Despite $30 oil and $4-plus gas throughout much of 2003, oil-service stocks didn't reflect this sustained boom. One could attribute that to sluggish capital spending by the major oils, a warmer-than-expected 2002-03 winter, market sentiment in general or a combination. The times, however, are changing. By almost any measure, the U.S. economy seems to be rebounding and, with the Dow recently punching through 10,000 again, investor sentiment appears to be turning bullish-toward stocks in general and energy-sector issues in particular. Also, there are signs that both major oils and independent producers will be doing more upstream spending in 2004-good news for the service sector. That leaves just one imponderable: the weather. "If we have a colder-than-average 2003-04 winter, that will accelerate the urgency to close the natural gas supply/demand gap in North America," says James K. Wicklund, managing director and senior oilfield-service analyst for Banc of America Securities in Houston. "If, on the other hand, we have a milder-than-average winter, that sense of urgency will lessen." Weather aside, Wicklund and other oil-service analysts point out that the underlying industry trend in 2004 will be toward higher levels of drilling, to take advantage of expected $4-plus North American gas prices and rebounding drilling demand internationally, in places like West Africa, India, the Middle East, Mexico and Russia. All this means higher utilization levels and dayrates for drillers, and improving margins for oilfield-equipment suppliers. But which service stocks are likely to show the greatest gains in share-price appreciation during 2004? To find out, Oil and Gas Investor polled five leading industry analysts. Their top choices follow, in order of how frequently a company was mentioned and highest projected percent gains in share price. Patterson-UTI Energy This second-largest land drilling contractor in North America, with a fleet of 340 rigs, is a pure play on the outlook for improved rig utilization and dayrates in 2004, says analyst Wicklund. "In the past two upcycles-the ones that peaked in 1997 and 2001-it was the best-performing stock in my coverage universe. This company blends the operating expertise of Patterson Drilling with the financial expertise of UTI Energy." Utilization levels for this driller have recently averaged 55%, says Poe Fratt, senior oil-service analyst for A.G. Edwards & Sons in St. Louis. "However, with strong natural gas prices and higher E&P spending, the driller's utilization levels in 2004 should rise to nearly 65%. Meanwhile, its rig margins-$1,700 to $1,800 per day at the start of 2003-should move up to nearly $4,000 by the end of 2004." Joe Agular, partner and oil-service analyst for Johnson Rice & Co. in New Orleans, looks for the company to generate $2 per share of free cash flow in 2004, up from 40 cents per share in 2003. "Also, with no debt and more than $100 million in cash, it has great flexibility going forward." Nabors Industries Since September 2001, margins for U.S. land drillers have risen from an average $1,000 per day to about $2,600 recently, and they should average $3,400 in 2004, says Wicklund. "That type of operating leverage is greater than in any other subsector of oilfield services. Nabors-the world's largest contract land driller-is well positioned to take advantage of that leverage as North American E&P companies step up drilling activity in a strong gas-price environment." The analyst also likes the fact that Nabors has about $1.5 billion in cash and a debt/total capitalization ratio of only 16%. Waqar Syed, oilfield-service analyst for Petrie Parkman & Co. in Denver, says that although the company has more than 400 rigs, only 157 were working in the Lower 48 in third-quarter 2003 out of some 280 to 290 actively marketed rigs. "More recently, however, it had 173 rigs running, and in 2004 it should average 190 active rigs, with utilization around 65%." Syed says that Nabors has good exposure to Canada, where the 2003 rig count averaged a record 422. "The company believes its earnings could be up 30% in 2004 in Canada versus 2003." He also notes the company is looking to gain a foothold in land drilling in Russia and Mexico. Fratt says margins for Nabors, which were $1,800 per day at the start of 2003, should move up to around $4,000 by the close of 2004. Pride International With debt/total capitalization of 49.6%, the company has a lot of debt on its books, says Syed. "However, it has placed a significant portion of its 12 floaters and 33 jackups under long-term contracts, so there's good assurance of cash flow for the next several years." That cash flow, he says, will help Pride pay down debt, and as that happens, the stock should appreciate. Currently, its shares are undervalued, trading at 7.2 times 2004 EBITDA (earnings before interest, taxes, depreciation and amortization) versus a peer-group multiple of 10.8, and at 24.3 times 2004 earnings versus a group multiple of 29.4, he says. Fratt says that, during second-half 2003, the company was able to put a lot of its jackups to work in Mexico-an attractive dayrate environment-which should help full-year earnings and cash flow in 2004. "At the same time, Pride has seen dayrates for its Gulf of Mexico jackups move up, from a 2003 low of $17,000 to around $28,000," he adds. He expects the company's rig utilization there to also rise, from a recent 50% to 75% in 2004. Ensco International Jackups are the best-positioned rig asset class in the near term, in terms of benefiting from improved utilization and dayrates, says Syed. "We're seeing demand for these rigs coming from the national oil companies of Mexico and India. Also, they're in demand in places like Trinidad and Qatar." The Gulf of Mexico is also becoming attractive for jackups, he says, because so such