Were Paul Revere alive today and a Boston buysider focused on energy, he would likely be riding through the New England countryside to alert investors to relentlessly pursue the shares of oil-service stocks. Indeed, the lantern atop the historic Old North Church near Boston's financial district would be signaling Buy, with one flash of light for conservative investors; two, for aggressive portfolios. Undoubtedly, Revere would be repeating this market alert throughout the rest of the East Coast buyside community, in places like Greenwich, Connecticut, and the southern tip of Manhattan, where Wall Street translates the sentiments of the buyside into billions of dollars worth of trades each day. This particular New England patriot wouldn't be alone in his rallying efforts. Very simply, there is broad consensus among buysiders throughout the East Coast-where the bulk of U.S. institutional-investor money resides and is measured in trillions, not billions, of dollars-that if investors are going to take advantage of recent $60-plus oil prices and $8-plus natural gas prices, the oil-service sector is the place to be in 2006. The rationale: with E&P companies and integrated oils having announced 20% to 30% increases in their 2006 capex budgets, it's the oil-service sector that has the pricing power, earnings momentum and the most stock-price-appreciation potential going forward. Says one Boston-based buysider, "Drillers are negotiating contracts at much higher dayrates than we've seen in the past, and the contracts are for much longer periods-particularly in the case of deepwater drillers, which are now obtaining three- to five-year contracts, rather than 12-month commitments, at very favorable rates." Ditto for service companies that are vendors to the drillers, explains another East Coast-based buysider. "Whether it's supplying top drives, drillbits, tubing or pressure-pumping services, the demand and margins for such equipment and services are going to increase, right in line with the increase in the number of rigs, rig-utilization levels and capital spending by producers," he says. This isn't to suggest E&P stocks have entirely lost their luster, despite their huge run-up last year. On the contrary, most institutional investors agree operators that are organically growing production-and exceeding Street expectations with respect to their ability to grow output-should be viewed favorably. In their estimation, those stocks-and those of other producers looking to unlock unrecognized value through restructuring-are likely to achieve a strong expansion of price/earnings multiples versus where they're trading today. Meanwhile, other buysiders take the tack that integrated oils are now more undervalued than their smaller-cap E&P brethren and are likely to outperform the latter group in the near term. As one analyst puts it, "Big oil is cheap today." But back to the much touted oil-service sector. Which stocks within that group are likely to show strong earnings growth and market-price appreciation this year and next? Hint: start looking offshore-but don't stop there. Team focus A subsidiary of Mellon Financial Corp., The Boston Company Asset Management has about $60 billion of institutional equity investments under management. Of that, its domestic equity investments, totaling about $27 billion, have about a 10% weighting to energy. "Since 2003, we've probably increased our weighting to energy across the board, notably among the larger-cap stocks," says William E. Costello, vice president and portfolio manager for the buyside firm. The reason? "We're believers in stronger commodity prices for a longer time than we've seen in past cycles," he says. "This doesn't mean we're looking for a run-up in prices like we saw in 2005. But we do expect that-with little excess supply capacity-oil this year should average in the high $50s and natural gas, $9 to $10. That view, in turn, leads us to like the oil-service names versus the integrateds because cash flows ultimately will accrue more to the former group." Todd W. Wakefield, a vice president, energy analyst and portfolio manager at the firm and who specializes in small-cap growth stocks, similarly puts service companies at the top of the pecking order, ahead of integrateds and E&P companies. "Companies in the latter two sectors are going to have to spend more money to drill more wells and use more technology, which translates into powerful earnings growth for oil-service companies." Alexander S. Marshall, a vice president and portfolio manager who covers oil-service and E&P stocks for the firm, explains that in 2003 and 2004, E&P was the energy sector to be in but that in 2005 and beyond, the service sector will become a much better place to make money. He notes that the U.S. rig count and the cost for producers to drill wells are ratcheting higher each day; meanwhile, domestic gas production remains relatively flat. "This suggests operators are chasing smaller deals. So in order for them to keep production steady, they're going to need more and more rigs-of which there is but a finite number-and that, in turn, will continue to drive up dayrate levels and rig-equipment prices." Among service holdings that did well for The Boston Co. last year, the analyst cites Weatherford International, Grant Prideco, Tidewater, Lonestar Technologies, Maverick Tube, Global Industries, BJ Services and National Oilwell Varco. "Names we continue to like and own in the service sector are deepwater drillers, such as Transocean and GlobalSantaFe," says Marshall, who also likes transition-zone driller Todco and drillpipe and drillbit manufacturer Grant Prideco. The deepwater drillers are getting premium dayrates relative to replacement-cost economics because