"I also like (Hornbeck Offshore Services) because there's a general negative perception among investors about marine activity, which they typically consider to be a low barrier to entry," says Pierre Conner of CapitalOne Southcoast.

Starting out 2008, oil prices wasted no time briefly pushing past the century mark while natural gas prices languished at $7 to $8—an event not typically seen in early-January trading on the Nymex.

This may well underscore what many oil-service analysts already concluded in late 2007—the cycle for oil is strong and the outlook for North American gas in 2008 is bearish, with pricing possibly as low as $5.50 by the third quarter of this year.

In such a market environment, many market seers believe drilling globally for oil is going to become a more dominant industry theme.

“We’re bullish on the oil-drilling cycle, particularly internationally, where drilling has lagged the U.S.,” says one. “As we see it, the international markets are going to continue to grow in 2008 and 2009—driven mainly by oil—and the service companies that are going to be best positioned this year will be those with a heavier weighting to international and offshore markets or some specialty, niche technology or product.”

With this in mind, many market mavens are taking a closer look not so much at the high-flying names in the service sector, but at small-cap service stocks—those with market caps under $2 billion.

Why? Due to their size, they’re more highly leveraged to percent gains in revenues, earnings, margins and stock-market valuations. Also, many have been beaten down well beneath their consensus net asset values.

To find out which small-cap service stocks are best positioned to take advantage of consensus market trends and make visible market strides in 2008 in terms of stock-price appreciation, Oil and Gas Investor recently visited with three leading oil-service analysts. They are J. Marshall Adkins, managing director of energy equity research for Raymond James & Associates in Houston; Pierre Conner, managing director and oilfield-services analyst for CapitalOne Southcoast in New Orleans; and Joe Agular, senior partner and oilfield-service analyst for Johnson Rice & Co., also in New Orleans.

Atwood Oceanics Inc. This Houston-based offshore-drilling contractor has a fleet of five semisubmersibles and three jackups. Notably, about half its rigs are in the deepwater worldwide, and in 2007, 93% of its revenues came from international operations through such customers as Woodside Energy and BHP Billiton Petroleum.

“We’re looking for very visible revenue growth in its offshore drilling business, from $400 million in 2007 to $534 million in 2008 as earnings climb from $139 million to $221 million,” says Adkins.

The main driver of this growth? “There’s a scarcity of offshore deepwater drilling assets internationally, and for contractors like Atwood that have such assets, upstream companies are paying up and signing long-term contracts—and the company already has on its books many of those higher-rate contracts.”

For its fleet of mid-depth semis—where the largest growth in revenues and net income is occurring for Atwood—the driller received in 2007 average dayrates of $160,000 and the analyst expects rates for those rigs to rise to $234,000 in 2008.

Cal Dive International Inc. This Houston company is basically comprised of the old shallow-water Gulf of Mexico diving assets of current-day Helix Energy Solutions.

“Cal Dive’s recent $628-million acquisition of Horizon Offshore, an offshore construction company, adds a fleet of shallow-water construction assets and provides Cal Dive with a good platform for revenue and earnings growth,” says Agular.

“In addition, since one of Cal Dive’s goals is to diversify internationally, the Horizon acquisition allows this to occur more easily because Horizon is already established in several international markets. Also, it’s much easier to leverage diving services off a construction contract than it is to just offer diving services alone.”

Combined 2007 revenues for the two companies were roughly $1.1 billion and Agular is estimating a conservative $1.2 billion for 2008 while earnings climb from about $153 million to $175 million.

Adkins says, “The acquisition of Horizon Offshore is an accretive transaction that will complement the firm’s diving business and give Cal Dive greater international exposure and a higher earnings profile in 2008. Also, part of Cal Dive’s growth story going forward will be its expansion through international acquisitions of diving companies in higher-growth places like Asia and the North Sea.”

When Cal Dive was a stand-alone company prior to the Horizon acquisition, Adkins had been forecasting revenue to grow from $608 million in 2007 to $690 million in 2008, with earnings rising from $107 million to $137 million. “However, this acquisition will dramatically increase Cal Dive’s 2008 results.” Adkins notes that on the revenue side, Horizon by itself sported $480 million in revenues in 2007 and net income of $31 million.

Geokinetics Inc. This Houston-based geophysical contractor is an acquirer of seismic data for E&P companies, with operations 50% in North America and 50% international. In particular, the firm focuses on the more difficult onshore and transition-zone seismic data-acquisition assignments worldwide.

Conner says, “The stock is very inexpensive and trades at less than four times estimated 2008 EV (enterprise value)/EBITDA (earnings before interest, taxes, depreciation and amortization) versus a peer-group average multiple of 5.4.

“In addition, the company is exposed to the seismic data-acquisition market, which we believe will experience double-digit growth annually for several years.”