supply is coming out of that market and because there's an increasing emphasis by the industry on drilling deeper wells on the shelf, where the gas-reserve potential is now estimated to be 55 trillion cubic feet. "Ensco, with half its fleet of 43 high-quality jackups in the Gulf of Mexico, is one of the purest ways to play the improving fundamentals for jackups," says Syed. Fratt, too, notes that the international jackup markets are benefiting from high spending by the integrated oils and expanded capital outlays by state-owned oil companies. "This has pushed effective jackup utilization, on a global basis, to more than 90%. In 2004, the jackup market-from which Ensco derives 95% of its revenues-will be very tight." Adds Fratt, "If natural gas prices are $4 or higher in 2004, and if there is royalty relief for drilling deep-shelf Gulf of Mexico wells, rig-utilization levels there could also reach 90% and we could see a further 20% to 25% improvement in dayrates." Varco International While this company provides capital equipment for drilling rigs, such as top drives and pipe-handling equipment, much of its business is focused on providing other service companies with value-added capabilities to their E&P customers, says Wicklund. "Varco provides about two-thirds of all the coiled-tubing units used by the industry for the remediation, workover and stimulation of wells. This is a market that has been growing 8% annually during the past 10 years." The company is also involved in the manufacture, sale and rental of solids-control equipment, as well as waste-disposal equipment. "This allows its customers the ability to recycle expensive drilling fluid and to minimize the transportation and disposal of hazardous waste," he says. "Trading at less than 25 times 2004 earnings versus a service-industry average multiple of 23, Varco is one of the best value picks in our universe." Agular says, "The company's tubular-services business and its drilling-services business-mainly solids-control on drilling rigs-are the reasons I'd want to own the stock." Also, it recently bought Ico Inc., a tubular-inspection and pipe-coating company that competed with Varco's Tubosope business. "This acquisition significantly strengthens Varco's position in that market." Baker Hughes "We're looking for service companies with high-revenue exposure to international markets," says Bill Sanchez, senior oilfield-service analyst for Howard Weil in New Orleans. "While an investor gets that with any of the large-cap service companies, Baker Hughes-which provides drilling fluids, drillbits, directional drilling tools and services, and artificial-lift equipment-offers compelling value. The stock is trading at a discount, on both an absolute and relative basis versus historical earnings multiples." While Inteq-Baker Hughes' directional-drilling-systems business-should see margin expansion in 2004 from higher rig utilization in the Gulf of Mexico, "the company also stands to benefit from increased industry focus on Russia, given its strong presence in artificial lift," says Sanchez. Although all of Baker Hughes' product lines should benefit from a broad recovery in industry capital spending in 2004, two of the company's businesses-drilling fluids and oil tools-are currently underperforming, notes Fratt. "However, with the benefits of restructuring in the drilling-fluids business, and lower capital spending and more disciplined pricing in its oil tools and directional-drilling businesses, those businesses' margins should improve." BJ Services This is a pure play on the high-margin, pressure-pumping business, says Wicklund. "The industry fracs and stimulates virtually every natural gas well drilled, so the rise we expect in domestic gas drilling in 2004 will significantly benefit BJ Services. In addition, the increase we're seeing in international gas drilling provides long-term secular growth potential for the company's services." The analyst believes the company's pressure-pumping margins will increase to 21% in 2004 from 19.7% in 2003. Meanwhile, free cash flow for BJ Services, whose debt/total capitalization is a low 23%, should exceed $215 million this year versus $139 million in 2003. Sanchez says, "While the company may have a little more exposure to the U.S. rig-count market than we'd like, 2004 earnings estimates for BJ Services are very achievable." These estimates suggest the stock is currently undervalued, based on historical forward multiples of earnings, he adds. The analyst likes the company's strong exposure to Canada, "which should average a higher rig count in 2004 than last year as some of the acquisitions made by E&P companies in prior years begin to be exploited." Also, he notes, the company has exposure to important international markets such as Mexico and Russia. GlobalSantaFe "As the jackup market tightens in 2004, both internationally and in the Gulf of Mexico, this offshore driller-which derives 75% of its revenues from the jackup market-should see its earnings, cash flow and stock price recover," says Fratt. He points out that the driller, which has a fleet of 46 jackups and 15 floaters, is enjoying 100% utilization of its 10 jackups in the Gulf of Mexico while internationally, only three of its remaining jackups are idle, those in the West Africa market. "With the improving utilization levels and dayrates for jackups that we're forecasting for 2004-and a recovery in the West Africa jackup market-this company will begin to trade closer to 100% of replacement value rather than at 70% of that value, as it recently has," says Fratt. "The stock will also be helped by a firmer market for its floaters, with utilization rising from 75% to 85% and dayrates increasing from $45,000 to $65,000 at the lower end of the market." Rowan Cos. With 21 of its 23 jackups in the Gulf of Mexico, this