For the U.S. offshore drilling industry, this January wasn’t particularly illustrious, as shares in the sector sold off 13% for the month versus a like decline for the OSX (Oilfield Service Index) and a 9% dip for the S&P 500.

Since then, however, the stocks of offshore drillers have rallied appreciably, averaging a 12.8% rebound as February closed out. Helping lift the sector off its lows have been record-setting, ultra-deepwater rig contracts and signs of a recovery in the Gulf of Mexico jackup market.

“Surging natural gas prices have particularly helped Gulf of Mexico-exposed jackup companies like Hercules Offshore (Nasdaq: HERO), Rowan Cos. (NYSE: RDC) and Ensco International (NYSE: ESV), which have generally outperformed the OSX and the overall offshore drilling index,” says Judson E. Bailey, oilfield-service analyst for Jefferies & Co. in Houston.

“Going forward, we continue to see signs of further improvement in the global deepwater market in addition to the Gulf Mexico jackup market,” he adds. “Meanwhile, in the international jackup market, although dayrates are likely to remain soft, we expect demand to be robust enough to absorb upcoming jackup deliveries.”

Perhaps not coincidentally, a new record for ultra-deepwater dayrates was set this February as Ocean Rig ASA (Olso: OCR) announced a three-year contract for its Erik Raude rig at a dayrate of $617,000 offshore West Africa, notes Bailey. Also impressive: a three-year contract extension that Transocean (NYSE: RIG) inked with Anadarko Petroleum for use of its ultra-deepwater drillship, Deepwater Millennium, to begin 2010 in the Gulf of Mexico at a dayrate of $535,000.

Within the Gulf jackup market, modest dayrate increases are under way. He cites a three-month rig contract in the low $80,000s that Ensco just received from Hunt Oil, up from one in the mid-$60,000s. In addition, Rowan Cos. garnered a six-month contract from Apache Corp. in the mid-$70,000s, also up from one in the mid-$60,000s.

During the next few months, Bailey expects more long-term, premium contract announcements not only for existing offshore rigs but also for several under construction. He also expects delivery slots on newbuild ultra-deepwater rigs—for delivery in early 2011—to be filled by this summer.

Bailey predicts a high level of M&A activity to continue as established and new offshore drillers attempt to grow their offshore fleets, given that asset demand remains high in growing markets like Brazil, India, China and the Middle East.

So is now the time for investors to be eyeing the stocks of offshore drillers? Despite the rebound in this sector’s shares in first-quarter 2008, “we believe that valuations remain compelling, particularly considering the growth potential of the sector during the next two to three years,” says Bailey.

While the service seer believes companies with Gulf of Mexico jackup exposure like Hercules provide compelling near-term trading opportunities, he contends that deepwater-leveraged companies provide the most compelling long-term opportunities.

“Overall, our offshore drilling group currently trades at approximately 10 times our 2008 earnings-per-share estimate, at 6.4 times our 2008 TEV (total enterprise value)/EBITDA (earnings before interest, taxes, depreciation and amortization) estimate and at 90% of replacement cost.”

He rates as Buys: Transocean, with a 12-month target price of $160 per share; and Diamond Offshore (NYSE: DO), with a target of $125.

Among smaller-cap names, he sees Hercules Offshore as a value play on a potential rebound in the Gulf of Mexico jackup market, with a target price of $30. The analyst also likes Pride International (NYSE: PDE) as a diversified play on domestic and international offshore drilling markets, with a target price of $43.

Similarly sanguine in his outlook for land drillers, Bailey recently upgraded to Buy several names in the sector. Specifically, he raised his 12-month price target for the shares of Grey Wolf (Amex: GW) from $7 to $7.50; those of Patterson-UTI (Nasdaq: PTEN) from $23 to $27: Pioneer Drilling (Amex: PDC) from $15 to $25; and Union Drilling (UDRL) from $15 to $20.

The rationale? The analyst sees U.S. onshore drilling activity and dayrates improving and becoming steady by mid-2008.

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