An Energy Services Starter Kit

Crude oil prices have slid steadily from $78 a barrel in July to the mid-$50s in November. But in just the past couple of weeks, they've hoisted themselves back near $63.

Oil prices are all over the headlines. What you may not have noticed, however, is that oil services stocks, whose fortunes ultimately are tied to those same crude prices, actually began to turn higher as early as October, after sliding in sympathy with crude for the previous two months. The energy services group consists of those companies that help the oil and gas producers -- from Exxon Mobil (NYSE: XOM  ) to the smallest independent -- locate, drill for, produce, and transport oil and natural gas. They include such names as Schlumberger (NYSE: SLB  ) , Halliburton (NYSE: HAL  ) , and Baker Hughes (NYSE: BHI  ) , along with a bevy of smaller, more specialized companies. Perhaps this group recognized sooner than you and I that higher crude prices were in the offing.

But before looking at some specific oil services names that I think warrant Foolish attention, let's consider a few of the drivers of crude prices, because in the final analysis, the services group will rise and fall on swings in those prices. In the short term, we have to pay attention to such factors as weather, economic fluctuations, variations in the currencies of the industrialized world, and, last but certainly not least, OPEC's grouchiness quotient. I'll remind you that OPEC is comprised of such bastions of geopolitical dependability as Iran, Iraq, Nigeria, Libya, Venezuela, and Indonesia. As long as those nations behave themselves, crude prices will benefit. But who among you will give me solid odds that they all will remain on good behavior for, say, the next five years?

Longer-term, the worldwide consumption of crude currently is in excess of 80 million barrels per day. However, the Energy Information Administration, an arm of the Department of Energy, predicts that by 2030, worldwide consumption will likely jump to about 118 million barrels per day -- call it 120 million barrels.

This means that, in an era of smaller oil discoveries, we'll need to maintain current production over the next 24 years -- a sizable task in itself -- while adding half again as much crude to the daily mix as we currently produce. This set of challenges, both short- and long-term, lead me to believe that Foolish investors would do well to keep a close eye on the energy services sector. On that basis, let me describe a few of the companies in that sector that I believe are especially interesting.

The first name out of the chute is Hydril (Nasdaq: HYDL  ) , a Houston-based mid-cap company that manufactures premium connections for drill pipe, production tubing, and casing, as well as pressure control devices. As drilling moves into deeper waters or encounters more corrosive conditions, the quality of the connections joining sections of drill pipe or the casing that prevents the well from caving in becomes crucial. The same can be said for the devices that prevent wells from blowing out. I believe that Hydril is the foremost member of this segment of the service sector.

The company, which currently trades near $76, has moved up from near $50 in early October. Its trailing and forward price-to-earnings ratios are 20.3 and 16.9, respectively, versus a norm for the service industry approaching 25 in the good times. Its management, led by CEO Christopher Seaver -- an attorney, a former foreign service officer, and a member of Hydril's founding family -- is solid, as is its debt-free balance sheet. From $2.92 in per-share earnings in 2005, analysts expect it to move to $3.68 this year and $4.46 in 2007.

Among the offshore drillers, I particularly like Transocean Inc. (NYSE: RIG  ) , a large-cap company with about 90 rigs in its fleet. These rigs include 32 high-specification semisubmersibles and drillships, 23 other "floaters," and 25 jack-ups. Semisubmersible rigs are precisely what their name implies: large units whose flotation tanks are filled with water during drilling, such that the rig sinks partially below the surface and thereby gains increased stability. Jack-ups usually have three legs that are sunk into the sea bottom during drilling. They typically drill in shallower water than do semisubmersibles.

As with Hydril, the theme here is deep water, as exploration efforts move farther out in search of larger hydrocarbons deposits, particularly of oil. Transocean's trailing P/E ratio is 28.4, while its forward P/E is just 10.5, based on analysts' expectations of an earnings jump from $1.57 per share in 2005 to $7.47 in 2007, as day rates surge. Transocean is one of less than a handful of drilling contractors capable of serving producers' needs in deeper water horizons.

I also like the energy services sector's largest company, Houston-based Schlumberger, which sports an $81 billion market capitalization and a share price near $69. Schlumberger operates through two divisions, the first being Schlumberger Oilfield Services, which provides a host of services for drilling, well completions, and maximizing reservoir productivity. Its smaller division, WesternGeco, is a leader in seismology and multi-component surveys for determining the magnitude of oil and gas prospects.

Schlumberger's trailing P/E is 26.1, and its forward multiple is 18.4, based on analysts' expectations that its $1.67 EPS for 2005 will increase to $2.93 this year and $3.74 in 2007. Also important is the more than $500 million that the company's management sinks into research and development each year. My interest in Schlumberger is based in part upon its broad spectrum of products and services and its geographic diversity, which involves operations in 80 countries.

The smallest of the names on my energy-services-deserving-of-attention list is NATCO (NYSE: NTG  ) , which produces oil and gas separation and dehydration equipment, equipment for the removal of carbon dioxide and other contaminants from gas streams, and automation and control systems, primarily for use on offshore facilities. The carbon dioxide removal equipment is particularly important for eliminating contaminants left behind by tertiary recovery techniques, during which carbon dioxide is flooded into a well in an attempt to improve hydrocarbon production.

NATCO's shares are currently trading at about $34.50, or about the middle of its $20.08 to $42.62 range for the past year. The company's trailing P/E is 19.7, and its forward P/E is just 13.5. NATCO's $0.82 per share in 2005 earnings is expected to increase to $1.97 this year and $2.56 in 2007. As I believe is the case with many of the companies in the energy services group, NATCO benefits from solid management guidance.

This will provide you with some of the basic tools necessary for dipping your toe into the oil services investment water. I will add the caveat that the group can be volatile, as is the case with any sector that is closely tied to commodity price fluctuations. But I also believe that, given the impetus for increased oil and gas exploration and production activity that I have described and that will last for years to come, it is wise for Foolish investors to be at least somewhat represented in this group.

For a look at some great stocks trading at deep discounts, take a free 30-day trial of Motley Fool Inside Value. You'll get access to all past and current picks, as well as calculators, discussion boards and more.

Fool contributor David Lee Smith owns shares in Schlumberger. He welcomes your questions or comments. The Fool's disclosure policy thinks "Schlumberger" is a lot of fun to say.


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