Although commodity prices have softened of late, many oilfield-service analysts remain unshaken by perceived high natural gas or crude-oil inventory levels. For them, the longer view suggests the recent decline in oil and gas prices and the attendant skid in energy-stock valuations are but temporary phenomena.

What they're focused on long term are steep North American gas-production decline curves, renewed fears of global oil-supply disruptions in Europe, the Middle East and South America, and steadily rising, if not robust, demand for oil and gas worldwide. The consensus: the energy markets are likely to rebound later this year and the market could still see $7 to $8 gas and $60 oil.

Against this backdrop, these market mavens are closely scrutinizing small-cap oil-service stocks-those with market caps under $2 billion-to see which are likely to show the greatest share-price appreciation in 2007.

Why focus on the smaller-caps? One, they're more highly leveraged to percent gains in revenues, earnings and stock-market valuations than the larger-cap oil-service names; two, in many cases, they've already been beaten down below their consensus net asset values.

To find out which small-cap service stocks are set to make major market strides in 2007, in terms of stock-price appreciation, Oil and Gas Investor recently visited with four leading oil-service analysts. They are J. Marshall Adkins, director of equity research for Raymond James & Associates in Houston; Pierre Conner, managing director and oilfield-service analyst for Capital One Southcoast Inc. in New Orleans; James K. Wicklund, managing director and senior oilfield-service analyst for Banc of America Securities in Houston; and Poe Fratt, vice president and senior oilfield analyst for A.G. Edwards & Sons in St. Louis.

Investor Marshall, your top picks?

Adkins Given the recent retreat in oil-service stocks, we believe the shares of lowly land drillers should have some of the best upside for 2007. The two names in this group that jump out are Oklahoma City-based Bronco Drilling, which has a fleet of 64 rigs, and San Antonio's Pioneer Drilling, which has a fleet of 60 rigs.

Our investment thesis is the same for both companies. We expect both oil and U.S. natural gas prices to firm in the second half of the year. More importantly, we think a modest decline in 2007 domestic drilling activity will lead to meaningful gas-supply declines as we enter 2008. Lower gas supply means higher natural gas prices and more land-drilling activity next year.

And remember, land-drilling stocks will start to price this 2008 outlook around mid-2007. So just on that basis alone, the 2008 earnings and this year's stock-price performance of both Bronco and Pioneer should be much better than what the market has been recently discounting.

Investor Anything else the market may be missing?

Adkins Yes. There's a fear this sector has been adding too much new capacity and that dayrates and daily margins are going to come down regardless of any improvement in oil and gas prices. While new rigs will compound the problem of an activity decline in early 2007, lower gas supply and higher gas prices should drive drilling-rig demand well above rig supply in 2008. Simply put, if U.S. natural gas prices move above $8, every drilling rig that can work will be working next year.

Investor Your outlook for daily rig margins for both Bronco and Pioneer?

Adkins For Bronco, we see daily margins per rig moving from an average of $9,700 for calendar 2006 down to $9,100 for 2007, then back up to $9,900 in 2008. Since Pioneer has more long-term contracts, its average daily per-rig margins will be slightly less volatile, moving from an average of $9,250 for calendar 2006 down to $8,900 for 2007, then back up to $9,500 in 2008.

Investor Pierre, your macro-outlook?

Conner We think global economic growth in 2007 will support a recovery in oil prices to above $60 oil and, after a short period of weakness, a rebound in gas prices to above $7. This, in turn, will support increased drilling activity later this year. On the gas side alone in North America, we're seeing pretty steep decline curves so we have to maintain, or slightly grow, drilling activity just to maintain flat production levels.

Against this backdrop, we like Houston-based Hercules Offshore, which has a fleet of nine shallow-water jackups, mainly in the Gulf of Mexico; some offshore drilling operations in India and the Middle East that it expects to grow; and a fleet of 64 liftboats-47 in the Gulf of Mexico and 17 in West Africa.

Investor The investment thesis?

