Three oil exploration stocks set to surge

As 2006 gets underway, doubts over whether the oil price can keep rising are proving unfounded the good news just keeps on coming for the oil majors.

BP this week announced profits for last year that have only been bettered in UK corporate history by Shell, leaving investors among them, we hope, many MoneyWeek readers feeling rightly pleased with themselves.

But over and above the oil majors, there is another group of companies feeling even happier about current events those in oil services.

This sector comprising everything from contractors who carry out seismic surveys to consultants and rig providers is "making hay" as the oil giants' profits trickle down the industry, say Tracey Boles and John Penman in The Sunday Times. So much so that many firms are reporting that turnover has doubled in a year, figures that even Shell and BP would be jealous of.

The problem for the majors is that, although their profits may be "eye-watering", they cannot spend the money as quickly as they would like on new development because the sector is suffering from a lack of services, equipment and skilled workers.

This bottleneck, due to lack of investment in recent years, means that oil services firms have as much work as they can take and can charge accordingly. The service firms are "reaping the rewards", says Jeff Corray, UK senior oil and gas partner at consultant KPMG.

But in spite of the high costs, oil majors are turning on the spending taps. This year, BP plans to spend $15bn on exploration, production and the rest of its business. Who exactly is to benefit?

Seismic-survey contractors such as Schlumberger and Halliburton are the first to benefit, according to the oil-services firm Petrofac. Owners of offshore drilling platforms, such as Rowan, are also "among the first" to profit during an oil-industry upturn, with the most sophisticated deep-water drilling rigs costing up to $500,000 a day to hire, more than triple the rate two years ago.

This is leading to a boom in the sector. Firms are keen to expand and have cash to spend, which explains the recent wave of consolidation, says Kwan Yuk Pan in the FT. The services companies down the chain are even beginning to gobble up the oil firms themselves, as in the case of the recent acquisition of Remington Oil & Gas by services firm Cal Dive International in a deal valued at $1.4bn.

And it is mergers and acquisitions like this that are going to help keep the sector and the offshore drillers in particular growing at such a fast clip. Over the last two years, the offshore drilling firms have developed seemingly "limitless" pricing power, says Alan Laws, sector analyst at Merrill Lynch. The huge rise in earnings growth and cash generation means that investors must take a longer-term view to the end of the decade to "truly capture" the story.

So what of the future? The market may already be expecting capital spending to increase, but with 66% more engineering and construction tenders outstanding for offshore oil and gas projects than 12 months ago, Martijn Rats at Morgan Stanley believes the market will still be "positively surprised" in 2006-2007. After that, he forecasts that oil-firm capital expenditure will continue to grow by 15%-25% a year until "at least" the end of the decade, as oil firms with quickly expanding balance sheets desperately try to find and extract more oil. Good news for oil services companies.

The three best bets in the sector

European oil services stocks rose 55%-70% during 2005 on the back of huge oil sector spending, says Morgan Stanley's Martijn Rats. However, he still expects 15%-30% further upside.

Among his top picks are offshore driller Saipem (SPE:GR, e15.90) and engineering firm Wood Group (WG, 238p), both of which he rates "overweight". Among Saipem's "key attractions" is the earnings growth from offshore drilling, with rates more than doubling in 2005 alone. Using 15.5 times as his target p/e ratio, his new price target is e20, 27% above the current price.

Wood Group, on the other hand, has been one of the "poorest performing" oil services stocks globally since January 2003 because of the weakness in the deepwater engineering and US gas turbine maintenance markets. However, fundamentals are "improving rapidly". The market is still negative, but this is now unjustified and the target of 280p means more than 16% potential upside.

Oil services group Hunting (HTGF, 269p) indicated recently that a healthy order book and production backlog should mean that its results for the year to 31 Dec 2005 to be released on 2 March will be "ahead of current market expectations", says Afxnews.com. The shares are currently at record levels, but with demand rising rapidly and oil and gas companies budgeting "significant" spending increases, the company is "well positioned" to benefit.