all-out, re-positioning strategy. They're offloading fringe assets and using the cash to pump up their most profitable, core operations. Right now, this is one of the most under-appreciated stocks out there. But it won't stay under the radar for long.

Around two-thirds of their US rigs are high-specification rigs and many of these were purpose-built for certain producers with particular projects in mind. Some of the hottest natural gas reserves in the US right now include unconventional plays such as the Barnett Shale located near Fort Worth Texas--producing in the Barnett is economical, even at current gas prices.

This land driller's strategy in these hot drilling markets is impressive. The company first agrees to design and build a high-spec rig for a specific purpose and secures a term contract for that rig at an attractive, pre-set day-rate. By securing a multi-year term contract before the rig is even built, the profitability of the rig is locked in

By signing term contracts guaranteeing a day-rate, the driller allows the producer to finance the construction of the rigs. This is the basic strategy the company has consistently used to build up its high-specification fleet. And demand for these fit-for-purpose rigs remains strong -- they have 81 new rigs under construction right now, all with signed term contracts to support profitability. Around 24 of these rigs will go into service by the end of 2007 and 8 additional rigs go active at the beginning of 2008

And management knows that even once term contracts expire, high-specification rigs are easier to contract and sport higher margins than less-capable rigs. That's bad news for some of their competitors with heavier exposure to less cutting-edge rigs.

Bottom line: Their US business is holding up well, supported by a solid foundation of term contracts and high-specification rigs with better day-rate prospects.

But the real shining star is their international operations. Right now, international contracts account for slightly less than one-quarter of the driller's profits. But, management says that operating profits from international operations will actually equal or exceed profits from the Lower-48 States by the end of 2008.

International revenues are on fire. In fact, the driller saw margins rise by $1,000 on average per rig in the second quarter--that's a sign that there's no lack of pricing power abroad. Plus, the company has a number of international contracts scheduled to roll over soon, likely to higher day-rates.

Management has put together a diversified worldwide business with operations in North Africa, Saudi Arabia, Latin America and just recently, Russia. In many of these markets this driller commands the lion's share -- it has the scale and global network to bid on the most attractive international projects. This is an advantage smaller competitors just can't match.

Of course, quality of rigs is even more important internationally than in the US. Since they own the largest fleet of high-specification rigs of any driller, they're well-placed to bid on these lucrative contracts.

The company's international operating income soared 30 percent between the first and second quarter this year; profits rose more than 70 percent over the same quarter a year ago. And management is looking for growth well over 50 percent next year.

The driller has even been able to directly arbitrage US weakness and international strength by taking rigs out of the US or Canadian markets, upgrading them, and putting them to work internationally on term contracts. Ten rigs are slated to do just that between now and the end of the year.

If gas prices recover and drilling activity picks up in North America, their U.S business could easily soar. At a minimum, I see upside to its early 2006 highs over $40 per share.

Also, consider that the stock historically begins to rally in earnest before the rig count starts to recover -- usually around 6 to 9 months before. Thus, a mid-2008 turn for the gas markets implies the stock starts running within the next month or two. This US-based land driller is a buy recommendation in our aggressive Gushers Portfolio.

Bargain Driller # Two: My prediction -- the rates for this European deep water oil driller will top $1 million per day by 2012.

It's perhaps the most-aggressive drilling contractor anywhere in the world today.

Currently, all the company's rigs are out on contracts and earning revenues. But the company's real value isn't the rigs it already has working: It's the newbuild rigs it owns that are scheduled for delivery during the next few years.

The company has a total of two drillships and seven deepwater semis on order--with large, well-known shipyards with a reputation for delivering construction projects on schedule.

The first new rig is scheduled for completion in the fourth quarter of 2007. That rig is signed up on a contract with Total at a day-rate of $480,000 starting in the first quarter of 2008.

Contracts have been secured on a new drillship and semi – beginning in mid-2008 at day-rates of $520,000 and $460,000, respectively.

There's even more potential value in the other uncontracted rigs. There are very few deepwater rigs that haven't yet been contracted between 2008 and 2010. The company owns five deepwater rigs that are scheduled for delivery in 2008 without contracts. That's more rig availability than any other company on Earth.

The point is that this driller has some spare capacity in a market that has none. If you're a producer looking for a rig, this may be your only option. This astute company has zeroed in on the real sweet spot of this supply squeeze.

