Crying Over Spilled Oil

06/21/2010 2:45 pm EST

Focus: STOCKS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

Jack Adamo, editor of Jack Adamo’s Insiders Plus, finds two oil-services providers unfairly tarred by the BP disaster.

I’m split on the energy sector. On the one hand, I have no doubt that the price of oil has been held artificially high by paper trading rather than demand. That’s a dangerous situation, because if the psychology changes, that can reverse with a vengeance as all those paper hangers go short.

On the other hand, the oil spill in the Gulf of Mexico has knocked prices for a loop on many stocks that have no liability there, based solely on the premise that the six-month freeze on deepwater drilling will hurt the sector. There are a number of stocks that have fallen 30% to 50%, primarily due to that factor, although some have other lesser problems as well.

There’s good news and bad news about Diamond Offshore Drilling (NYSE: DO). The good news is that it is down 44% in the last few months; it’s selling for less than eight times expected earnings; it has no exposure to oil spill liabilities (earlier mistaken reports said that it did); company management has been very savvy and frugal in the past, and it has a hefty dividend.

The bad news is that the dividend is variable; the company has one of the older fleets of rigs in the industry; newer built rigs will be coming on line in the next few years from competitors; some projects will be delayed due to the moratorium on deep water drilling, and some of its drilling contracts (probably three or four) will be subject to force majeure. That is, they may be cancelled due to circumstances beyond the contractor’s control, namely the drilling moratorium.

Still, no one in his or her right mind thinks that the drilling ban will be permanent. As much as I’d like to see cleaner energy meeting more of our country’s needs, the simple fact is it cannot possibly happen quickly enough to make banning drilling practical in the Gulf. All in all, I think we have a good chance to make 10-15% with this stock in a month or two, with downside risk in the range of only 7-10%. It isn’t a great risk-to-reward profile, but it’s a good one, and I believe the timing is right. Buy Diamond Offshore Drilling up to $64.

In the same sector we have Oceaneering International (NYSE: OII). The company makes equipment, primarily ROVs (remotely operated vehicles) for use in building and maintaining deepwater drilling rigs. The shares are down 33% in the last month or so based on the supposition that the drilling moratorium will hurt this year’s earnings, as well as its long-term prospects. While the first assumption is probably correct, the second one could very well be dead wrong. As I asserted earlier, I doubt deep water drilling will be banned. More likely, it will resume with far more stringent safety measures. It seems logical that such measures would require the use of the kind of equipment Oceaneering provides. If I’m right, these shares have very solid upside potential—perhaps 20-30% over the next few months, as new regulations become known and the procedures needed to achieve compliance become apparent. Buy Oceaneering International up to $50.

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