Still Cautious on Gulf of Mexico Driller Stocks

We assert that our Cautious views are NOT overstated and are certainly NOT fully reflected in the share prices of the Offshore Drillers. We are reiterating this assertion despite the Philadelphia Oil Service Index [OSX] being down 22.9% from its May 10, 2006.

The main risks that are currently riding the drillers are: 1) the significant declined in commodities (crude & natural gas) prices; and (2) a cost inflation of 15-20%. We don’t expect the aforementioned to improve in the short-term mainly due to: (a) supply for natural gas and crude are quickly catching up or could probably outpace demand in the next couple of months; and (b) the rise in costs is due to the triple % increases in average day rates for the past couple of years. Consequently, demand for drilling, which was supported by the increases in commodities price, is slowing down (short-term).

In reviewing the recent fleet status of the Offshore Drillers we note that day rates in the US Gulf of Mexico [GOM] are slowly showing signs of an up-tick (based on contract terms) beginning in early Q107 versus early expectation of Q406. Investors should note that this is a highly cyclical industry and higher commodities prices are responsible for an increase in demands, which is then followed by increases in day rates.

In our opinion, current natural gas prices are at a critical level that could have day rates in the GOM remaining unchanged or could cause them to dip further during the next contract roll-over. Note here that natural gas prices are 59.7% lower than a year ago and are 16.7% below the price from two years ago.

Certainly the pull back in the Offshore Drillers from the peak is being touted as a buying opportunity. With the decline of commodities prices, higher expenses, a slowdown in demand and a build up in gas/crude supply, we have yet to see a catalyst that would suggest otherwise.

Q306 has come to an end, making it one of the worst performance quarters in this cycle to-date. The OSX declined 11.5% Q/Q. We would not recommend adding to position on the Offshore Drillers—At least not until we are half way through with Q306 reporting season (perhaps).

We continue to advise staying (temporary) clear of companies that are heavily exposed in the GOM, i.e., ENSCO (ESV), Pride (PDE) and TODCO (THE). Further given that the drillers are a homogeneous group, we suggest Noble (NE) -- leverage -- GlobalSantaFe (GSF) and Rowan Cos. (RDC [both rigs {RDC & GSF} have mob delays and higher expenses]). Our focus remains true to the more balanced mid-water and deepwater players, namely Diamond Offshore (DO) and Transocean (RIG) --- despite the expectation of higher costs.