Markets & Finance

Oil Drillers: Well-Positioned for Gains


S&P says the group's fundamentals are solid and its stock price momentum has improved. Among the top plays: Noble

From Standard & Poor's Equity ResearchThe Standard & Poor's 1500 Oil & Gas Drilling subindustry index has seen an improvement in its rolling 12-month price performance over the past few weeks (see accompanying chart). For the week ended Aug. 24, the index jumped 4.4%, vs. a 2.4% snap back for the S&P Composite 1500 index, which consists of the large-cap S&P 500, MidCap 400, and SmallCap 600 indexes. Year to date through Aug. 24, the subindustry index gained 20.3%, vs. a 4.6% climb for the S&P 1500.

On Aug. 21, Stewart Glickman, S&P's energy sector group head and oil and gas drilling analyst, reiterated his positive fundamental outlook on the subindustry index despite the arrival of Category 5 Hurricane Dean to the Yucatan peninsula. "Although we see some hurricane risk to drillers with rig assets located in Mexico's Bay of Campeche, we believe that secular demand for drilling rigs, especially offshore and overseas, remains strong, and we expect further day-rate gains and strong utilization through 2008," he wrote in a research note.

S&P's positive outlook for the group is based on anticipated favorable industry conditions and its view that capital spending will remain high, particularly in international regions with low-cost drilling opportunities. Internationally, Glickman thinks supply-demand fundamentals are strongest in the North Sea, the Middle East, West Africa, the Mediterranean, and India, where he thinks strong demand from major oil companies and nationalized oil companies and tight rig supply are contributing to rising day rates (i.e., daily rig rental costs charged to customers). S&P sees more modest growth in day rates in South America and the Asia Pacific region.

Beginning of a Slowdown Stateside

In North America, both onshore and offshore drilling rigs have seen some slippage in day rates in 2007—after three years of large gains—but Glickman thinks day rates have begun to stabilize, more so for premium equipment. Onshore North America has experienced the beginnings of a slowdown, notes Glickman, but he believes rising demand for unconventional natural gas plays will support rig demand and prevent day rates from falling too far in the second half of 2007.

Offshore in the U.S. Gulf of Mexico, recent day-rate weakness has been largely confined to jackup rigs (mobile offshore rigs capable of working in water up to 400 feet deep); S&P believes strength overseas will induce further rig migrations and lead to a slight uptick in day rates after significant declines. The U.S. deepwater and midwater markets for semisubmersible rigs (i.e., floating offshore drilling units) continue to improve, with recent contracts at extremely high day rates.

Over the longer term, Glickman expects demand for contract drilling to increase. In the U.S., he believes high field depletion rates and increasing demand for natural gas will continue to support healthy drilling activity. Internationally, S&P expects additional spending by major oil companies and state-owned oil companies to be the main growth driver for drilling, as they continue to search for low-cost drilling opportunities, mainly in less mature regions.

Plenty of Price Appreciation Potential

The number of rigs either under construction or on order has increased to 139, comprising 79 jackups, 42 semisubmersibles, and 18 drillships (i.e., self-propelled floating vessels); of the 139 rigs, 115 are currently under construction, with 14 due for delivery in the second half of 2007 and 56 more in all of 2008. However, some of these rigs are being built without contract commitments, so it remains to be seen how quickly they will become operational.

As of late July, Global Insight projected prices for the benchmark West Texas Intermediate grade of crude oil averaging $62.94 per barrel in 2007, with the U.S. benchmark natural gas price averaging $7.66 per million British thermal units.

So there you have it. Based on the subindustry's solid relative strength, combined with favorable overall fundamentals, S&P believes the group has additional price appreciation potential. S&P's top pick in the group is Noble (NE), ranked 5-STARS (strong buy).

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (i.e., price performances in the past 12 months that were among the top 10% of subindustries in the S&P 1500), along with a stock with the highest S&P STARS (tie goes to the highest market value).

Subindustry

Company

S&P STARS Rank

Price (8/24/07)

Auto Parts & Equipment

Johnson Controls (JCI)

3

$113

Commodity Chemicals

Lyondell Chemical (LYO)

3

$46

Computer Hardware

Apple AAPL

4

$135

Construction & Engineering

Jacobs Engineering (JEC)

5

$65

Construction & Farm Machinery

Trinity Industries (TRN)

5

$36

Consumer Electronics

Harman Intl. (HAR)

3

$114

Diversified Metals & Mining

Freeport-McMoRan Copper (FCX)

3

$87

Fertilizers & Agr. Chem.

Monsanto (MON)

3

$68

Footwear

Nike (NKE)

4

$54

Internet Retail

Amazon.com (AMZN)

2

$79

Photographic Products

Eastman Kodak (EK)

3

$28

Steel

Nucor (NUE)

4

$55

Technology Distributors

Ingram Micro (IM)

4

$19

Tires & Rubber

Goodyear Tire (GT)

3

$29

Source: Standard & Poor's Equity Research


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