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Oil-services stock prices have gained 15% in just the past two months. But this has not been without some volatility.

The 15% move puts investors back to where they were at the beginning of the year.

Here are reasons I believe the action in these stocks is not over, and some ways to invest in an underappreciated group:

Let's start with the basics.

Oil-services companies engage in a variety of activities related to exploring, developing and managing oil and gas production. The move in oil prices to more than $100 last year has been good to this group. The oil-services stocks clocked in a stellar average return of more than 40% for 2007. In comparison, the ETF that tracks West Texas crude,



, gained 50% for last year.

Undoubtedly some of the selloff in the oil-industry stocks can be attributed to profit-taking at quarter end and nervousness about the true price of oil. Some say the weaker U.S. dollar combined with supply disruptions in places like Nigeria added a premium to oil prices that should have otherwise fallen with lower demand forecasts and higher short-term supplies. This may be so for the price of oil, but it's the level of oil prices that matters to oil-services companies.

One overlooked announcement recently illustrates why oil-services stocks should continue to draw investor attention for a longer period than previously anticipated.


(PBR) - Get Petroleo Brasileiro S.A.- Petrobras Report

announced it had awarded a $4 billion contract to

Noble Corp

(NE) - Get Noble Corporation plc Report

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for five deep-water drilling rigs, nearly doubling Noble's backlog to $10 billion. The Noble announcement extends a current arrangement but on much better terms, as Noble indicated in its press release.

What's going on here?

The current supply of deep-water drilling equipment is running at full capacity.

Deep-water drilling-rig day rates continue to hit new highs. Globally, exploration companies are going into deeper and deeper waters to find oil. But there are a limited number of deep-water rigs.

According to ODS-Petrodata, deep-water drilling rig fleet utilization has been running at 100% for the past three years. This means that new contract rates are being penned at record-breaking premiums. Not surprisingly, the 18 to 24 month waiting lists for new rigs are getting longer, as the Noble backlog indicates.

Incredible backlogs are not an isolated event.

Just last week,


(RIG) - Get Transocean Ltd (Switzerland) Report

, the leading rig supplier, estimated that 69% of undelivered new builds are already contracted. Other companies are reporting similar tightness and backlogs.

Emerging-market growth like Brazil's will increase demand for drilling.

Geographically, Brazil is a key source of new demand for deep-water rigs, especially with the recent discoveries in the region. Brazil along with Angola and India are three major developing basins of business for rig companies.

In the past six months, PetroBras has discovered three super-giant oil fields in Brazil's offshore Santos Basin. If the estimates of 33 billion barrels in reserve from Carioca-Sugar Loaf prove correct, then this ranks as the third-largest oil field in the world after Saudi Arabia's Ghawar (66 billion barrels) and Kuwait's Greater Burgan (46 billion barrels). This oil bonanza is in addition to the other two new Brazil finds, Tupi and Jupiter, which are estimated to contain about 6 to 8 billion barrels each.

With these estimates, Brazil may now hold the world's eighth-largest conventional oil reserves. This is a paradigm-changing event. Some analysts are even speculating that Brazil may potentially join Venezuela and Ecuador as the third South American member of OPEC.

But getting this new oil out is not without its challenges. The Tupi oil field lies under more than 7,000 feet of water and then through layers of sand, rock and salt. Drilling depths are greater than 22,000 feet. These deeper waters will require new approaches that push technology limits and increase costs. Getting the oil out of the Earth also means getting more drill ships. Unfortunately, these ships take time to build and are already in short supply, putting more upward price pressure on existing equipment rates.

It's not just the big countries that are looking for drills. Even Colombia, which geographically lies between Venezuela and Ecuador, is preparing to become a larger oil and gas exporter and will need more drills. It is preparing for auctions in 2009 of additional blocks on its Pacific coast for oil and gas exploration.

The key points here are:

a) Whether you add in new techniques or new discoveries, Latin America is becoming a significant global factor for oil and oil services companies.

b) The Latin America case illustrates how these two unstoppable forces of 1) limited supply and 2) much greater demand define the longer term positive earnings environment for oil-related stocks in the region and globally.

c) Next time you see a drop in oil prices that has investors scared about oil service stocks -- back up the truck and add to your portfolio.

Let's look closer at some approaches for this.

How to Invest in Drilling Stocks

For the active investor, here are the five leading rig stock picks sorted by rig-count ranking.

