Another way to profit from oil's rebound

As crude prices bounce back, oil services and drilling stocks are reaping the benefits.

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By Mina Kimes, writer-reporter

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NEW YORK (Fortune) -- "Drill baby, drill" may have failed as a campaign slogan, but the mantra appears to be working for investors.

The S&P Oil & Gas Services ETF (XES) has jumped 57% over the last three months, outperforming the S&P 500 (SPX) by 25%. Service and drilling stocks, which were pounded last year as production companies made steep cuts, are riding the wave of near-$70 crude.

They're also benefiting from reports of slowing declines in rig utilization -- Baker Hughes (BHI, Fortune 500) announced last week that the number of active rigs declined by just one, the smallest drop since last year.

When crude prices rise, pure play oil producers like Exxon (XOM, Fortune 500) and Chevron (CVX, Fortune 500) are typically the first in line for growing profits. But because their shares are so widely-held, their stocks can only move so far. "The problem with those names is that everyone owns them," says Jerry Jordan, manager of the Jordan Opportunity Fund.

Jordan thinks that net inflows to the market are likely to peter out, meaning future gains will come from rotation within sectors. "Now that people are feeling better about oil, we're starting to see people sell Exxon and buy companies with quantifiably more beta," he says, referring to a stock's ability to outperform the index.

Those returns don't necessarily correlate to fundamentals, says Robert MacKenzie, an analyst at FBR Capital Markets. "In terms of earnings growth, these companies will experience lower numbers in 2010 than 2009." Yet he's recommending several services stocks anyway, in part because he believes those headwinds are factored into prices. "Right now, the market is looking out to 2011," he says. "Most of the negative stock movement is behind us."

Where there's a drill, there's a way

Like oil producers, services stocks are a varied bunch. The major divide is between firms that provide technological expertise and maintenance and ones that drill for oil. Among drillers, there are companies that work primarily on land, as well as ones that drill in shallow, mid, and deep water.

Right now, most managers prefer deepwater drillers because of their visible backlog and earnings growth potential. "All of the incoming demand now is for advanced, deepwater rigs," says Robert Stimpson, a portfolio manager at Akron-based Oak Associates. Most incremental demand, he says, is coming from Petrobras (PBR), the Brazilian producer that's expanding its operations in complicated offshore sites.

Among Petrobras' contracted drillers, MacKenzie likes Transocean (RIG). "A much bigger percentage of Transocean's fleet consists of ultra-modern rigs compared to Diamond Offshore (DO)," he says. Transocean spent $2.2 billion on upgrades last year, nearly double the year before -- a move that looks prudent now that its high-tech rigs are in demand. The company is trading at a price to earnings ratio of seven, while Diamond is priced at nine times earnings. MacKenzie expects Diamond to suffer because of its participation in the softening midwater market.

Investors with more risk tolerance should look at shallow water drillers like ENSCO (ESV), wrote Deutsche Bank's Mike Urban in a recent note. While the deepwater growth story is still strong, he write, it's time to look for stocks that are more likely to benefit from a sector-wide recovery.

Fewer analysts are as optimistic about land drillers, which have exposure to low-priced natural gas. Stocks like Nabors (NBR) and Patterson-UTI (PTEN) soared in recent months, but they were bolstered by short-term trading, says David Havens, an analyst at Sterne, Agee, & Leach. "Fundamentally, they don't exhibit the best growth prospects," he says.

Stocks at your service

Oil services stocks, which provide technological expertise to projects, are trading, on average, slightly higher than the drillers. Havens says that's because they have real growth potential, while most drillers will only recoup their losses going forward. "We think services stocks will show earnings growth in 2010," he says. "The deepwater drillers have predictable cash flow, but where's the growth?"

Among services firms, Johnson & Rice analyst Joe Agular prefers companies with global operations, because demand is cropping up in disparate locations. He likes bigger names for the same reason (smaller ones tend to operate mainly in North America).

"If a company is doing more than 40% of their business outside of North America, they're better positioned right now," he says. Argular recommends Halliburton (HAL, Fortune 500), which does 58% of its business overseas. FBR's MacKenzie also likes Halliburton. "The market is underpricing it to its peers," he says. "There's still a lingering discount due to its ties to the former administration, but it's generating good results." Halliburton boasts a 32% return on equity, which is twice the industry average.

Another services name gaining buzz is Weatherford (WFT), whose stock has nearly doubled this year but is still trading at 12 times earnings. Weatherford fits Agular's preference for an international play -- the company recently won contracts in Mexico and Iraq and just purchased TNK-BP's oil services division in Russia. The move was applauded by JP Morgan's Michael LaMotte, who wrote that the deal added to Weatherford's "business momentum and 2010 visibility." To top of page

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