Small Driller a Wellhead of Profits

10/05/2011 7:30 am EST

Focus: STOCKS

Ian Wyatt

Publisher & Chief Investment Strategist, Wyatt Investment Research

There remain large untapped reserves of oil and gas in North America, and despite weakness in the market and energy in particular, there are still solid fundamental reasons to be energy investors, writes Ian Wyatt of SmallCapInvestor.com.

According to oil-services company Baker Hughes (BHI), which has been keeping tabs on all types of drilling activity since 1944, there are now 1,974 oil rigs operating in the US as of August 19, an increase of 323 from this time last year. Canada has seen its rig count increase by 107, to 486 rigs, over the past year.

Investors who own a portfolio of US-listed, land-based oil exploration and production stocks will be well positioned to match investment gains with increases in the price of oil.

Think about it—if oil prices are going higher over the long term, don't you want to own part of the companies that produce and drill for the oil? If this logic makes sense, than now is a good time to be looking around for stocks to begin positions in.

My favorite strategy is to own shares of several companies, from big to small, including both production and drilling companies.

One of my favorite small-cap stocks is Patterson-UTI Energy (PTEN), a land-based driller that pays a small dividend of just over 1% at the current share price.

Concerns over limited oil production capabilities in the Middle East point directly toward the growing importance of domestic energy production.

The Obama administration, just like every administration before, appears adamant that domestic energy production must grow. While there remain concerns about the future of offshore oil exploration in the wake of the BP (BP) disaster, land-based drilling for oil and natural gas remains a sector likely to see continued growth.

Patterson UTI Energy is a Texas-based company that drills onshore wells for other companies that are exploring for oil and natural gas.

Think of Patterson UTI as a hired gun. Unlike oil and gas exploration companies, Patterson UTI doesn't have exploration risk. Instead, the company is hired by exploration and production companies to drill oil and natural-gas wells. The company gets paid an agreed upon rate per day of drilling services, whether its clients hit pay dirt or not.

Patterson UTI, with a $2.9 billion market capitalization, owned 341 land-based drilling rigs at the end of 2010. This made the company the second-largest operator in the US.

The company offers well-drilling services in many of the most promising regions for domestic oil and gas production, including the Bakken Shale, The Marcellus Shale, and the Eagle Ford.

This company benefits when demand for rigs outpaces supply, which results in higher rig-utilization rates and increased contract fees. You see, companies like Patterson lease their rigs for a flat fee per day—known as "day rates." When demand for rigs is up, Patterson can raise its rates.

With the price of crude oil recently between $80 and $100, demand for land-based drilling has been increasing. This is a big positive catalyst for Patterson UTI, which was able to generate $21,000 per rig per day in the most recent quarter.

Not only is Patterson UTI raising rates, but it's also growing the number of operating rigs. Over the last year it has increased its rig count by 50, to 215 rigs, in the United States and Canada.

While growing the average billable rate has been a boon to Patterson UTI, the company also benefits from the stability offered by long-term contracts. During 2011, roughly 40% of the company's rigs will be under long-term contracts. While these contracts limit the upside opportunity from increased day rates, they do provide safety and security to the company since this commitment guarantee revenues.

I think a fair value for the stock today is $30. With this much upside to the stock, Patterson UTI looks quite attractive. [The stock has fallen with the rest of the market, from well above $20 to under $16 at midday Tuesday—Editor.]

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