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Hercules Offshore to the Rescue

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HERO was formed by a band of investment bankers a few years back to rationalize the jackup rig and lift boat business in the Gulf of Mexico. The Todco merger actually completes that goal...

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As gasoline and natural gas prices have soared in recent months, a very interesting thing has happened. Or not happened, to be more specific. Consumption of these key sources of energy has not waned, much to the surprise of oil and gas producers.

The lack of much protest from consumers -- aside from the angry phone calls on talk radio -- has really shocked the folks who run the Organization of Petroleum Exporting Countries, more commonly known as OPEC, and led them to believe that there's no point in providing more supply to knock down prices. As a result, it looks to me as though we are probably never going to see oil move down below $40 per barrel again in our lifetimes.

If that's true, then analysts' and investors' view of the energy sector is going to undergo a radical upward reappraisal over the next few months and years. Energy companies' shares might seem high to you now, as big-caps like ExxonMobil (XOM) are trading at all-time highs, but you ain't seen nothin' yet. When investors collectively decide that the new "band" for oil prices is $50 to $65 rather than $35 to $50, then virtually all energy stocks are in for a major upward move.

In this scenario, every subsector of the energy industry will move higher: Oil and gas drillers, services providers, explorers, refiners, pipeline owners and the major integrators. We are just in the third inning of the game now, and it should continue to surprise people.

Just to give you an idea of where it could go, consider the last decade in which there was a major upward reappraisal of energy: the 1970s. Back then, Exxon shares rose 157% from January 1970 through June 1977. That was great, but by the time the decade was over, Exxon shares were up almost 300%. Now fast-forward to this decade. From January 2000 to June 2007, Exxon shares were up 145%. If they were to mirror what happened in the '70s, they'll end the decade at around $125, or up 50% from the current $84 quote.

All this is good news for the energy companies, but not such great news for the average consumer. We know how gasoline prices are breaking budgets. So in order to put some of the cash you're shelling out at the pump each week back into your pockets, I've been suggesting not just ExxonMobil, but a couple of other energy companies that are set to profit from higher oil and natural gas prices as well as drilling rates.

Our Hero

One of my favorite names for the past three months has been Hercules Offshore (HERO). I started buying it in March a few days after the company announced its purchase of energy services rival Todco (THE), as I expect the merger to work out very well.

Shares are up 30% since then, and I have recently learned that the last major hurdle to the merger -- the Hart Scott antitrust review -- has been cleared. The deal is likely to be completed after shareholder meetings in July, and not long after that we're really going to see an upward reappraisal of HERO's earnings prospects and stock price.

HERO itself was formed by a band of investment bankers a few years back to rationalize the jackup rig and lift boat business in the Gulf of Mexico. The Todco merger actually completes that goal, as you'll now have a single company dominating shallow-water drilling off the coast of Texas, Louisiana and Mississippi. Indeed, the combined outfit will own 40% of all "mat" jackup rigs in the entire world, and HERO is already the world's largest operator of lift boats, which are a slightly different type of drilling rig.



After the deal closes, HERO will be able to take as many rigs and inland barges out of production as necessary to keep day-rate pricing rational and remove some measure of cyclicality from the business. The amazing thing about the deal is that HERO was actually able to buy the Todco rigs for less than the price it would have had to pay on the open market for new rigs, had they been available -- and they come with highly capable crews to boot.

Day rates for jackup rigs in the Gulf of Mexico are running well below the $120,000 level seen in 2006 in the wake of Hurricane Katrina disruptions. But they do appear to have stabilized around $70,000, and management has told investors that they expect prices to drift back up toward the $100,000 level over the next year or two.

The bottom line is that you're going to have improved pricing and efficiency at a time when natural gas drilling prices are likely to begin to recover. And at the same time, there may be some sales of redundant assets that will boost the bottom line as well. My estimate for 2008 is $5.30. Put a very modest 11X multiple on that, and you get a 15-month target of $58, which is 75% above the current price.
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Position in HERO, XOM

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