With oil breaching $60 a barrel and natural gas trading well above $7 per thousand cubic feet (mcf), it's hard to imagine the climate for energy stocks getting any better than it is right now. In fact, many oil and gas stocks are trading near at least 52-week if not record highs and estimates for solid second-quarter earnings seem to have set the expectation bar at lofty levels.

Of course, these same comments were made a year ago when oil prices were at $40 a barrel and natural gas was closer to $5 per mcf. But even as stock prices have entered new territory, it's important to remember an important axiom of the market: It isn't where stocks have been that matters, it's where they are going.

With that in mind, the energy thesis remains bright for the second half as solid demand, strained supply and the need to continue to accelerate drilling activity will provide plenty of opportunities for energy companies in the second half of 2005.

Moderating but Strong

Regardless of their outlook, almost all energy analysts and investors have one thing in common. Very few, if any, have accurately predicted the meteoric rise in commodity prices in the first half of 2005. As my regular readers know, I have been among the most bullish on oil and natural gas prices for the past 12 to 18 months, and even I did not expect the rapid run in crude prices and the linked run in natural gas.

A number of events have pushed prices higher:

  • Concerns over security in the Middle East.
  • Production challenges in non-OPEC nations such as Norway and Mexico.
  • The political fiasco in Russia.
  • Weather has had a clear impact, including the lingering effects of last year's hurricanes and the threat this week from Cindy and Dennis.

However, the primary reason for the sustained lift in crude prices is tight supply and robust demand.

Clearly, the growth in China -- and, in part, India -- has driven global crude demand, which is steadily approaching 90 million barrels per day (mmbpd). Given that global, sustainable production capacity is somewhere in the 85 mmbpd range, price has moved higher in search of a new supply-demand equilibrium point. The volatility and upward pressure on prices is a classic economic sign of a new paradigm in pricing.

That doesn't mean $60 per barrel is the right price, but it strongly suggests a quick return to the $40 level is unlikely. I continue to believe oil prices in the $50 range are both likely and appropriate in the current environment. While that means some moderation in price, it also means very robust pricing from which to value oil and gas companies.

Natural gas faces similar supply and demand characteristics but will remain a regional market until meaningful liquefied natural gas (LNG) comes to market later this decade. That said, in North America, base production continues to decline at nearly 30% per year, meaning it takes more new discoveries just to sustain current production levels. And, with the clean environmental aspects of natural gas, demand from power plants as well as other commercial and industrial applications is likely to remain robust.

Natural gas storage remains at comfortable levels, but that comes after a very mild winter season that followed an unusually mild summer of 2004 that allowed stockpiles to build. Over the last three weeks, warmer weather and now tropical storms have shown the impact weather can have on storage activity. As a result, like oil, natural gas prices are likely to remain strong in the coming months.

More Supply Means More Wells

The urgent quest for new sources of crude oil and natural gas means there is a need to drill more wells. And that means continued growth in demand for drilling rigs, both land-based and offshore.

On land, that should mean continued strong performance by

Nabors Industries

(NBR) - Get Report

, a leader in contract land drilling. Currently, nearly all of Nabors' rigs are working for exploration and production companies and demand is beginning to strain supply. As a result, day rates -- the price per day an E&P company pays to use a rig to drill a well -- continue to increase, as do Nabors' profit margins. While many thought margin acceleration would begin to flatten after a first-quarter ramp, early indications suggest the margin acceleration continued in the second quarter. As a result, 2005 earnings estimates, currently in the $3.30 range, are likely to move higher.

In addition, Nabors has increasing exposure to international markets, with an opportunity to move three dozen to four dozen rigs overseas in the coming year. That is especially true in Saudi Arabia, where Nabors continues to receive requests for rigs as

SaudiAramco

looks to accelerate drilling to offset increasing production declines. The Saudis are running nearly 100 rigs, almost double from a year ago, and continue to request more. Moreover, unlike rig contracts in the U.S., which are typically well-to-well, Saudi contracts typically run for a minimum three-year term and command day rates 30% to 50% above current domestic rates.

Offshore drillers also will benefit from increased activity. Jack-up rigs, which operate in shallower water such as the Gulf of Mexico shelf and parts of the North Sea, have seen day rates increase dramatically as nearly all rigs are working. That benefits companies like

Rowan

(RDC)

and

Ensco

(ESV)

. One company with significant leverage as demand continues to increase is

Todco

( THE), which still has a pool of jack-ups that can take on new work. In addition, diversified rig companies like

GlobalSantaFe

(GSF)

that have a fleet of rigs that work in various water depths benefit from both an increase in shallow and deepwater prospects.

Technology Focus

As the quest to find new oil and natural gas moves to deeper horizons, the application of new drilling technology is in focus. Clearly, companies like

Halliburton

(HAL) - Get Report

, and

Schlumberger

(SLB) - Get Report

lead the pack here, although some smaller players are worth mention.

In deepwater exploration and production, the need for production and connection equipment on the sea floor, known as subsea technology, is becoming much more important.

CooperCameron

(CAM)

and

FMC Technologies

(FTI) - Get Report

are the leaders here and continue to battle over lucrative contracts from the Gulf of Mexico to West Africa. FMC Technology's focus on packaging both hardware and technical expertise make this niche player an interesting play.

Two other names to watch on the technology front include

Weatherford

(WFT) - Get Report

for its significant focus on new drilling and production technologies, and

Hydril

( HYDL), with its focus on premium connections and pressure-control equipment. Both benefit from deeper, more challenging drilling applications.

While moderation in energy prices may cause some pause in the energy-stock rally, the need to drill to replace and expand production should keep the energy equity cycle intact. As a result, the second half of 2005 should provide plenty of powerful opportunities for energy investors.

Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he appreciates your feedback;

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