driller should benefit from the improved dayrate environment expected for that market in 2004, says Syed. Of particular interest are Rowan's four high-end jackups, the Super Gorillas, which can simultaneously drill and produce reservoirs, lowering an operator's costs. "Two of these Gorillas have recently been working in the Gulf of Mexico, but the right market for them is the North Sea, where they can be used to develop marginal oil fields-and command dayrates of $120,000 to $150,000 versus $60,000 to $75,000 in the Gulf of Mexico," Syed says. McDermott International The company's defense contracting business, involving the manufacture of nuclear fuel systems for the U.S. Navy and managing nuclear sites for the Department of Defense, is generating earnings and cash flow growth, says Agular. "Meanwhile, the company's marine construction services for the oil and gas industry-a business in a turnaround mode after suffering from oil-industry contracts that didn't perform well-is starting to show signs of promise." Agular notes this business segment is helping a consortium develop oil fields in the Caspian Sea, and that it has fabrication yards in the Middle East and Indonesia-areas with good business prospects. Also, it has created an alliance with BP to handle a lot of that major's deepwater Gulf of Mexico work. "Despite this turnaround, the stock remains undervalued and underfollowed." Superior Energy Services This production-services company, offering rental tools, coiled tubing, wireline, lift boats, and plugging and abandoning (P&A) services, has been largely focused on the Gulf of Mexico, from which it derives 90% of its revenues, says Agular of Johnson Rice. "The next stage of its growth, however, will be through international expansion. Recently, the company acquired a U.K. rental-tool company, which could help its market growth in West Africa, the Middle East and the North Sea." Through it SPN Resources division, the company is also buying oil and gas fields that have back-end production-where operators may soon be looking at a P&A liability. "This is a good fit for the company and adds value; we should see it entering into more of these arrangements, mainly in the Gulf of Mexico." Grant Prideco This company has about 60% of the worldwide drill-pipe market and will benefit from improved margins in that business as drilling demand picks up in mid-2004, says Agular. He notes the firm's drill-pipe margins rose to 21.4% in third-quarter 2003 from 16.8% the previous quarter. Also, the company bought Reed-Hycalog, the Schlumberger drillbit company, for $300 million. "This has been a good, stable business for Grant-Prideco that has allowed it to regain market share in that area," he says. "And while the tubular business has been lackluster lately, the company is cutting costs and making that division more efficient." Agular notes the company is also working on "intelligent" drillpipe, which would allow an operator to send logging- and measurement-while-drilling data through the drillpipe faster than mud-pulse systems do. Universal Compression Holding This company, which has about 35% of the worldwide market for contract compression services for gas production onshore and offshore, is a play on the North American and international gas story, says Agular. "As gas wells age, they need compression services; in the case of coalbed-methane wells, they need compression right away. As the demand for such services increases, so, too, will the need for Universal's units. Already the company is throwing off free cash flow of $2 per share." Smith International The wells the industry is drilling today are becoming deeper and more complex, requiring more complex drilling fluids and higher volumes of those fluids, says Wicklund. "Smith, a market leader in the drilling and completion fluids business, is benefiting from both these phenomena, selling more fluids and higher-margin fluids." While the stock often appears expensive, "its growth in revenues and margins has consistently been at the top of the range for my universe," the analyst says. "Free cash flow in 2004 should be $192 million, up from $135 million in 2003." FMC Technologies This company, which has about a 38% share of the subsea production systems market, should benefit from the continued secular growth in deepwater drilling and the resulting development of discoveries requiring the use of its services, says Wicklund. "We expect subsea completions/development to grow 15% annually for the foreseeable future." He looks for the company to generate $143 million of free cash flow in 2004, up from $65 million in 2003. Noble Corp. This internationally focused offshore driller, with a fleet of 38 jackups, six high-spec semis, three midwater-depth semis and three drillships, has a fairly visible 2004 earnings stream, says Sanchez. He points out that Noble has a large jackup presence in Mexico, exposure to the Middle East and India-where drilling programs are expanding-and to West Africa. The company also holds options to purchase two additional jackups for those markets. Says Sanchez, "Despite the fact that Noble has the highest return on capital employed among offshore drillers, this stock is undervalued versus its peer group." National-Oilwell This company, primarily a capital-equipment provider for onshore and offshore drilling rigs, is particularly strong in the areas of mud pumps, draw works and top-drive equipment, says Sanchez. "Its stock, however, is trading at a discount to forward earnings versus historical valuations, both on an absolute and relative basis. What the market may be overlooking is that the company has had a less cyclical earnings stream than other service suppliers because it's a backlog-driven business. This backlog gives National-Oilwell high earnings visibility, which is what investors are seeking."