Investors who made oil and gas stocks a part of their 2004 portfolios feel energized as the calendar turns to a new year. With oil prices piercing $50 and natural gas prices heating up as well, energy equities followed. Higher prices mean higher cash flow for exploration companies, which, in turn, means more drilling and more revenue for energy service companies.

However, the "threat" of milder weather and the possibilities of new supplies of crude coming from overseas have helped bring oil prices down from the stratosphere, back into the $40 range. While those prices, if sustainable, provide plenty of opportunity for energy investors into the new year, the rapid descent -- similar to the ascent just months earlier -- has spooked some energy pundits as the new year approaches.

For some, that means opportunity. For others, it suggests "lights out" for the energy rally into 2005. Both can't be right.

Supply and Demand

While spikes in energy prices can occur for a number of reasons, long-term price direction is almost always determined by supply and demand. Certainly, 2004 had its share of exogenous variables in the oil markets: instability in the Middle East, uncertainty in Venezuela, production issues in Saudi Arabia, strikes and strife in Nigeria, and challenges toward capitalism in Russia, just to name a few.

All of those issues contributed to the price acceleration in crude and created what many called an unsustainable "risk premium" in the price. While all of those variables certainly had an impact, so too did the impact of rising global demand for crude.

Whether it was the acceleration in development in China or India or the slow but steady improvement in the global economy, demand for all energy sources -- crude, natural gas and coal alike -- increased in 2004. While the debate will rage about what rate of growth China will post in 2005, the fact is that the burgeoning country will continue to use more, not less, energy. As a result, global demand is likely to continue to rise into the new year.

And that's a time when supply remains challenged. With most smart energy pundits suggesting we are near supply-demand equilibrium, any increase in demand will further strain producers who are already struggling to keep pace with growth.

That is not only true in oil markets, but also in North American natural gas markets where supply shows little, if any, growth when compared to year-ago levels.

The simple fact is this: The easy oil and gas has already been found. New deposits of hydrocarbons will be found deeper in the earth, in locations more difficult to access and requiring more expensive technologies. This means that the equilibrium price at which explorers will find it economic to search for new sources of energy will continue to inch higher in the coming year.

More Rigs, Less Oil and Gas, Means More Rigs

That may seem confusing, but it's really simple. In 2004, over 50% more drilling rigs ran in the U.S. than in the year before, but natural gas production barely budged. As I noted in an Oct. 28 column, the need to drill more wells just to keep pace with the increasing decline of current production should lead to more activity among energy service companies.

In 2005, that will continue to benefit the contract land drillers. Companies like Nabors ( NBR - Get Report) should benefit from more land-based natural gas drilling in the United States as well as an acceleration in the winter drilling program in Canada. In addition, Nabors has made additional inroads in the lucrative Saudi oil markets, continuing the transformation into an international drilling contractor. Not only will more drilling put more rigs to work, it will also push contract day rates higher, meaning margins should improve.

Back at home, other land-based contract drillers such as Pioneer Drilling ( PDC) and Patterson-UTI ( PTEN - Get Report) stand to benefit as well, although their platforms are not as large nor as diverse as Nabors. And, in Canada, companies like Precision Drilling ( PDS - Get Report) should start the year with a bang as the frozen tundra brings significant activity to our north.

All Wet

While land-based drillers should continue their strong performance, offshore drilling is likely to accelerate in the new year. Signs of increased activity in the Gulf of Mexico were clear in the second half of 2004, and that should continue into 2005.

Companies like Rowan ( RDC) and Ensco ( ESV) should do well, as drilling on the Continental Shelf in the Gulf of Mexico continues to increase, creating a tight market and higher day rates for rigs. The market could become even tighter if areas such as offshore Nova Scotia, Trinidad and the North Sea compete for equipment currently working in the Gulf of Mexico.

Deepwater activity is likely to be a major story in 2005. With majors like ChevronTexaco ( CVX - Get Report) and ExxonMobil ( XOM) joining independents like Anadarko ( APC) and Kerr-McGee ( KMG) in deepwater exploration, companies with larger semi-submersible and floating rigs like GlobalSantaFe ( GSF), Transocean ( RIG) and Diamond Offshore ( DO) stand to benefit.

There are risks to deepwater exploration: A sharp correction in commodity prices makes such exploration less attractive. And, while success rates have improved recently, this drilling is high risk, with dry hole costs in the millions of dollars. A string of bad luck would likely create a chilling effect on future exploration.

Drilling Down on Services

Other service companies should also benefit from continued drilling strength. Weatherford ( WFT), for example, is a leader in new drilling and completion technologies that help create more productive, cost-effective wells. Either ahead or on the heels of major service companies such as Halliburton ( HAL) and Schlumberger ( SLB), Weatherford's new technologies are being adopted around the world as they improve drilling and production efficiencies.

Another service company, Superior Energy Services ( SPN), will also benefit from increased activity in the Gulf of Mexico. With a fleet of work boats and a host of stimulation and workover services used by many of the major Gulf of Mexico exploration companies, 2005 could provide significant growth for Superior. In addition, the company's recent entry into the late-lived production business through its SPN Resources subsidiary should add to 2005 earnings. With the potential to earn north of $1 per share in 2005, Superior is a nice mid-cap value play.

Of course, a collapse in energy prices is the largest risk to energy stocks. While that seems unlikely, it will be difficult for energy stocks to move higher as energy prices work their way to more moderate levels. However, absent prices below $30 oil and $5 gas, 20005 should provide plenty of ideas for energy investors.

While energy stocks may not seem as cheap as they did at the beginning of 2004, the potential for continued growth in 2005 means a number of solid opportunities for energy investors in the year ahead.

At time of publication, Edmonds was long ExxonMobil, although holdings can change at any time.

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. 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 welcomes your feedback and invites you to send it to cedmonds@thestreet.com.