Drilling for Dollars

01/05/2007 12:00 am EST

Focus:

Steven Lord

, FINalternatives

We would like to welcome Steven Lord to the pages of the Digest. A widely-experienced analyst and editor, Steven's comprehensive research is always a treat. Here, he makes his case for the continued performance in the oil sector...

"The offshore drilling and drilling service companies should see the greatest earnings leverage next year (and where stock prices have not yet reflected it), resulting in significantly below-market P/E ratios. Moreover, I think earnings estimates in many cases are too conservative, based on contracts we see being signed this year.

"Integrated oil companies like Chevron are drilling holes everywhere they can in a worldwide hunt for more oil, and the majority of the most promising prospects lie offshore, creating a low-density, high-demand situation for offshore drilling rigs. By early 2006, every capable oil rig in the world was in use, and every major oil firm had a backlog of new wells awaiting one.

"Spending by major oils is expected to jump by at least 9% in 2007. Meanwhile, with oil firmly perched over $60, offshore drilling contractors are able to significantly raise their prices (called "day rates") as their rigs come off prior multiyear contracts. And new rigs under construction won't be ready until 2008 at the earliest, meaning capacity is limited right when demand is the highest. Note, too, that drilling contracts cannot be broken merely due to a drop in the price of oil.

"The stock market has not yet fully discounted the extraordinarily strong operating environment. Stick with small- and mid-cap names, since this is where the earnings leverage from rising prices is the greatest. Hercules Offshore (HERO NASDAQ GS) is a small company with nine jack-up drilling rig platforms that boasted a 99% utilization rate last quarter. But the company is also a specialist in so-called liftboats (mobile platforms that can come alongside a rig and do maintenance and other services). This is crucial, since every day a rig is out of service means hundreds of thousands of dollars to the operator, making "repairs on the fly" literally standard procedure. With 43 liftboats and a 40% market share, HERO is the dominating force in this critical subindustry.

"In the third quarter of 2006, HERO's average day rate jumped to $12,641--133% higher than at the same time last year. 2005 earnings of $1.13 per share should reach at least $3 per share in 2006 and $4.83 in 2007, while the firm's expected five-year growth rate is over 40%. At current prices, the stock trades for only 11 times trailing earnings, a mere six times 2007 consensus estimates, and for a PEG ratio of 0.3."

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