While downside risks remain, the overall outlook for the oil sector has improved in recent days, owing largely to the tentative signs of a supply response to anemic global demand. With demand falling sharply due to worldwide economic problems, inventories started building at a faster rate since last fall.

In response, OPEC (which accounts for roughly 40% of all oil supplies) announced a number of production cuts. While there was ample skepticism early on regarding OPEC’s ability to enforce the announced cuts, recent evidence suggests a significant level of compliance within the cartel.

As such, while oil prices over the coming weeks will track the outlook for the global economy, the commodity’s improved supply situation is expected to help prices consolidate around current levels.

Natural gas, on the other hand, is a North American story and developments here over the coming months will determine its outlook.

On balance, we see more upside potential than downside risk in the sector.

OPPORTUNITIES

The risk-reward trade-off for a number of sub-sectors remains very compelling, in our view. The large-cap integrateds, oilfield services and offshore drilling sub-sectors offer lucrative opportunities at current levels.

The relatively low-risk energy conglomerate business structures of the large-cap integrateds, with their fortress balance sheets, ample free cash flows even in a low oil price environment, and growing dividends are well suited for uncertain times like these. Our preferred names in this group remain Exxon (XOM) and Chevron (CVX).

The underlying business fundamentals of oilfield service companies, particularly those with an international focus and deepwater-capable drilling contractors still remain robust. We like Schlumberger (SLB) and Baker-Hughes (BHI) in the oilfield service space, and our preferred deepwater drillers remain Transocean (RIG) and Diamond Offshore (DO). We like Pride (PDE) as an emerging and relatively under-appreciated deepwater driller.

WEAKNESSES

We strongly feel that industry players in the servicing and drilling ends of the business with substantial natural gas-focused and North America-centric operations should be avoided.

The two major sub-sectors that fit that description would be the onshore drillers and service players with heavy pressure pumping operations. We believe that pricing and margins for operators in these two sub-sectors will remain under pressure through 2010, even as the outlook for natural gas price improves.

Halliburton (HAL), the largest North American pressure pumping player, and BJ Services (BJS), one the largest in this category, need to be avoided. We also have Sell recommendations for Nabors (NBR) and Patterson-UTI (PTEN), two major North American land drillers.

Zacks Investment Research
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