Day Rates Don't Bode Well for Oil Service

For energy service and drilling stocks, rig day rates and asset-replacement costs have excellent track records for indicating the future price direction of a stock.
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The recent advance by the Oil Service HOLDRs (OIH) - Get Report ETF and drillers such as Transocean (RIG) - Get Report and National Oilwell Varco (NOV) - Get Report and has generated investor chatter about a possible rally from service, drilling and rig stocks.

When choosing the right time to enter a bruised market, it is important to pay attention to the right metrics. For energy service and drilling stocks, rig day rates and asset-replacement costs have excellent track records for indicating the future price direction of a stock. Oil prices are less dependable. A stock's recent market performance has proven to be a horrible indicator of future price direction.

Demand for drilling rigs of all kinds evaporated when energy commodity prices bottomed last fall, and they have stayed low as the price of oil crept higher over the last month. When production companies slow the pace of leasing drilling rigs, rig operators tend to slash prices. They also stop ordering new rigs from manufacturers.

Analysts at TPH Energy Research are predicting that rig day rates will fall further before they improve, and that low day rates will likely extend through 2010. This is bad news for the oil service sector and for the Oil Service HOLDRs. It is very bad news for offshore rig operators like Transocean,

Noble

(NE) - Get Report

and

Diamond Offshore

(DO) - Get Report

.

"Historically, this group has been very simple in terms of when you make money owning these stocks, and that is when day rates are increasing, " TPH Energy said Wednesday in a email. "We don't see this happening in 2009 or early 2010."

In a declining day-rate environment, drilling stocks usually find a bottom when they reach a multiple of the replacement cost of their assets. TPH Energy says that the historical multiple is about 50%. The average replacement cost for companies in the group reached the 50% mark last fall, but the prices for oil rigs and for rig components such as steel have fallen sharply since then. Until the price of steel bottoms, drilling and rig stocks will have trouble finding a floor to stage a long-term rebound.

Last Tuesday, TPH Energy slashed its 2009 and 2010 earnings estimates for seven offshore-drilling companies, including Transocean, Noble,

Pride International

(PDE)

, Diamond Offshore and

Hercules Offshore

(HERO)

. Companies that have little debt and plenty of cash reserves are best positioned to navigate safely through the trouble the group faces. Transocean and Pride International take the top spots while Hercules Offshore trails the pack, according to the TPH Research Note.