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Low on Gas, High on Drillers

By John Kartsonas Standard & Poor's investment outlook for oil- and gas-drilling stocks is positive, while the outlook for equipment-and-services stocks is neutral. Our view reflects our expectations for a pickup in spending in North America as concerns about natural-gas supplies deepen and economies rebound, partly offset by moderate demand for services in the international market. As of June 18, the S&P Oil & Gas Equipment & Services Index was up 10% year to date, while the S&P Oil & Gas Drilling index was down 0.6%, vs. a 13.2% increase in the S&P 1500 Index.

Due to reduced exports from Venezuela, Nigeria, and Iraq, and a long cold winter in North America, world oil inventories were recently at low levels. Although oil prices have declined from their highs during the period before the Iraq war, they are still above historical levels, hovering around $30 per barrel. We expect prices to ease a bit during the second half of the year, closer to the $25 range. Global Insight projects WTI prices to average about $28.90 per barrel in 2003, up from $26.10 in 2002.

SPENDING SPREE. In addition, with decreased natural-gas production and increased heating demand during the past winter, U.S. natural-gas inventories at the end of March were at their lowest levels in a decade. However, with record storage injections during the past couple of months, inventories are currently standing about 13% below their five-year average and slightly higher than the gas in storage during the same period in the 2000 summer energy crisis. Global Insight sees Henry Hub natural gas prices over $5.69 per million British thermal units (MMBtu), vs. around $3.24 MMBtu during 2002.

With natural-gas and oil prices remaining at high levels compared to their respective historical averages, we expect drilling activity in North America to continue to increase. As of late July, Baker Hughes' (BHI) U.S. rig count was at 1,089. During the last 10 years, the rig count has been above the 1,000 level only in two periods, in 1997 and in 2001. In both of those years, the Philadelphia Oil Service (OSX) stock index, a benchmark for the industry, was above 100. However, the OSX was at 85 as of July 24, and we believe that share prices have the potential to move higher. We remain optimistic that as the supply tightens, especially for offshore rigs, pricing will start to improve, which should lead to higher earnings for drilling companies concentrating on North America.

On the capital-spending front, we expect spending by producers to rise over 5% in 2003, while domestic spending should increase at much higher rates, given the tight supply for natural gas. North American natural-gas depletion rates are over 30%, indicating that if energy companies don't spend enough, supply will fall and the market will tighten even if demand is not strong. In a recent appearance before the Economic Club of New York, Federal Reserve Board Chairman Alan Greenspan described the issue of natural-gas supply as a "very serious problem."

TWO TO WATCH. Looking at the longer term, the tight supply-demand situation for North American natural gas should continue to keep prices above historical levels. We expect these high prices to translate into higher drilling activity going into 2004 and beyond.

Given our outlook, we favor Nabors Industries (NBR) for its exposure to U.S. land drilling. As the largest land driller in the U.S., we expect it to benefit from higher day rates and margins, which we expect to start to improve in the second half of this year.

In addition, we look for ENSCO International (ESV) to benefit from higher drilling activity for natural gas. With one of the largest premium jackup rigs in the Gulf of Mexico, we expect the shares to get a boost from what we believe is going to be a strong second half for offshore drillers concentrating in the Gulf of Mexico. Analyst Kartsonas follows oil equipment and services stocks for Standard & Poor's

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