Despite improved rig counts and strong U.S. natural gas prices, not everyone subscribes to the consensus view that the recent increase in the Oilfield Service Index (OSX) will be sustainable. "We believe [service-sector] revenue growth this cycle will be slower than previously, and that earnings power has been diluted by excessive growth in oil-service capital employed," says Gordon Gray, global oil and gas analyst, European equity research, JPMorgan, London. Gray says his analysis of revenue-weighted rig counts points to an 8% global growth rate between first-quarter and fourth-quarter 2003. "In the last cycle, when [sector] earnings doubled, the growth rate was 20%." In addition, the analyst notes, the reduction in new capital available, rising upstream cost inflation and an increased focus on returns should reduce rig demand through the current cycle. "We estimate a reduction from these effects of 200 rigs, implying a rig count of 1,100 versus the previous peak of 1,293." He adds that overcapacity in the service industry is destroying pricing power and the pace of price improvements. "Combined with lower demand, we do not think prices will escalate by the 9% that consensus fourth-quarter 2003 estimates would require to reach forecast earnings." Furthermore, the analyst has observed increases in cash and non-cash costs for the sector, cycle-to-cycle. "In first-quarter 2003, these led to a 25% reduction in operating profit versus the same period in the previous cycle." Says Gray, "We estimate 2003 OSX earnings per share of $3.25-below consensus-and expect disappointments to weigh on sector performance in the second half of this year." The analyst is more upbeat on E&P sector stocks. "Market data continue to support a 'stronger for longer' view on U.S. natural gas prices. Our 2003 Henry Hub spot gas price forecast is $5.60 per MMBtu." His analysis indicates that recent E&P valuations have been discounting around $4.10 gas prices this year versus his own price expectation of $5.60. "We believe that continued evidence of capital discipline and debt reduction would convince investors of the sector's continued upside potential in coming months." In Gray's view, recent E&P valuations allow for at least 20% potential upside. The analyst's top sector stock picks among the larger E&P companies are Apache, Pioneer Natural Resources and Unocal. "We view Unocal as a contrarian value play, and the other stocks as offering the best combination of underlying growth potential, returns and valuation." -Brian A. Toal