Geokinetics is a consolidation and turnaround story, he adds. Recently, the service provider has made some large acquisitions and has transitioned to a new management team. “So investors get the benefit of expanded markets, improvements operationally as the company consolidates, and new management focus.”

For 2008, Conner expects total revenues to grow to $456 million, up from $379 million in 2007, as net income triples to $18.4 million from $6.5 million.

Gulf Island Fabrication Inc. A Houma, Louisiana-based service company, Gulf Island builds platforms for oil and gas development, primarily in the Gulf of Mexico.

Agular says, “We believe that in the Gulf of Mexico—where deepwater activity has become a renewed focus of major oil companies and new fields have been found—a good number of offshore platform-construction jobs will be awarded in 2008 for 2009. And once some of those jobs are awarded to Gulf Island, the stock will respond.”

Longer term, the analyst expects a multi-year growth period for Gulf Island, perhaps even beyond 2009, driven by increased E&P spending and deepwater drilling.

For 2007 and 2008, Agular sees the company’s revenues being flat, right around $469 million. “However, we expect Gulf Island to improve profitability to $39 million in 2008, up from $30 million in 2007, since some of the contracts the company worked on during the first part of 2007 had less profitable margins than those contracts the company will be working on this year.

“Furthermore, we think Gulf Island’s backlog is going to grow substantially in 2008, and this should act as a positive catalyst for the stock.”

Hornbeck Offshore Services Inc. This Covington, Louisiana-based diversified marine service provider has 45 offshore supply vessels, mainly in the deepwater Gulf of Mexico. The company also owns 33 tank barges and tugs that service the downstream business, moving fuel oil and other marketable fuels, primarily in the Northeast.

Conner says, “In terms of offshore supply vessels serving the deep water, Hornbeck is in a long-term growth market for half its business while being in a stable, high-margin business in the downstream side with its tank-barge and tug operations.”

He predicts that, in the offshore supply-vessel arena, the company’s revenues should grow from $224 million in 2007 to $315 million in 2008 while its total net income after taxes rises from about $93 million to $112.5 million.

“I also like the stock because there’s a general negative perception among investors about marine activity, which they typically consider to be a low barrier to entry,” he adds. “However, Hornbeck’s niche is a highly specialized market, in terms of higher-end vessels leveraged to the deep water, which is a growth area.

“True, a number of [supply] vessels are being built today, but the demand for them is exceeding conventional expectations.”

Ion Geophysical Corp. This Houston-based service company, formerly known as Input/Output, manufactures seismic equipment—land and marine data-acquisition systems—and also provides seismic services around the world, including data processing. Notably, 68% of its overall seismic business is international.

Agular says, “Ion has worked on commercializing some new digital seismic-equipment technology for land use which will allow operators to capture a lot more data than previously. A lot of this new technology will be in the market through the company’s product offerings in 2008, thus the sale of such products should help Ion both on the revenue and margin side.”

The company’s seismic data-processing business is another growth area, he adds. In addition, it’s developing some of the software for running offshore data-acquisition systems.

“In our view, seismic is going to become more valuable as the current oil and gas cycle continues because any improvement in helping an E&P company find hydrocarbons more easily is something customers will ultimately want to buy.”

The analyst sees Ion’s revenues growing from $704 million in 2007 to $820 million in 2008 as net incomes rises from $48 million to $79 million.

Lufkin Industries Inc. Based in Lufkin, Texas, this is the largest manufacturer of oilfield pumping units in the world and also manufactures mechanical power transmission equipment—finely machined gears—used in compressors and drilling top drives.

Adkins says, “Every oil producer in the world that isn’t flowing 2,000 barrels per day is a candidate for a pumping unit and, as fields mature, the demand for pumping units is rising. Meanwhile, as oil prices continue to hold up, this will also increase the demand for pumping units.”

Thus the pumping-unit market is getting bigger and, at the same time, Lufkin is expanding internationally to take advantage of oil-production growth in the Middle East and Latin America, the analyst adds.

He sees the company’s overall revenues growing from $590 million in 2007 to $650 million in 2008 as net income jumps from nearly $73 million to $84 million. “The fastest part of this financial growth is going to come from Lufkin’s power-transmission equipment business, which we see growing more than 20% this year. Its pumping-unit business, meanwhile, should grow 10% to 20%, primarily from international demand.”

Mitcham Industries Inc. This Houston-based service company is a worldwide leader in leasing land seismic data-acquisition equipment and also manufactures and sells marine seismic equipment.

Conner says, “Mitcham is highly leveraged to a significant growth market—seismic—which we believe has an extended cycle due to the need to replace reserves.

“Its seismic-leasing segment is a high-margin business, generating cash margins better than 90%. In addition, seismic channel counts—the density of data-collection channels, which allows for better interpretation of subsurface structures—grew 40% in 2007 and will continue to grow in the mid-teens worldwide for several years.

“This will provide Mitcham with further opportunity for revenue and earnings gains.”