there's a supply/demand imbalance in that market, he believes. "And if one carries leading-edge dayrates out a few years, the earnings potential of these companies is incredible." Meanwhile, a drillpipe manufacturer like Grant Prideco also stands to benefit from stepped-up rig activity. "As we drill more and more wells, continue to go deeper into more pressurized formations and get more involved in horizontal drilling, more premium drillpipe will be increasingly needed by the industry." Wakefield, who sees greater cash flows being spent in the deep water and on more infrastructure-building by the industry, also believes that Dril-Quip, a provider of subsea production equipment, is likely to be a beneficiary of these trends. "There's a good possibility it could be awarded a $25-million subsea project by a major oil, which would cast the company as a fully integrated subsea-system player and fuel significant upside in the stock." The analyst is similarly sanguine about Oil States International, one of the largest distributors of oil-country tubular goods. This outlook is based on a recovery in Oil States' offshore-production group, which offers connector products for deepwater production facilities and pipeline tie-in systems. Stressing his team is bullish on all sectors of the energy industry, Costello cites Marathon Oil and Questar Energy as two portfolio stocks likely to perform well in 2006. "We're short on refining capacity in the U.S. and that has led to increased crack spreads and profitability for refiners," he points out. "As a percent of its profits, Marathon is the most exposed to domestic refining of all the integrateds." In addition, unlike other majors, Marathon is showing controlled production growth, which should increase 12% in 2006, as the result of its construction of a liquefied natural gas (LNG) facility in Equatorial Guinea and its return to Libya, he adds. Costello also believes that while Questar Corp. has a utility and a pipeline division, Wall Street is overlooking the key driver of the company's growth: its E&P division which accounts for 75% of assets and earnings. "Questar is in Wyoming's Pinedale Anticline along with Ultra Petroleum, another fast-growing E&P company we like, where it's showing 10% to 15% annual production growth," he says. "However, it's testing a deeper shale formation in the region that could be more prolific than the Barnett Shale and triple the company's asset base during the next five years." Pricing power An investment-management firm with about $110 billion in assets under management, Eaton Vance Management in Boston has an overall 10% to 12% weighting to energy through its various equity funds. "Back in the mid-1980s, OPEC had spare productive capacity close to 15 million barrels per day; today its daily excess crude capacity is down to around 2 million barrels, so clearly supply/demand fundamentals have tightened," says Charlie Gaffney, vice president and lead energy analyst for Eaton Vance. "In addition, geopolitical risk has arisen in many parts of the world from which excess crude supply is coming, such as Venezuela, West Africa and the Middle East. All this sets the stage for continued strong commodity prices and energy-stock valuations in 2006." With an outlook this year for $40 to $60 oil and $6 to $9 gas, Gaffney sees another 20% to 30% upside in service-stock values and an average 15% to 20% gain for E&P shares. "We're very bullish on the oil-service group because it clearly has pricing power, which is accelerating," he says. "Drillers, for instance, are renegotiating contracts at much higher dayrates than we've seen in the past-and the contracts are for much longer periods, particularly in the case of deepwater drillers which are now obtaining three- to five-year contracts rather than 12-month commitments at very favorable pricing." Another cause for his bullishness: E&P companies and integrated oils have announced 20% to 30% increases in their capex budgets for 2006. Such a move reflects-and more than offsets-the rising cost structures facing drillers and equipment suppliers alike, in terms of the increased price of cement, steel and labor. During the past two years, Eaton Vance has profited from its equity-holdings in Halliburton, whose stock more than doubled during that time. "While the company has benefited most from the resolution of its asbestos issues, the growth of its oil-service group and recent restructuring steps should continue to spur earnings," the analyst says. The firm has also been enriched by its equity exposure to offshore drillers Transocean and Noble Corp. "These are names we haven't shied away from going into 2006 because we believe that higher dayrates, longer-term contracts and tight rig supply continue to bode very well for these companies," Gaffney says. On the E&P side, the portfolio manager sees a win-win scenario in 2006, whether commodity prices move up or down. "Amid strong commodity prices, we should see good returns and strong earnings growth in the group this year. But even if prices fall, that still presents the opportunity for many larger-cap E&P companies-sitting on strong cash flows and balance sheets-to buy smaller-cap or midsize producers at potentially discounted valuations." Within the upstream sector, the firm has benefited from equity positions in Marathon Oil, Burlington Resources and The Williams Cos. In the case of The Williams Cos., Gaffney believes its restructuring story is just about over and investors are going to increasingly recognize the imbedded value in the pipeline company's E&P business, based on its growing production and reserve profile in Colorado's Piceance Basin. The energy analyst is no less bullish on Canadian oil-sands players, favoring Canadian