During the past couple of years, amid frothy commodity prices, the oil and gas industry has dramatically ramped up its E&P spending, particularly in the U.S. But there's a sea change ahead.

In 2007, look for a higher percentage of upstream dollars to be spent in international markets, not in the U.S. or Canada. What this means for investors is that the stocks of oil-service companies with major exposure to global oil and gas markets-both offshore and onshore-may well be one of the hotter tickets to many happy returns.

This is the mindset of James D. Crandell, managing director and senior oilfield-service equity research analyst for Lehman Brothers in New York. To be sure, this market maven brings a wealth of perspective to the table when it comes to an understanding of the dynamics and direction of the service industry.

Prior to joining Lehman Brothers in 1999, Crandell had a 17-year career at Salomon Brothers and Salomon Smith Barney as senior oil-service and drilling analyst and, ultimately, director of U.S. equity research and global head of equity research.

The 30-year veteran researcher, who was also a buyside energy analyst with Connecticut Mutual Life from 1978 to 1981, has been recognized 17 times in Institutional Investor's "All-American Research Team" survey as one of the top analysts among his peers during the 1983-93 period and most recently in 2006.

Why is Crandell so bullish on the service sector today and which segments-and companies within those segments-does he think will show the greatest growth in profitability and stock-market performance? Oil and Gas Investor recently visited with the savvy service seer to find out.

Investor What's your macro-outlook for the energy sector in 2007?

Crandell I've been covering this sector for 30 years, and this is by far the best cycle I've seen. We're using an oil-price forecast this year of $55 for West Texas Intermediate and $7 for gas at the wellhead. Given that level of pricing, we believe E&P capex on a global basis will grow by about 9% in 2007 versus 2006-the sixth consecutive year of increased spending. However, the character of that spending will be dramatically different than what we've seen in the past two years.

Investor How so?

Crandell In the past two years, we saw explosive E&P spending growth in the U.S.-a rise of 35% in 2005 and 40% in 2006. This year, however we see upstream spending flat to down in the U.S. while it grows internationally by 15% to 20%. The fact is, we're at oil prices well above the level that would support continued increases in global E&P spending. Even if crude prices drop to $40 to $45, the up-cycle will continue.

Investor So you think the bull market for energy is far from over.

Crandell Not only is it far from over, but we believe the current cycle of E&P spending will carry forward into the middle of the next decade. Very simply, we're seeing what we think is the early- to mid-stage of very exceptional long-term oil and gas activity growth in such areas as the Middle East, North Africa, the Caspian Sea and deepwater plays around the world.

Investor What's the mood of the buysiders right now?

Crandell They generally share my sense of optimism about the long-term; however, there's genuine nervousness this year about the U.S. and Canadian gas business, stemming from the recent level of gas inventories. They see the possibility that, if we end the winter season with inventories well above historical norms, this will lead to a drop in gas prices and, in turn, a decline in rig activity.

While we share some of this concern, we believe that whatever the decline is in price or rig activity, it's a self-correcting problem. If production falls off, then the so-called inventory problem will be solved by the winter of 2007-08.

Investor Given these macro-views, what do you see ahead for the oil-service sector?

Crandell We have an overall positive investment thesis, much of which stems from our view of the growth in global E&P spending. Thus, most of our emphasis, in terms of investment recommendations, relates to service companies that have a significant part of their business exposed to the international arena or that are very well positioned to grow there.

The fact is, we're now in a fairly tight supply/demand situation for crude oil-a situation we feel will persist for the next several years-and the best places to bring on incremental production are the Middle East, North Africa, the Caspian and the deep water. Those are the places that are going to enjoy the thrust of E&P spending by major oils and larger independents that are shifting their budgets to those areas, and by the national oil companies.

Investor In the international arena, which segments of the service sector will likely do best, in terms of improved dayrates, margins, utilization, revenues and earnings?

Crandell My colleague, Angie Sedita, covers the contract drillers and believes the deepwater drillers are the companies best positioned to show the strongest growth over a sustained period of time. But in addition, we also like the deepwater-completion companies-a segment where we see growth extending well into the next decade.

In our growth outlook for the Eastern Hemisphere, we also see the need for a significant number of new rigs, thus companies that can either build new rigs from scratch or provide rig-equipment packages are also well positioned for growth. So, too, are the providers of reservoir-evaluation services such as logging-while-drilling tools or rotary-steerable drilling systems.

In the U.S., we're also very bullish about the outlook for the pressure-pumping business longer term. There's a huge demand for such services due to the growth in the drilling of unconventional gas-resource plays.

Investor Specifically, which companies in these service sectors stand to benefit most?

Crandell Starting with the deepwater drillers, which should show the best long-term growth because the supply/demand fundamentals in that sector are going to remain tight during the next several years, Angie likes Diamond Offshore, Transocean and Noble Corp.

Most of the fleets of these three companies are made up of deepwater equipment, and recent dayrates have exceeded $500,000.

Other beneficiaries will be supply-vessel companies that have a significant percent of their fleets oriented toward the deepwater, including Tidewater and Hornbeck Offshore.

On the development side, most deepwater wells are being completed with subsea production trees manufactured by such companies as Cameron International and FMC Technologies. Both have a very good outlook due to the strong demand for deepwater development and subsea completions. Also well positioned in that area is Oceaneering International. It operates a fleet of remotely operated vehicles and manufactures subsea umbilicals, both of which will be in demand as deepwater development rises.

Investor What about the rig manufacturers?

Crandell The company that truly stands out in this area is National Oilwell Varco. For deepwater rigs, it provides the entire rig-equipment package, including all the rotary and pipe-handling equipment. The value of such rig-equipment packages can be as much as $250 million. In addition, the company has the ability to build onshore rigs from start to finish.

The big drivers in the rig-construction cycle will not only be the need for new rigs as drilling activity expands, but also we have very old rig fleets-both onshore and offshore-and those rigs will need to be replaced, or at the very least upgraded, with some of the state-of-the-art equipment that National Oilwell Varco provides.

Investor What other service-sector companies are poised for growth?

Crandell Those providing downhole reservoir-evaluation services, such as well logging and measurement-while-drilling, and companies providing rotary-steerable drilling systems-a technology that's benefiting from increased horizontal-drilling activity in the onshore U.S.

The major beneficiaries of the growth we see in those businesses would be Schlumberger, Halliburton, Baker Hughes and Weatherford International.

Investor Any other favorites?

Crandell Companies providing pressure-pumping, well-stimulation and fracturing services around the world. The U.S. is a major market for these services due to the growth in drilling unconventional gas-resource plays. Internationally, there's also demand for these services as operators try to increase the amount of recoverable oil from existing wells. The companies best positioned to benefit from these trends are again Halliburton and Schlumberger, as well as BJ Services.

Investor Are there smaller-cap names you like in this sector?

Crandell Weatherford International, which is expanding its pressure-pumping business internationally, and Key Energy Services, a leading workover-rig company in the U.S. that's also expanding its well-stimulation fleet.

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