Manufacturing marine seismic data-acquisition equipment is also a growth market worldwide, Conner adds, and the company has the opportunity to improve margins in this business segment as well. In addition, there are niche acquisition opportunities for the firm that should be accretive.

Natco Group Inc. This Houston company manufactures oilfield tanks and separators to help producing fields run, primarily in North America. It also makes automated control systems associated with oil processing and manufactures specialized CO2 and hydrogen-sulfide separation devices for pulling those elements out of the gas stream and is largely an international business.

Adkins says, “We expect that nearly half the earnings of this company going forward will be international-driven on the gas-technology side.”

He projects the company’s gas-technology business will grow from just under $100 million in revenues in 2007 to $140 million in 2008 as its automated controls revenues improve from $115 million to $137 million. The firm’s tank and separator business, meanwhile, will likely be flat year-over-year at roughly $235 million.

Agular says, “We’re very bullish on the oil-drilling cycle, particularly internationally, and this company participates in this big-picture global trend in a pretty strong way in both its oil-and-water separation and gas-technology businesses.

“In fact, 54% of the firm’s total revenues come from international operations.”

Natco is involved in a joint venture in the Middle East to build oil-and-water separation facilities. “In 2009, this could add $50- to $100 million in revenue for the company and maybe 25 to 30 cents in earnings per share.”

This would be on top of estimated 2008 total revenues of roughly $670 million and earnings of $55 million, he adds. Comparatively, its 2007 earnings were $45 million on revenues of $565 million.

Natco’s gas-technology segment is a great margin business, he says, particularly in Southeast Asia. “In fact, this segment probably generates 40% of the company’s total profits.”

Particle Drilling Technologies Inc. This Houston-based company is in the process of proving a patented, step-change drilling technology that would allow E&P companies to drill faster in hard-rock formations—about three to six times faster than what can be achieved with conventional drillbits, says analyst Conner.

“That could save an operator as much as $500,000 on a typical hard-rock well, whether in the Rockies, the Midcontinent or Permian Basin.”

This technology has zero market today, but the analyst believes it has the potential to become a more than $1-billion market annually.

While a higher-risk opportunity for investors, Conner sees the company’s total revenues—now zero—growing from about $16 million in 2008 to more than $80 million in 2009 as net income leaps from about a $2-million loss to a $20-million profit. “And as this growth occurs, Particle could potentially become a take-out target for a larger company that would like to include this technology in its portfolio.”

Tesco Corp. A Canadian service provider headquartered in Houston, this firm is involved in two primary drilling-technology activities worldwide: manufacturing, sales and rental of top-drives mainly for land rigs and providing casing services, which involves casing running and drilling with casing.

Agular says, “The real sizzle with this company is its automated casing running, which makes the installation of casing more efficient, as well as its drilling-with-casing technology, which replaces conventional drillpipe to drill a well.

“Also, Tesco has patents on retrieving the drillbit and downhole tools from the bottom of the casing string, allowing an operator to more easily drill horizontal and directional wells.”

While the drilling-with-casing and mechanized casing-running market is very small right now, as these technologies take off, Tesco is well positioned for growth with its patented-service offering, says the analyst.

“In 2007, casing drilling accounted for only $20- to $25 million of the company’s revenues; in 2008, that’s probably going to double. More importantly, this market could one day be a $1-billion business.

Conner agrees. “The real jewel of Tesco is its casing-drilling business, which provides significant upside for the company,” he says. “Currently, casing drilling is probably a $50-million market worldwide, but over time we also believe this market could grow to about $1 billion.”

The analyst predicts that Tesco’s casing-drilling business, which in 2007 generated a net loss on about $13 million of estimated revenues, will double in 2008 and become breakeven as it sets up for a highly profitable 2009.

Meanwhile, Conner expects the company’s top-drive business to remain very stable as international demand for top drives builds while the firm’s U.S. top-drive business begins to taper.

Tetra Technologies Inc. The Woodlands, Texas-based service provider has several main business areas: completion fluids that are used primarily in the offshore arena throughout the world, an international gas-testing business for measuring well-flow rates, a well-abandonment business closely linked to its participation in Gulf of Mexico E&P operations through its Maritech Resources division, and gas-compression operations.

Adkins says, “This is one of the few gas-exposed (service and supply) names we’re recommending for 2008 because it’s really a turnaround story.

“The company stumbled in 2007, involving operational issues on the well-abandonment side as well as increased cost issues on the completion-fluids side. However, we think most of those problems should be behind Tetra by the end of January 2008.”

The analyst predicts better margins in the firm’s completion-fluids business and improved operational efficiencies in its well-abandonment activities and directly linked E&P business. Specifically, he sees overall revenues growing from $1 billion in 2007 to $1.2 billion in 2008 as net income rises from $65 million to $137 million.

In its E&P business alone, he sees revenues moving up from just under $170 million last year to $220 million this year, due largely to increased production.