Drilling For Dollars

Mar 19, 2007 (From SmartMoney via Dow Jones Newswires)

[Oil prices have been swinging wildly, but profits at the companies that help produce the stuff are going one way only: up. Why it's time to buy oil drillers.]

IN LATE 2006, AS THE PRICE OF A BARREL OF OIL WAS NOSE-DIVING from the high $70s to the low $50s, Roger Plank and other executives at Apache, the country's largest independent oil producer, revised their 2007 prediction for oil prices down to $55, from $60, a barrel. How much confidence does Plank have in the newer figure?


"Over 50 years in the business, you learn you can't really call it that close," says Plank, Apache's chief financial officer and son of the firm's founder. But whether oil is $70 or $40, Plank estimates Apache will spend more than $4 billion on drilling this year, up from $1.3 billion five years ago.

The big price swings in oil lately may be making some people nervous, but they're creating a timely opportunity for investors -- in the companies that build the rigs and actually drill for the stuff. Indeed, the roller-coaster ride in prices has knocked shares in the oil-services sector down 5 percent since July, even as the broad market has moved up sharply. And yet, the long-term prospects for many of these firms are very strong. Like Apache, all of the big oil producers are pouring billions into new exploration, and the search for black gold will only continue: According to the U.S. Department of Energy, at current prices oil demand could rise by 38 million barrels a day by 2030, an amount greater than the entire current production of the Middle East.

Of course, a worldwide recession would slow the growth of energy consumption, hammering all energy-related stocks in the short term. But even the Energy Department's gloomiest scenario shows demand continuing to grow. And for now there's no slowdown in sight.

Price volatility will continue, with growing demand in emerging markets, war in the Middle East and political unpredictability in big oil-producing nations such as Nigeria and Venezuela all playing a role. Big investors, too, are increasingly roiling the market with multibillion-dollar bets on the direction of energy prices. The number of hedge funds investing in the energy sector has tripled, to 542, in the past two years alone, says Peter Fusaro, chairman of Global Change Associates, a hedge fund research group. These investors trade oil and natural gas futures based on short-term factors, like weekly oil inventories, attacks on gas pipelines, even the weather. And because they tend to buy or sell en masse, the price of the underlying commodity often swings to extremes.

Since oil prices peaked last summer, the entire energy sector has struggled. But the long-term profit picture for many of the companies in this group remains unchanged, making for some attractive bargains. To capitalize on this continued push for energy, SmartMoney looked for the stocks best positioned to benefit from the billions spent searching for ways to satisfy the world's lust for fuel. That meant avoiding some of the biggest winners of the past few years, pure-play natural gas and coal producers. After three years of drilling and reasonably mild winters, U.S. natural gas inventories are nearly 20 percent above their five-year average, easing a fear of a natural gas shortage and lowering prices. Meanwhile, the U.S. has no shortage of coal. And while the shares of the companies that mine the stuff have pulled back over the past year after a sharp runup, their valuations are not particularly attractive.

We did, however, look at oil-exploration firms, especially smaller ones probing areas like the Caribbean and the Caspian Sea for new oil supplies. We searched for equipment firms that will create oil platforms and environmentally friendly power plants. Finally, we couldn't overlook one giant oil company whose stock is ridiculously cheap. The resulting five energy stocks, which are, not surprisingly, all based in and around Houston, should fuel a portfolio regardless of the latest blip in the price of crude.

Noble (NE, $72)

TO TRACK THE STRATEGY of leading offshore driller Noble, follow the course of one of its largest vessels, the Noble Homer Ferrington. The 254-foot-long, 225-foot-wide, 80-foot-tall floating oil rig is a behemoth with the ability to drill through 30,000 feet of rock in water up to 6,000 feet deep. From 1985, when it was built, until 2004, the Homer Ferrington was stationed in the Gulf of Mexico. But in 2004 the ship was rebuilt and sent 6,500 miles away to the coast of Nigeria. Exxon Mobil now pays Noble $128,000 a day to have the vessel and its crew drill there. As of January the Homer Ferrington was one of seven Noble vessels floating off the coast of West Africa.