I also must admire their aggression in what's clearly a very strong contract drilling market. The company says it's interested in making more acquisitions, possibly of a large, US-based driller. The company believes it could target an acquisition of as high as $16 billion by taking on more leverage.

Because of the strong, locked-in revenues coming from contracts, servicing that debt shouldn't be a problem. The stock has actually reacted positively to talk of its role as an acquirer; most believe industry consolidation is desirable longer term in the drilling business.

I'm looking for 50% gains for the stock over the next 12 months.

Bargain Driller # 3 : The growth market for this company remains the Eastern Hemisphere markets such as Africa, the Middle East and Asia. The company's Eastern Hemisphere business posted year-over-year revenue growth of 40 percent, and management reiterated expectations that the level of growth would continue through the end of 2007.

And, they've consistently posted higher growth than their peer group in these key markets.

One service function the company has really pushed internationally is directional drilling. As the term suggests, these are services related to the drilling of non-vertical wells.

Years ago, most Eastern Hemisphere markets could produce prolific oil and gas reserves using simple, cheap, vertical wells, but that's no longer the case. Directional drilling is now becoming the standard. And this company's expertise hands them contract after contract.

And there's more. When asked what the most salient technology for the company this year, their CEO replied solid expandables.

Drilling deep wells can be a challenge because the operator must maneuver through different geological layers. This driller's solid expandables technology offers a solution to this problem.

It's a type of metal casing that can be placed in the well and expanded to fit the shape of the well itself. The entire well can be drilled with very little loss of diameter. This is another high-tech service function that's in high demand right now, and this company has a very real competitive advantage.

Oil reserves are getting more and more difficult, expensive and complex to produce, requiring far-more-advanced technology. This company's expertise fits well with this theme. They're in a privileged position to profit from servicing mature and production-challenged wells worldwide.

In my Wildcatter's Portfolio, this stock is up 12% in the last four months (40% annualized).

Bargain Driller # Four : When it comes to deepwater activity, my canary in the coalmine is this firm that has owned and operated five generations of rigs since the '70s, with a sixth generation under construction. Companies like ExxonMobil and Chevron pay a handsome day-rate for leasing its rigs.

Day-rates for advanced offshore rigs can be close to or more than $600,000 per day in the current market. To make a long story short, the company owns 42 semis and 13 drillships; more than its closest competitor. Moreover, their rigs are by far the most advanced.

Even better, the company's newbuilds — newly-built rigs that are mainly still under construction--are also contracted. As soon as the newbuilds leave the shipyard, they're headed out to start working on signed, guaranteed contracts. Moreover, when this company decides to build a new rig, it first secures a contract on that rig. This policy also reduces risk.

The other point to consider is the fact is that this company is continually setting new record day-rates for deepwater rig contracts, double or more what they were just a few years ago. Even their newbuilds are getting contracts at sky-high day-rates despite the fact they're not scheduled for delivery for another year or two.

This company has more than $21 billion in backlogged day-rate revenues over the next eight years. These are all firm, signed contracts that are unbreakable. That figure includes more than $5 billion in signed, contract revenues for both 2007 and 2008.

The company tells us that most of its high-spec rigs are booked solid through 2008 with only very limited capacity in 2009. Management is not "overly anxious to contract" these rigs.

They're simply making the bet they can sign up the last few rigs at even higher day-rates by waiting for producers to become really desperate for rigs. So far, this bet has most certainly paid off.

For instance, the company contracted a third generation rig in the North Sea earning a day rate near $400,000, up from less than $150,000 per day on the current contract. And finally, they rolled another North Sea third generation rig contract over at $350,000 per day, roughly 75 percent higher than the same rig is currently earning.

Bottom line: The company just inked a deal to expand its fleet of rigs dramatically while handing shareholders a gigantic special dividend. As the company rolls over legacy contracts to newly-agreed contracts at sky-high rates, earnings will rise. This company's growth is locked in for years to come.


By Elliott H. Gue
The Energy Letter

© 2007 Elliott H. Gue
Elliott H. Gue is editor of The Energy Letter , a bi-weekly e-letter as well as editor of The Energy Strategist , a premium bi-weekly newsletter on the energy markets. Mr. Gue is also associate editor for Personal Finance , where he contributes his knowledge of the energy markets.

Mr. Gue has a Master's of Finance degree from the University of London and a Bachelor of Science degree in Economics and Management from the University of London , graduating in the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that university.

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