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Big Energy's Enablers

They'll take you on a wild ride, but energy-service companies offer the biggest potential.

ExxonMobil earned $36 billion in 2005 -- a single-year record for a publicly traded company. Its stock has performed admirably, returning 17% since the start of 2005. Yet Exxon's stock looks like a chump when stacked against the stock of companies that supply the rigs, manpower and technology that help energy companies discover and extract oil and gas. On average, energy-services stocks have risen by 53% since the start of '05.

Is it too late to invest in the helpers? We don't think so. During the past two decades, major energy companies have not invested nearly enough in finding and developing new oil deposits. Now they're playing catch-up -- a game that seems likely to continue for years. "We're in an energy-services bull market for at least the next 24 months," predicts analyst Marshall Adkins, of the Raymond James brokerage.

The energy-services sector is notoriously volatile. Companies usually build too much equipment during the fat years, then in the lean years that inevitably follow, many go bankrupt. Says T. Rowe Price energy analyst Timothy Parker: "The stocks will do much better than the rest of the energy sector in an up cycle and much worse during a downturn." To put it mildly, these aren't buy-and-hold investments.

But how do you know when to sell? Not by looking at short-term declines in stock prices. On average, energy-services stocks suffer 10% drops four or five times yearly. (In fact, the group sank 14% in the first half of February.) As long as oil -- $58 a barrel in mid February -- stays above $40, demand for drilling gear and services should remain strong. Instead, keep an eye on the global economy. If the U.S. economy weakens markedly or China seems to slip toward recession, that's your sell signal. Don't wait for earnings to decline.


The four stocks and three funds described here should flourish for at least another year or two. Stocks are listed in order of risk, starting with the least risky.

Global heavyweight

The world's biggest and best player is Schlumberger. From undertaking three-dimensional seismic analyses of oil and gas deposits to bringing in complete wells, Schlumberger's technological expertise is unmatched. Its managers spent decades cementing ties with government leaders in the Middle East, Africa and the former Soviet Union, and that gives the Netherlands Antilles-based company an edge when it comes to signing deals.

Because of the quality factor, Schlumberger (symbol SLB) tends to sell at premium prices. At $113, the shares sell at 23 times the $4.96 per share that analysts expect the company to earn in 2006, reports Thomson First Call. But the rich price-earnings ratio is warranted, says FBR analyst Robert MacKenzie. "Schlumberger is the leader in many of the most profitable industry trends," he says, "and it has the best franchise internationally -- particularly in some of the more remote and politically sensitive areas of the world."

Underwater driller

Just as Willie Sutton robbed banks because that's where the money was, explorers search underwater because that's where the energy is. That's where Noble (NE) comes in. It has one of the world's best fleets of jackups -- football-stadium-size offshore drilling platforms replete with cranes, derricks, heliports and living quarters for more than 100 workers -- that attach to the ocean floor and operate in depths up to 400 feet. Noble (not to be confused with Noble Energy, a producer) is also expanding its fleet of deep-water semi-submersibles. Even larger than jackups, these floating platforms can drill in water as deep as 12,000 feet -- and up to seven miles below the seabed.


Demand for this dazzling equipment is so strong that oil firms are signing multiyear contracts at increasingly higher rates -- sometimes for rigs that won't be completed for years. Analysts expect Noble, based in Sugar Land, Tex., to earn $5.39 per share this year, and MacKenzie Davis, co-manager of RS Global Natural Resources fund, sees $8 a share in '07 (the stock, at $70, sells for 13 times '06 estimates). Davis calls Noble chief executive James Day "one of the smartest guys in the oil patch." Case in point: During the last energy downturn, in 2001, 88% of Noble's drilling platforms were leased -- a terrific record.

Biggest land driller

Noble's success under the water does not mean that drilling on land is now obsolete. Quite the contrary. Demand for land drilling gear and services is booming as higher prices prompt explorers to search for oil and gas in smaller and harder-to-reach deposits. Nabors Industries (NBR), the world's largest land driller, is the obvious beneficiary. "Land rigs used to be leased for a month or two at a time," says Standard Poor's analyst Stewart Glickman. But with demand surging, the company "is getting multiyear contracts for rigs that haven't even been built yet."

Over the next two years, Nabors plans to deploy 100 new, highly mobile rigs. That, coupled with its dominant position in the U.S., means that it can put its equipment into operation in more places more quickly than any other driller. Based in Barbados, the company also has a growing international presence, operating rigs in Canada, the Middle East and Africa. The stock, at $69, trades at 11 times estimated 2006 earnings of $6.25 per share.

Risky compressor play

Investing in one of the riskier stocks in a risky industry practically defines the term flier. And that is certainly true of Hanover Compressor (HC), a debt-laden company that is extricating itself from an accounting quagmire. Shareholders sued and the Securities and Exchange Commission investigated the company several years ago. The chief executive resigned under fire in 2002.


Under new management, Hanover's fortunes are improving. The Houston company manufactures, rents and sells compression equipment used to push oil and gas out of the ground. Hanover has only one major competitor, Universal Compression Holdings, and supply is tight. "Hanover is the last guy standing with spare capacity," says Glenn Primack, co-manager of FMI Focus fund. Moreover, Hanover's newest business venture -- providing state-of-the-art equipment that separates impurities from oil and gas at the refinery -- is growing rapidly. Hanover lost money last year, and analysts expect earnings of just 29 cents a share this year, giving the stock, at $16, a nosebleed P/E of 55. But they see earnings soaring to 70 cents a share in 2007.

The fund alternative

Until recently, Fidelity used its Select Energy Service fund (FSESX; 800-343-3548) as a training ground for analysts. Fourteen managers have shepherded the fund since its launch in 1985. But late last year, John Dowd, 37, a Sanford Bernstein energy analyst with 15 years' experience and an impressive knowledge of the industry, took over the fund. At the end of 2005, the fund's top holdings included Schlumberger, Nabors and Noble. It returned 76% over the past year to February 1 and 41% annualized over the past three years. The expense ratio is 0.96%.

PowerShares Dynamic Oil Gas Services (PXJ, $19) is an exchange-traded fund that was launched last October. It invests in a stock index that changes every three months, based on a computerized system that ranks stocks on 25 criteria. Expenses are 0.6% annually. Another option is Oil Service Holdrs (OIH). A close cousin of ETFs, Holdrs are extraordinarily cheap, charging a nominal custody fee of $2 per quarter for each round lot of 100. Oil Service Holdrs own fixed percentages of 18 of the largest energy-services firms. One disadvantage: You must buy a minimum of 100 shares. At a recent share price of $134, you'll need to pony up at least $13,400. Oil Service Holdrs returned 76% over the past year and an annualized 42% over the past three.