Four years ago Noble had 18 of its 49 vessels in the Gulf of Mexico; now it's just nine out of 60. This flexibility has been incredibly profitable for Noble, as the rates it can charge companies for its vessels have shot up even faster abroad than they have in the Gulf. Noble's net income rose 337 percent, to $725 million, last year, from $166 million in 2003. Clearly, some of that huge gain in profit came from higher oil prices, which boosted demand for Noble's services. But many oil-services-company analysts, such as Deutsche Bank's Mike Urban, credit management's savvy decision to move some rigs out of the Gulf with much of the firm's success.

Though some investors worry that many of the firm's rig contracts will expire this year, all but one of the new contracts Noble has announced have been for a higher rate. For example, Exxon's 37-month deal for the Homer Ferrington ends on Dec. 31; Anadarko will take over the rig on Jan. 1, 2008, paying $433,000 a day -- more than triple the old rate.

For 2007 analysts expect Noble to earn $1.2 billion, or $8.98 a share, up 68 percent from the $5.35 a share it made last year. Yet it still trades at eight times expected earnings. What's more, in early February, Noble's board upped the company's share-repurchase plan to 15.3 million shares, or 11 percent of the outstanding stock, which could further enhance earnings.

Rowan (RDC, $31)

LIKE NOBLE, ROWAN HAS been opportunistic in deploying its fleet. Two years ago all but two of the company's 19 drilling rigs were floating in the Gulf of Mexico. Danny McNease, Rowan's chief executive, felt his firm was both overexposed to the highly competitive market and missing out on some golden opportunities worldwide. So McNease reshuffled the deck.

This spring eight of the rigs will be in the Middle East, an area Rowan hasn't worked in since 1981. Three rigs will be in the North Sea, and another is going to Trinidad. While day rates have flattened out in the United States, they continue to rise in almost every other part of the world. When two of Rowan's rigs start drilling operations off Saudi Arabia soon, the company will collect about $190,000 a day, on average, for the next four years. That's a much higher daily price than what Rowan gets on most of his current deals for vessels in the Gulf.

The new locales should work wonders for Rowan's earnings. Last year Rowan earned a record $311 million, or $2.82 a share, on sales of $1.5 billion. Analysts expect revenue to reach $2 billion this year, with earnings rising 66 percent to $4.68 a share. Now Rowan has a fleet of 21 offshore rigs, with three more to be delivered between now and 2009. The Houston-based firm also has another 24 land-based rigs and a small but growing rig-construction business.

The stock market, however, remains skeptical. Shares trade at less than seven times 2007 earnings estimates. To be sure, Rowan's rigs needed some refitting before their new assignments, and downtime at the dock means no revenue coming in and higher costs to make changes to the rigs. But McNease told investors all the rigs will be deployed this spring, and higher costs associated with the refitting work will fall back to normal by year's end. Deutsche Bank's Urban says the stock could reach $40 within 12 months.

Diamond Offshore (DO, $80)

DIAMOND OFFSHORE specializes in drilling in depths where you might find Captain Nemo and the Nautilus. Thirty of Diamond's 46 vessels are "semisubmersibles," rigs that drill in waters from 1,000 to 7,500 feet deep. By contrast, Noble has only 13 vessels that drill in deep waters, and Rowan has none. Diamond has a 22 percent worldwide share of semisubmersible rigs.

Deep-water rigs are in high demand these days, as steep energy prices have sent oil companies to deeper waters in search of crude. These projects, off the shores of India, Indonesia and China, as well as in the Gulf of Mexico, continue to make financial sense as long as oil stays above $40 a barrel. Almost half of Diamond's $2.1 billion in 2006 revenue came from deep-water contracts, so the biggest risk for the company is that oil prices fall below the $40 mark, which few believe is likely.

This year analysts expect earnings to grow 66 percent to $1.1 billion, or $8.48 a share, from $661 million, or $5.12 a share, last year. And Diamond sports a very attractive 2007 P/E of 9. Diamond's low P/E has inspired speculation that it could be acquired by either private-equity investors or a foreign oil-services firm.

Some investors worry about the amount of maintenance work Diamond's fleet will face in 2007. In February the company estimated its 46 vessels will have a combined 915 days of downtime in 2007, about 5 percent of the total possible workdays, and a few days higher than Diamond estimated a month earlier. But it's hard to quibble with a lost day or two when earnings are expected to grow 66 percent this year and the valuation is so cheap.