Natural Resources and Suncor Energy. "Both represent a call on the long-lived nature of oil-sands reserves, plus they have good managements and strong balance sheets, and have executed strong production growth," says Gaffney. "In addition, they represent strong takeout candidates, given that there are not only other companies but also whole countries looking to invest in oil-sands projects." Producers pressured Overall global productive capacity for crude oil and natural gas is tight and is likely to remain that way for the next few years; thus, any small shock, either on the supply or demand side, could lead to even higher commodity prices than the market has recently witnessed. So observes Harry Arora, portfolio manager for Amaranth Group Inc. in Greenwich, Connecticut. Amaranth, a hedge-fund manager with more than $7 billion of assets under management, is currently allocating up to one-third of its capital to commodities, principally energy. Included in this allocation is a substantial investment in the equities of energy companies. "A few years ago, we had 6- to 7 million barrels per day of excess crude oil productive capacity available from the Middle East; today, we're looking at maybe 500,000 to 1 million," he explains. "So we're in a cycle where we're going to see strong commodity prices-whether that's $50 or $70 is impossible to say-and good profitability for energy companies." Which energy sectors might fare best in such an environment? "Even with current high commodity prices, E&P companies are facing two major challenges: costs are increasing and it's becoming increasingly more difficult in mature basins like the U.S. to find significant quantities of hydrocarbons," Arora says. "So, from a valuation perspective, many U.S. producers are under some pressure." Gulf of Mexico producers, in particular, have been punished quite harshly in terms of valuations versus more rapidly growing, unconventional-resource operators in the Rockies, he adds. "True, the Gulf of Mexico is a much faster depleting basin, requiring more capex, plus it's a riskier environment because of the hurricanes. But the valuation discounts for producers there seem too extreme." Oil-service companies, on the other hand, may be in a better situation, from a valuation perspective, the portfolio manager contends. While he allows that costs are rising for that sector as well, in terms of labor and steel, they're increasing at a much lesser rate. "In our view, there are segments of the service sector that are going to enjoy further and faster stock-price appreciation, higher returns and continued premium valuations versus those for much of the E&P sector where one now has to be much more selective." This is true, Arora says, for the drillers and for the major integrated service companies because of the breadth of services they provide-and because of the increasing move by majors and larger independents away from mature U.S. basins into more prospective areas globally like West Africa or Russia. Such a thesis, however, doesn't dismiss the investment merits of the E&P sector as a whole. There are many producers that have and will be able to articulate a successful strategy of growing production while controlling costs and managing downside risk, he notes. "In the past, operators like EOG Resources, Apache and Anadarko have been able to demonstrate these characteristics. Also, there are many smaller-cap producers able to demonstrate another important characteristic-strong organic growth. Among these have been Southwestern Energy, Range Resources and Cabot Oil & Gas." Arora adds that Canadian oil-sands producers are also going to become an increasingly important part of future oil supply, not only globally but for the U.S. "As people become more comfortable with $50-plus oil, there will be significantly more investment in that part of the industry's value chain." Tight fundamentals Cadence Capital Management, a Boston-based money-management firm handling $7 billion worth of domestic equity investments for institutional clients, has about an 11% weighting to energy. "As this weighting suggests, we're bullish overall on the energy sector, but more so the oil-service segment than the E&P group," says Leanne M. Moore, senior energy research analyst for Cadence Capital. "Based on E&P capital budgets for 2006-initially expected to start out at a 20% increase over 2005 levels-oil-service stocks are going to have pricing power going forward. Comparatively, major integrated oils and independent producers are going to experience more margin compression due to that pricing power." The analyst's outlook is based on continuing tight supply/demand fundamentals, particularly for oil, which should cause recent robust crude prices to remain relatively stable. World oil demand, she notes, is expected to rise 1.7% this year; meanwhile, on the supply side, OPEC will be constrained in increasing its current 1- to 1.5 million barrels per day of spare productive capacity by the limited number of rigs available in the market. In addition, political instability and unrest in places like Russia, Nigeria, Iran and Iraq could cause interruptions in production, further tightening the supply side of the equation. Says Moore, "All this translates into an expectation this year of oil prices in the high $50s and average natural gas prices of $8.75-and in such an environment, the service companies have the pricing power." Just which service companies look attractive? "We like the drillers because their dayrates continue to roll over to higher highs," she says. "Transocean, for instance, continues to make higher highs-and a lot sooner-than people have expected. Also, drillers with a lot of uncommitted days for their rig rates are