A Well-Positioned Energy Play

Big demand for natural gas should fuel shares of drilling services firm OSCA

By Mark Basham

S&P's Focus Stock of the Week is OSCA, Inc. (OSCA ), which carries S&P's highest investment ranking of 5 STARS (buy).

OSCA, which began trading publicly following its 2000 initial public offering (the company was an equity carve-out from Great Lakes Chemical), provides oil and gas well completion products and services used to optimize the recovery of fossil fuels from wells primarily in the Gulf of Mexico and in select international offshore markets.

In addition to being the largest supplier of completion fluids in the Gulf, OSCA provides related services from its fleet of vessels such as pressurized pumping and downhole completion tool deployment. Data for 1999, the most recent year available, show that international operations accounted for 15% of net revenues.

The company's technology is regularly adapted for onshore use, as well. Well completion involves the injection of briny fluids into wells in order to maximize production. Offshore drilling typically involves dealing with fossil fuel reservoirs that contain significant amounts of sand and other debris. Reservoir sand can plug a well, inhibiting production and eventually making the well unproductive.

SPENDING SURGE. Demand for OSCA's services is being driven by a sharp rise in capital spending in the energy sector. S&P estimates that spending on new exploration and production projects will increase by more than 20% in 2001.

Several factors are contributing to this rise. In the U.S., production from aging existing fields is declining. A relative dearth of new drilling over the past several years is exacerbating the effects of this decline, most notable of which is a nearly four-fold increase in natural gas prices this winter. S&P believes that the renewed vigor in U.S. exploration is a long term phenomenon that will last for a number of years. Energy policy under the Bush administration is likely to provide more incentives for increasing U.S. developed reserves and production.

Second, increasing demand for natural gas, which is a regional rather than global commodity, should boost demand for OSCA's products and services. Demand for natural gas will likely increase at rates substantially above the rate of economic growth over the next decade, due to an expected large number of new gas-powered generation plants, as well as potential new uses for gas such as fuel cells. The National Petroleum Council reports it expects demand for gas to produce electricity will increase 5.8% annually through 2010.

Third, OSCA has demonstrated particular expertise in servicing offshore wells in difficult deepwater environments. Well completion services are particularly valuable in deep water drilling. The number of offshore rigs in U.S. drilling in water depths of 1,000 feet or greater reached a record 40 at the end of last year. More of these are in ultradeep waters -- those of 5,000 feet or more.

Fourth, S&P expects OSCA to benefit from improving prices and better capacity utilization for its services in 2001. The company continued to invest in expanding capacity during the late 1990's, despite record low energy prices. Now that demand is picking up, this added capacity will allow it to increase market penetration.

GAINS AHEAD. S&P estimates that, coming off a year over year revenue increase in 2000 of 44%, revenues in 2001 will climb at least 36% to $180 million. Margins widened considerably last year, resulting in a six-fold increase in earnings per share from $0.10 in 1999 to $0.61 in 2000. Earnings substantially exceeded our $0.50 estimate. We expect margins to expand further in 2001, resulting in a 70% rise in EPS to $1.05.

The 2002 outlook is positive as well, as U.S. E&P activity is projected by S&P to remain in its long term up trend. We expect revenues growth of about 25%, with additional margin expansion. EPS should climb by about 43% to $1.50. International expansion may provide further upside to our projections.

Positive fundamental and technical factors for the energy sector provide a firm backdrop for further gains in the stock price. Price momentum and relative strength indicators for energy stocks suggest that market sentiment remains positive. S&P expects energy sector earnings growth to remain positive for quite a few more years, as the industry responds to long term imbalances in supply and demand.

The outlook in 2001 for small and mid-cap energy stocks in particular is extremely upbeat. Earnings expectations are in a sharp uptrend, as measured for the Smallcap 600 and Midcap 400 energy sector indices, with 2001 earnings projections having risen 37% and 29%, respectively since September 2000.

S&P believes that the current valuation of OSCA's stock should take into account a reasonable expectation for peak earnings attainable in the current cycle. We are confident that earnings over the next two to three years will peak at a level that is at least double the $1.05 that S&P estimates OSCA will earn in 2001. OSCA has available capacity to increase its market share. The company has a small amount of outstanding debt and rising cash flow available to reinvest in the business, particularly to expand further in international markets.

LOTS OF UPSIDE. S&P believes that the shares merit a valuation based on potential peak earnings of a moderate discount to the valuation of the S&P 500. In light of discounted valuations of other cyclical stocks at historical periods of peak earnings, by applying a conservative 25% to 50% discount relative to the current 12 month forward PE ratio of the 500, we estimate the potential upside in the shares is a minimum of $24 up to a maximum of $35.

Should Great Lakes Chemical decide to sell its stake in the company, we believe a sale would likely entail a price toward the high end of this range. Absent a potential sale, we expect the share price to rise to at least $24 within the next 6 to 12 months, implying an approximate minimum 25% gain from the recent price of $19.

Basham is emerging growth/IPO analyst for Standard & Poor's

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