Diamond's management is not acting as if the downtime will hurt its financial position, either. In late January the firm declared a $4 special dividend, giving back more than $500 million in cash to shareholders. Kevin Shacknofsky, portfolio manager for the Alpine Total Dynamic Dividend fund, says that in addition to its small regular dividend, Diamond could pay $30 worth of special dividends over the next five years. So even if the stock didn't move off its current $80 price in that time, an investor would earn a nice 38 percent return.

McDermott International (MDR, $52)

McDERMOTT STARTED OUT erecting wooden oil rigs for mavericks trying to strike it rich in East Texas in the 1920s. Nearly a century later, the company is at the center of another energy boom, building multimillion-dollar platforms and pipelines for oil companies and constructing environment-friendly power plants for utilities.

McDermott's $1.5 billion rig and platform-construction business has ongoing projects from India to Australia. Sales jumped 27 percent in 2006, and analysts expect this business to grow even faster this year. Since December the firm has announced new projects to build an undersea pipeline in the Caspian Sea and expand existing oil-exploration facilities in Qatar.

Whether McDermott's oil-related construction business continues growing quickly past 2007 is subject to how fast exploration continues to expand. But its power-plant business has a lot of staying power, says David Spika, investment strategist for the top-performing Westwood family of funds. Utilities are in a rush to comply with tougher emissions standards at coal-fired power plants. That means utilities are either building new plants or installing new boilers and scrubbers to clean up emissions in existing plants. And the rush to build power plants isn't limited to the U.S. McDermott is a major contractor on coal-fired plants in China, says Stephen Gengaro, an oil-and-gas-services analyst at Jefferies & Co. The power-plant business could bring in $2.2 billion in sales in 2008, Gengaro estimates, a 29 percent jump from the $1.7 billion in sales in 2006.

McDermott has a third unit that operates nuclear-powered facilities. While nuclear power is hardly a growth business in the U.S. -- the last commercial nuclear facility came on line in 1985 -- McDermott brings in a steady $500 million in revenue managing several nuke-powered facilities for the U.S. government, including the Los Alamos National Laboratory and the Argonne National Lab. Last year McDermott got certified to do work at U.S. commercial nuclear plants, allowing it to repair the 103 existing plants or eventually build new ones.

ConocoPhillips (COP, $67)

CONOCOPHILLIPS IS the Rodney Dangerfield of energy stocks: No matter how well it performs, it gets no respect. This year the company is poised to earn almost $15 billion in profits, pay $2.7 billion in dividends and buy back $4 billion in stock. Yet the stock trades at just eight times this year's expected earnings.

While ConocoPhillips is a perennial SmartMoney favorite -- we've recommended it twice in the past 18 months -- investors always seem to find plenty of short-term reasons to dislike the stock. (The shares are up, though only marginally since we picked them each time.) Investors worry falling commodity prices will make Conoco's profits evaporate. And if it's not prices that are troubling, then it's the company's declining proven oil reserves. And if it's not the declining reserves, it's that Conoco's most promising future reserves are coming from politically dodgy places such as Venezuela and Russia. But investors are letting short-term worries overshadow a bargain price for a company that mints money. Whether oil rounds up to $100 a barrel or dips down to $40, Conoco, the nation's third-largest integrated energy firm, will make money because it currently produces the equivalent of 2 million barrels of oil and can refine another 2.7 million barrels daily.

And even if oil did fall to $40 a barrel and natural gas to $4 per million cubic feet (they are now $58 and $7, respectively), Conoco would make nearly $12 billion in profit this year, says Oppenheimer oil analyst Fadel Gheit. In that unlikely scenario, Conoco would have a P/E of 9.

Granted, because of lower gas and oil prices, Conoco's earnings likely will not match 2006's record profit of $16.2 billion, or $9.84 a share. But analysts still think Conoco will make more than $14.3 billion, or $8.69 a share, in 2007. And expect the company to be a buyer of its own shares. It bought back $925 million worth in 2006 and recently announced that it would buy back $4 billion more. "It's a diversified business, it's very cheap, and it's a company that makes a lot of sense to us," says Spika. We agree.

Copyright (c) 2007 Dow Jones & Company, Inc.

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