4 sweet stocks from the oil slump

By Michael Brush

Cheaper oil has brought welcome relief at the pump.

But it has brought pain to anyone who owns the stocks of companies that provide the rigs, drill bits and know-how used to get oil and natural gas out of the ground.

The stocks of these companies in recent weeks have fallen to levels not seen since last December -- even though oil prices are still a lot higher than they were back then.

Here's why: Investors know that if oil prices fall low enough, energy producers will slash their exploration and production budgets. That would leave oil-services companies stuck with lots of expensive gear on idle, and it would crush their profit margins.

But the sellers are making a big mistake. While oil prices have fallen to $63 a barrel from recent highs above $75, they won't fall enough to dent exploration and production budgets.

So now's the time to buy four stocks in this patch: Baker Hughes (BHI, news, msgs), Schlumberger (SLB, news, msgs) and offshore rig companies Transocean (RIG, news, msgs) and Atwood Oceanics (ATW, news, msgs).

No sign of $40 oil

"Until you see oil make a run at $40, there's no reason to think that oil-services spending will be lower this year or next year, or the year after," says Tim Parker, an oil-services sector analyst with the mutual fund group T. Rowe Price. "I can't think of any exploration and production company that was budgeting on the basis of $75 oil."

Don Hodges, president of the Hodges Fund (HDPMX), thinks oil would have to go below $40 to create a "drastic change in drilling programs."

Don't bet on that happening. Amir Arif, a Friedman Billings Ramsey analyst who has made several astute energy-sector calls in this column, believes oil prices will settle in the low $60 range.

Arif thinks fundamentals alone -- limited spare capacity combined with healthy demand from emerging economies like China and India -- justify a $50-a-barrel price for oil. On top of that, energy traders will continue to add a "risk premium" of another $12 or so to account for the possibility that supply disruptions caused by tensions in the Middle East could suddenly make oil scarcer. Parker thinks oil could go to $55 by the end of the year or next year. But he believes the Organization of the Petroleum Exporting Countries would cut production to support prices if oil slipped much lower than that.

The bottom line: Oil prices will stay high enough for energy companies to continue plowing money into finding and producing more oil and natural gas -- something they've neglected to do for years, so they still need to catch up.

"We expect double-digit increases in spending for several more years," says Credit Suisse First Boston energy sector analyst Ken Sill, who's also telling clients to buy energy-services stocks in the current weakness.

Another reason to buy this group is that the stocks look cheap even though they are still up a lot over the past few years. The Philadelphia Stock Exchange Oil Service Sector index now trades for about 10.3 times the earnings that companies in the index are expected to make over the next 12 months. That's lower than the low of 11 times expected earnings hit in September 2001. Back then oil sold for about $23 a barrel, says Calyon Securities analyst Mark Urness, who is also bullish on the group.

Here's a closer look at four oil-services stocks to buy now.

Offshore and overseas

When hunting for stocks in this group, it's key to look for companies that do a lot of business outside North America, where demand for oilfield services is more robust, says T. Rowe Price's Parker. It's also important to go with companies that offer offshore rigs as opposed to land rigs, he says. Offshore rigs cost a lot more to build. So there's less risk that lots of new offshore rigs will come on line and hurt pricing power -- a likely scenario for land-rig companies.

Schlumberger: With oil prices so high, energy companies are using more seismic imaging to locate reserves, as opposed to expensive test wells. That's why Schlumberger's seismic technology division, known as WesternGeco, is "growing like a weed," says Morningstar analyst Matt Morgan. Schlumberger also provides equipment and services used to develop wells.

The company has exposure in the healthier foreign markets. It gets about 70% of its revenue from outside the United States, including Saudi Arabia and Russia, Parker says.

Analysts expect Schlumberger's earnings to grow 23% a year on average for the next three to five years. Yet at $58 a share, its stock trades for 15.7 times expected 2007 earnings of $3.70 a share. Given the healthy outlook for oilfield-services spending, says Parker, Schlumberger should trade for a price/earnings ratio closer to 30 -- as it has during good times. "I see it getting into mid-$80 to mid-$90 range without too much trouble," Parker says.

Jefferies & Company analyst Stephen Gengaro has a $78 price target on the stock.

Baker Hughes: Despite the recent decline in oil prices, energy companies around the globe will continue to line up for the advanced drill bits sold by Baker Hughes, Parker says. The company is also a premier supplier of drilling fluids, pumps and other energy production gear. "Whatever they do, they do well," Parker says. The company gets about 60% from areas outside of North America, including Russia, the Caspian region and the Middle East.

Analysts expect earnings at Baker Hughes to grow 23% a year for the next several years, according to Thomson Financial. But at $62 a share, the stock trades for just 11.6 times expected 2007 earnings of $5.34 per share. That's a 50% discount to its median price/earnings ratio of 24 times expected earnings over the past five years. Urness, at Calyon Securities, has a 12-month price target of $105.

Big rigs: Rental rates for rigs have been spiraling upward because of high demand. The Norwegian energy company Statoil ASA (STO, news, msgs) just renewed a contract with Transocean for a North Sea rig for $429,000 a day. That was nearly twice the $245,000 a day it had been paying. It's not unusual to see deep sea rigs going for over $500,000 a day. Since they cost $100,000 or so a day to operate, rig companies are making "serious dough," Parker says.

With prices shooting up, you can expect the supply of rigs to increase, too -- which may make it harder to command those high prices. That's more of a risk for land rig companies like Grey Wolf (GW, news, msgs) or Patterson-UTI Energy (PTEN, news, msgs), since land rigs are relatively cheap, at about $10 million to $15 million apiece.

Offshore rigs cost four or five times as much. Robert Robotti, of Robotti & Company Advisors, estimates 37 new deep-water rigs will come on line over the next three years, an increase of about 20% a year. That's not enough to keep rig suppliers from making energy companies pay up nicely for rigs, he believes.

Transocean is the world's largest provider of offshore contract drilling services, and it dominates the market for deep-water drilling. It has an edge over competitors because it has dual-action rigs that perform two tasks at once. They can drill wells and test those wells or install infrastructure at the same time, cutting the time it takes to develop a well by 40%.

Analysts think Transocean earnings will grow 40% a year over the next several years, according to Thomson Financial. But at $72, the stock trades for 9.5 times expected 2007 earnings of $7.58 a share. During boom times for rig operators, like now, it should trade closer to 12 times expected earnings, Parker says. He thinks earnings will go up to $9 a share in 2008, suggesting the stock could trade up to $90 or $100.

A smaller offshore rig company that also looks like a buy in the current weakness is Atwood Oceanics, believes Robotti, whose managed accounts are up 13% a year on average over the past 10 years.

At $41 per share, Atwood trades for just 8.6 times the $4.74 per share analysts expect it to earn in the next 12 months. They expect 60% average annual earnings growth over the next few years. That would put earnings at $11.40 a share by 2009, suggesting the stock could trade up to $90 or more. Robotti thinks Atwood may get a boost from orders from ExxonMobil (XOM, news, msgs), an Atwood customer that he says is behind in lining up deep-water rigs.

Expert picks

With this column, I'll add all four recommended stocks to the Company Focus portfolio in our Expert Picks database, and we'll see how they do from here. Nine of the stocks in the portfolio are up in double digits in the past 30 days.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.