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How best to play the oil game? Head offshore

Analysts say the deep-water segment is in high demand. Here are four potential winners

How best to play the oil game? Head offshore

Globe Investor Magazine online, March 2, 2009

What's a smart way to play the volatile oil market? Try offshore drillers. They're still ringing in cash from contracts they locked in when the price of oil was surging last year. And once demand for crude begins to recover, drillers are likely to benefit from a scarcity of rigs.

"Now's the time to start to get into this space," says Lewis Kreps, an analyst at Jesup & Lamont Securities. According to Bloomberg data, commodity pundits expect crude to average $57.50 (U.S.) a barrel in 2009 and $77.50 a barrel in 2010. Crude closed Friday at $44.76, compared with a peak of $147 last July.

Once oil rises to at least $50, most deep-water reservoirs make economic sense, say Stuart Glickman, equity analyst at Standard & Poor's, and Stephen Schork, who edits the influential Schork Report.

UBS, which is skeptical about the oil-field services sector in general, notes that the deep-water segment is still in high demand. For example, of the 53 new rigs expected to hit the market before 2010, all but four are already contracted. Here are four companies they think will do well:

Transocean Inc.

Transocean is the biggest player in the space, with 140 deep-water rigs. Roughly 70 per cent of its business comes from the deep-water sector, leaving it with little exposure to the riskier shallow-water "jack-ups," which are considered more vulnerable to pricing pressure.

UBS analyst David Anderson says this stock is his top pick and is undervalued at about $59. Mr. Anderson thinks investors are needlessly concerned about potential contract cancellations. UBS says about 90 per cent of Transocean's deep-water rigs are under contract for this year, and 60 per cent are under contract for 2010.

Cash-strapped producers are unlikely to try and back out of these deals, UBS says. Since 1999, producers have tried to cancel only one contract - and they lost in court. Mr. Kreps says the deals in the industry are "iron-clad." Transocean will also generate $15-billion in free cash flow in the next three years.

Mr. Glickman says Transocean is historically cheap right now, trading around three times EBITDA (earnings before interest, taxes, deprecation and amortization), compared with seven to eight times historically. Forty-one analysts follow the stock, with 34 "buy" ratings and seven "holds." Their average 12-month price target, according to Bloomberg, is $97.14. It closed Friday at $59.77.

Diamond Offshore Drilling Inc.

Diamond differs from its rivals because its business model involves refurbishing rigs, rather than buying new ones. The method is far less capital-intensive - Mr. Kreps says Diamond pays about half of what competitors do for a similar rig - and has given the company a pristine balance sheet, with $640-million in cash on hand.

Like Transocean, Mr. Kreps thinks Diamond is well-positioned to increase its earnings over the next two years because newly refurbished rigs are likely to earn higher day rates on their upcoming contracts then they currently do. The regular quarterly dividend is 12 cents a share, but Diamond has a tradition of paying out sizable special dividends. Shareholders received $6.00 a share last year. Thirty-two analysts follow the stock, with 18 "buy" ratings, 10 "holds" and four "sells." Their average 12-month price target, according to Bloomberg, is $83.48. It closed Friday at $62.64.

Noble Corp.

UBS said Noble's price, down 50 per cent in the last six months to about $25, has been hit too hard because of its large fleet of jack-ups. Deeper-water rigs contribute about a third of its revenue at present, and will bring in about half of the total within the next two years, he says.

Meanwhile, Mr. Glickman expects about 40 per cent of 2009 earnings to come from the deep-water segment, and he says each of Noble's deep-water rigs have about two years of backlog orders, on average, protecting the company during this period of uncertainty. Thirty-six analysts follow the stock, with 21 "buy" ratings and 15 "holds." Their average 12-month price target, according to Bloomberg, is $38.74. It closed Friday at $24.59.

Atwood Oceanics Inc.

UBS says Atwood is a classic case of a stock that's been beaten up too much.

"The valuation here is compelling," Mr. Anderson says. Using a discounted cash-flow analysis, he feels Atwood should be worth $20 - compared to about $15 at present.

Atwood focuses on the "mid-water" segment - largely avoiding jack-ups and deep-water rigs. While UBS can see a few of these medium-sized rigs sitting idle in the coming months, the firm feels that risk is more than accounted for in the current stock price.

But the company has a small fleet and tends to operate in "off-the-beaten-path locations," Mr. Anderson says. While that helps it avoid competitors, it also limits its market size and could make it harder to find new contracts when current ones roll over. UBS recommends that clients build a position in Atwood slowly, using market weakness as buying opportunities.

Eighteen analysts follow the stock, with six "buy" ratings, 10 "holds" and two "sells." Their average 12-month price target, according to Bloomberg, is $25.46. It closed Friday at $15.28.

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