No. 1

. With 137 rigs, Texas-based Transocean leads this group. This company commands $32 billion in back orders. These orders represent more than five times last year's total revenues for the company. This is a global firm, with 94% of its business in international sectors. Being the largest player in a tight market certainly appears to have its advantages. This $60 billion market-capitalization stock was up 71% over the past year and trades at a deserved premium cash flow multiple (EV/EBITDA) to the group.

No. 2

. Another Texas-based provider, Noble Corp. holds the second spot with 62 rigs in its fleet. Like Transocean it too has a broad geographic portfolio of business. More than 78% of its total revenues are generated internationally. This $14.5 billion market value stock has not moved as much as its peers, up only 27% over the last 52 weeks. Current consensus estimates call for 2009 cash flow (EBITDA) to be up 54% vs. 2007, making Noble stock look very discounted in comparison with its peer stock group average.

No. 3

. The third stock on our list of winners,



owns 49 rigs. It recently estimated that deep-water revenue could more than quadruple from $150 million to $650 million in 2011. It has 80% of its rigs booked for 2008. This $8.9 billion market value stock also looks very attractive, selling at only 5.4 times 2009 consensus estimates of enterprise value to cash flow (EV/EBITDA).

No. 4


Diamond Offshore

(DO) - Get Diamond Offshore Drilling Inc. Report

merits the fourth position with $16.5 billion market value and 46 rigs. The U.S. Gulf of Mexico represents Diamond Offshore's largest market. Total revenues recently crossed the 50% mark last year; so now Diamond Offshore is more of an international operator and should experience faster growth. Management is very positive about the future. It suggestsutilization of world-wide floaters will run at 100% through 2011 andsupport higher corporate earnings.

No. 5


Pride International


ranks fifth on this list with 45 rigs. Over the past five years PDE has fully refocused itself toward offshore drilling, which represented $2 billion of net revenues last year. Of this amount, Mexico and Brazil accounted for 40%. The contribution from Latin America is likely to be higher in 2008, especially if it wins extensions for rigs under contract with Petroleos Mexicanos, the Mexican national oil company. Currently, Pemex is mired in a political process as legislators argue about possible constitutional changes to open up parts of the oil business to foreign firms. The last time the contracts were extended, day rates on these three rigs moved from 36,000 per day to 97,000 per day or about $106 million in annual revenue. Stay tuned for more news from Mexico City. You should expect a likely repeat of last year's increase. The stock is another attractive play selling at the lowest cash flow multiple in the group, only five times cash flow. At only $6.3 billion in market value PDE may also be attractive consolidation candidate.

For less-active investors those who do not care to watch the rig status reports for these companies or want to find an easier way to invest in this broad sector theme, exchange-traded funds may be the answer.

Here are some other funds and the leading stocks to consider for adding oil service stocks to your portfolio.


SPDR S&P Oil & Gas Equipment & Services ETF

(XES) - Get SPDR Oil & Gas Equipment and Services ETF Report

follows the S&P index of U.S.-based stocks in this sector. Currently no one position exceeds 5% of the total market value. For a 35 basis point expense ratio you get access to smaller stocks including recent winners like

Patterson Uti Energy

(PTEN) - Get Patterson-UTI Energy Inc. Report

up, 36% year-to-date, and

BJ Services Company


, up 21% year to date.

As an alternative, look at the more concentrated

PowerShares Dynamic Oil & Gas Services Portfolio

(PXJ) - Get Invesco Dynamic Oil & Gas Services ETF Report

that holds 30 shares. The underlying index evaluates companies based on fundamentals and slightly outpaces the S&P Oil & Gas Equipment Services index over the last seven-year period. The top three holdings are

Smith International



Baker Hughes





(HAL) - Get Halliburton Company Report


For those just seeking to create an instant 17-stock portfolio in oil services,

Oil Service HOLDRs Trust

(OIH) - Get VanEck Oil Services ETF Report

may be the ticket. But be careful; with the smallest number of stocks, this one has exhibited the greatest volatility.

Keep this simple concept in mind:

The age of cheap oil is behind us. High-priced oil means more money is spent on exploring for new fields and on maximizing the output of established ones. Oil-services companies that do this are positioned to generate excess returns.

Rudy Martin is the former director of research for Ratings. Earlier he worked 25 years in investment research and management positions with Fidelity Investments, Lincoln National, Dean Witter Reynolds and Transamerica Investments. He began his career as a securities investment analyst at Duff and Phelps where he published equity and fixed income securities investment recommendations. Martin holds a master's degree in finance from Kellogg Northwestern University and is also a Chartered Life Underwriter.