The Right Geography for Drillers

As Mideast volatility intensifies and world economies recover, the signs point to higher prices and strong demand for oil and gas

By Sam Stovall

With oil prices' dramatic increase in the wake of escalating Mideast tensions, it's no surprise that shares of energy companies have charged higher recently. On Apr. 8, jittery investors got another reminder of just how volatile the situation is when Iraq announced its plans for a 30-day halt to oil exports. And naturally, a key industry within the energy sector, Oil and Gas Drilling, has joined the list of those with top Standard & Poor's .

Standard & Poor's analyst Tina Vital has a positive investment outlook on the group. She expects crude prices to remain high, given the market's worries about the Middle East and oil workers' strikes in Venezuela. However, despite Iraq's plans to stop its oil exports -- and Iran's suggestion of a wider embargo against importers who support Israel -- Vital views any attempt to impose a large-scale supply halt as unlikely to succeed.

A 1973-style embargo would result in oil-dependent Middle East economies inflicting harm on their own revenues and goes against OPEC's objective of stabilizing world prices. Indeed, one day after Iraq's announcement to halt oil exports, Saudi Arabia reiterated its committment to the security of world supplies, agreeing to fill any shortfalls in the international markets.


  Vital also cites more fundamental factors for her positive view of drillers: Rebounding world economies and continued strong international spending by major oil and gas producers, their primary customers. This comes against a background of tighter world supplies as OPEC members have shown more discipline in sticking to the reduced output levels that the cartel agreed upon in January than many market watchers had expected.

Already, inventories have begun an overall decline in the U.S. (despite a stock buildup in the week ending Mar. 29, 2002). If world economies rebound as expected, OPEC's next move might actually be to raise output at its extraordinary meeting in June. Vital expects that OPEC and non-OPEC producers will continue to work together to maintain prices at levels that both producers and users can live with.

The longer-term trend for energy prices remains higher, says Vital. Prices for the benchmark West Texas Intermediate (WTI) grade of crude averaged $25.90 per barrel in 2001, and she believes that this level might be matched this year, dropping off a little in 2003. Natural-gas prices, based on the benchmark Henry Hub contract, averaged $4.27 per million BTU in 2001. Economic research outfit DRI-WEFA predicts that natural-gas will average $2.85 per million BTU in 2002 and $3.12 in 2003.


  With economies poised to recover, DRI-WEFA projects that world oil demand will rise 2.2% annually from 2005 to 2020. However, industry sources predict that nearly half of current production will have to be replaced with new supply by 2010 to keep pace. Therefore, significant capital investment in exploration and production will be needed over the next 5 to 10 years.

Vital estimates that global spending for exploration and production rose over 20% in 2001, to more than $110 billion. While spending may decline to near $100 billion this year as the recovery struggles to take hold and Middle East troubles escalate, Vital believes that it will increase again in 2003 and beyond.

Furthermore, DRI-WEFA projects that U.S. natural-gas demand will rise 3% in 2002, while recent cuts in drilling activity will likely lower U.S. production by 3.8%. Therefore, Vital believes that a resulting jump in natural gas prices in late 2002 or early 2003 will help U.S. natural-gas drilling rebound.

Vital has 5-STAR (buy) opinions on two drillers -- Global Santa Fe (GSF ) and Nabors Industries (NBR ) -- as a way to capture major producers' continued spending internationally while also playing the U.S. natural-gas recovery.

S&P Relative Strength Rankings

These industries carry six-month relative strength rankings of "5" as of Apr. 8, 2002 -- meaning that they're in the top 10% of the 115 industries in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600) based on prior six-month price performance.

Industry/Sector Largest Company (Market Cap.) S&P STARS* Rank
Apparel, Accessories & Luxury Items/Consumer Discretionary VF Corp. (VFC) 4 STARS
Casinos & Gaming Park Place (PPE) 4 STARS
Commodity Chemicals/Materials Lyondell (LYO) 3 STARS
Computer & Electronics Retail/Consumer Discretionary Best Buy (BBY) 4 STARS
Consumer Electronics/Consumer Discretionary Harman International (HAR) Not Ranked
Diversified Metals & Mining/Materials Phelps Dodge (PD) 4 STARS
Homebuilding/Consumer Discretionary Clayton Homes (CMH) 5 STARS
Internet Software & Services/Information Tech. Yahoo! (YHOO) 3 STARS
Oil & Gas Drilling/Energy Nabors (NBR) 5 STARS
Semiconductor Equipment/Information Tech. Kulicke & Soffa (KLIC) 5 STARS
Steel/Materials Nucor (NUE) 5 STARS
Semiconductor Equipment/Information Tech. FEI Co. (FEIC) 5 STARS

*S&P's ranking system for the appreciation potential of stocks over a 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Editor's Note: An earlier version of this story included a chart showing Yahoo having a 5-STARS ranking; it should be 3 STARS. Park Place was downgraded to 4 STARS from 5 STARS on Apr. 10.

Stovall is chief sector strategist for Standard & Poor's

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