benefiting immediately from new, higher dayrates versus drillers already locked into contracts. This was true for Todco in the Gulf of Mexico last year after the hurricanes." Moore also likes service suppliers-providers of drillpipe, wellhead services or supply boats-because operators are willing to pay up to ensure that such equipment is in place when they're spending so much per day on drilling. During the past two years, Cadence Capital's equity investments in the energy sector have benefited from holdings in Superior Energy Services, a renter of drilling equipment and services, primarily in the Gulf of Mexico and the Gulf Coast. "The demand for (Superior's) rental equipment has been robust, but the kicker for the company is its Superior Resources division, which acquires and exploits older wells that operators are either decommissioning or abandoning," the analyst says. "So Superior has been reaping the benefits of increased demand and pricing for their various offshore services, particularly after the hurricanes in the Gulf, while on the E&P side it's benefiting from higher commodity prices." Another top service performer in the firm's equity portfolio has been Oil States International. "While its tubular products are continuing to see stronger demand and higher margins, the company is also benefiting from increased deepwater drilling and the need to tie in more production facilities in that environment." This emphasis aside, Moore is quick to point out that Cadence still has exposure to the E&P sector. "However, for us to own stocks in that group, companies must show they're benefiting from organic production growth-not simply from robust commodity prices alone." Holdings in 2005 that matched this profile were St. Mary Land & Exploration and Denbury Resources. Insulated profit A diversified investment-management firm, Babson Capital Management LLC based in Boston has $97 billion of assets under management, with an equities exposure upwards of $15 billion. "We think oil and gas supply and demand are pretty much in balance at this time, and that recent commodity prices are probably close to the high end of the range we'll see for 2006," says Stephen Kylander, a managing director with Babson Capital, an energy analyst for the firm's small-cap fund and a portfolio manager for its midcap value fund; those funds have 5% to 10% weightings to energy. "Commodity inventory levels are close to their 10-year averages right now while we're seeing normal demand patterns, so unless we have a significant global supply disruption, or the perception of it, oil prices should stabilize in the $40 to $60 range with natural gas prices averaging around $8." Given this outlook at the start of year, the buysider has gravitated toward investments in energy companies that aren't dependent on the expectation of higher commodity prices and whose profitability is reasonably insulated from any declines in oil and gas prices and hence, less susceptible to prospective margin squeezes. Which energy companies? "With commodity prices where they are, and with E&P spending and activity levels as robust as they are, we believe the service sector should continue to experience increased demand and pricing leverage," he says. "Among offshore drillers-the likes of Transocean, GlobalSantaFe and Ensco-there's upward pressure on dayrates, which currently are driving to above-replacement-cost levels for the building of new rigs." Also, drillers such as these are entering into longer-term contracts, as much as three years in duration, Kylander points out. "Thus, regardless of what commodity prices do, there's good visibility as to what these companies' dayrates and earnings are going to be, not only this year but out through 2007 and 2008." The energy analyst is also focused on rig-equipment manufacturers and service providers like National Oilwell Varco, Grant Prideco and BJ Services. "Whether it's supplying top drives, drillbits, tubing or pressure-pumping services, the demand and margins for such equipment and services are going to increase, right in line with the increase in the number of rigs, rig-utilization levels and capital spending by producers." Although E&P companies may be a little more dependent on commodity-price increases, Kylander contends there are nuggets to be found in that sector as well. "Operators that are increasing production-and exceeding expectations with respect to their ability to grow production-should be viewed favorably. They have the opportunity not only to achieve strong earnings, but probably some multiple expansion from where they're trading today." One upstream holding in Babson's 2005 portfolio that exceeded the expectations of many was Spinnaker Exploration. Last year, the market was infatuated with onshore, low-cost, high-success-probability producers and gave Spinnaker a significant discount because of its offshore exploratory nature, the buysider explains. "We, however, amassed a solid position in the company, then trading below $30. Subsequently, Norsk Hydro recognized Spinnaker's value as well and took the company out at $65." A current E&P holding of the firm, similarly discounted by the market in the past, is Forest Oil of Denver. "This is a company that's trying to achieve greater value through restructuring," says Kylander. He points out that Forest is spinning off its Gulf of Mexico business into Mariner Energy, already focused on the Gulf, and concentrating its efforts onshore North America where it believes it can grow production volumes by more than 10% annually for the foreseeable future. "By dividing its onshore and offshore businesses, Forest has created the catalyst for each business to be ultimately valued more separately than both were on a combined basis."