Gushing Revenue for Drillers


By Stewart Glickman Tucked into the new Energy Policy Act of 2005, signed into law by President Bush on Aug. 8, is a provision that could benefit oil and gas drilling outfits.

Under the new legislation, drillers, who pay the government royalties when they produce oil and gas, will see additional relief from those royalties -- i.e., Uncle Sam will get a smaller portion -- for deepwater and ultradeep gas production in the U.S. Gulf of Mexico. The upshot: The new law could provide a greater incentive for these companies to drill new wells.

While we would note that the extent to which such relief will be incremental to existing royalty-relief programs is unclear, we are maintaining our positive outlook on the drilling subindustry.

RECORD FEES. Our assessment stems from extremely high oil and gas prices, production declines for existing wells, rising day rates (daily rig-operating fees charged to customers) for contract drillers, and high rates of rig utilization. We think that capital spending will remain high, particularly in international regions with low-cost drilling opportunities.

We believe drillers may see more of an upside even after a remarkable run thus far in 2005: Through Aug. 5, the S&P Oil & Gas Drilling index had advanced 37.6%, vs. a 1.8% gain for the S&P 1500 index.

Onshore North America has seen a number of land drillers generate record day rates and daily margins in 2005. We attribute the high day rates in part to a significant scarcity of available drilling rigs.

MIGRATING RIGS. With oil and gas producers concerned as much about rig availability as pricing -- and expectations that rig demand will remain high in the near future -- there recently has been increasing interest for long-term deals that secure rigs for up to three years. In some cases, land drillers are embarking on programs to build new rigs in exchange for such long-term commitments.

In the Gulf of Mexico, day rates are on the rise due to a combination of high demand and tight supply. With the migration of rigs to other regions around the globe, such as the Middle East, day rates will continue gaining, we believe. Information from ODS-Petrodata, an energy data and consulting firm, indicates that average day rates for 300-foot independent-leg cantilevered jack-ups (a type of mobile offshore drilling rig) hit more than $65,000 per day in July, 2005, up more than 30% from the beginning of the year.

Day-rate gains for semisubmersible rigs (floating offshore drilling units whose pontoons and columns, when flooded, cause the unit to submerge to a predetermined depth) have been similarly impressive, with average day rates up more than 40% since the beginning of the year.

DEPLETION EXPECTED. The GSF Celtic Sea, a 4th-generation semisubmersible owned by GlobalSantaFe (GSF

; recent price, $47) and capable of drilling in 5,750 feet of water, recently signed a one-year contract to commence in September, 2006, at a rate of $325,000 per day -- compared to a previous contract high of $175,000 per day.

Internationally, supply-demand fundamentals look very strong in the Middle East, West Africa, and the North Sea, where we think demand could exceed supply in 2005. Russia should see strong growth, although we think concerns over potential supply disruption and political issues make this a higher-risk region.

Over the longer term, we expect demand for drilling services to increase. In the U.S., we believe high depletion rates for existing oil and gas fields and increasing demand for natural gas will continue to support healthy drilling activity, both on land and offshore.

HOT INVESTMENTS. Internationally, we expect additional spending by major oil companies, as well as by state-owned oil companies, to serve as the main growth driver for drilling, as they continue to search for low-cost opportunities, mainly in new regions around the world. Planned building activity for new drilling rigs is modest, but rising, with 30 to 35 new jack-up rigs currently anticipated in the next several years.

Where does S&P see opportunity for investors among the drillers? Our top names in the group include GlobalSantaFe and Nabors Industries (NBR

; $67), both of which are ranked 5 STARS (strong buy), and Noble Corp. (NE

; $69), which carries a 4 STARS (buy) opinion.

Glossary

S&P STARS: Since January 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.

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A+

Highest

B

Lower

A

High

C

Lowest

A-

Above Average

D

In Reorganization

B+

Average

NR

Not Ranked

B-

Below Average

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Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.

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Analyst Glickman follows shares of oil and gas drilling companies for Standard & Poor's Equity Research Services


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