Conner This is a very undervalued offshore driller, trading at 3.6 times our estimated 2007 EV (enterprise value)/EBITDA (earnings before interest, taxes, depreciation and amortization) versus a peer-group multiple of 5.3. In addition, Hercules has the ability to make accretive acquisitions to grow its earnings power-as it did in 2006 through consolidation steps in the liftboat business.

In 2005, its net income was just $39 million. However, its liftboat acquisitions last year have caused us to raise our initial 2006 net-income estimate for the company from $71 million to a current estimate of $95 million, and with a full year's benefit from those acquisitions, we expect its net income in 2007 to reach $176 million.

Investor Any technology-driven companies you like?

Conner One is Tesco Corp., headquartered in Calgary but operationally based in Houston. The company provides top-drives for rigs that it sells to rig contractors and rents to E&P companies on a temporary basis.

It also provides casing-drilling services. This includes not only running casing but also-and this is the real investment thesis-drilling with casing, cementing it and thereby avoiding unnecessary and costly tripping of drillpipe out of a hole while at the same time maintaining wellbore stability. This technology, besides saving time and money, also makes previously undrillable wells drillable.

This technology could save more than $30,000 per typical land well. The real opportunity for the company, however, is if it begins using this technology offshore where it could result in cost savings of around $1 million per well.

Investor Jim, your favorite service stocks?

Wicklund One is Houston-based Complete Production Services, a basin-centered production- and completion-services company operating primarily in the Rockies and in Texas in the Barnett Shale and Permian Basin.

The company has been able to identify synergistic and accretive acquisitions that expand its product lines and footprint in basins where it already has a presence. This has allowed it to reduce costs while growing earnings and returns. So it's a consolidation play that benefits from the rig count continuing to move up.

This year, revenues should rise to $618 million from $500 million last year while earnings grow to $179 million from $138 million.

An undervalued stock, we believe the more operating income it generates from services and the less income it derives from drilling, the higher its valuation multiple will be.

Adkins We, too, believe the company is going to enjoy superior growth in profitability, not just from its core businesses getting better but also from bolt-on acquisitions. In fact, we see 10% to 30% annual earnings growth that's sustainable for the next two to three years.

Wicklund We also like Houston-based Key Energy Services, the largest workover-rig company in the industry, with a fleet of about 1,000 rigs operating primarily in West and South Texas, the Barnett Shale and the Rockies.

With a three-year accounting issue basically behind Key, management is now free to pursue strategic but carefully controlled growth, including upgrading its existing rig fleet and expanding its completion and production services to gain higher valuation multiples and to keep production flowing in a production-constrained environment.

We're looking for 2007 revenues to edge up to $1.6 billion from a prior-year level of $1.5 billion as earnings climb to $250.6 million from $210 million.

Investor Poe, your favorite small-cap service company?

Fratt With depletion rates in the U.S. still very high and E&P capital spending for onshore gas drilling expected to have an upward bias in 2007, we like Superior Well Services. This is an Indiana, Pennsylvania-based company engaged in pressure-pumping and other well-stimulation and completion services in such core gas-resource plays as the Barnett and the Fayetteville shales in Arkansas.

We believe Superior, because it has grown from a niche market focus in Appalachia to the establishment of service centers in Alabama, the Midcontinent, Texas and the Rockies-and since 2005 has grown its fleet of fracing trucks from 275 to 550-is going to have above-average market growth rates.

For 2006, Superior should generate $241 million of revenues-83% above that for 2005-and this year be able to grow revenues another 37%, to about $330 million. Similarly, earnings should rise from $14 million in 2005 to $32 million to 2006, to $47.5 million this year.

Investor Marshall, any names you like in the workover arena?

Adkins Midland-based Basic Energy Services, with a fleet of about 360 workover rigs and more than 600 fluid-handling trucks. It also provides pressure-pumping services.

This is a well-run, rapidly growing company whose activity is more than 50% levered to oil wells. So while the company would be a beneficiary of our thesis for gas pricing and drilling activity, the stock is also defensive-if our thesis doesn't work out-given the high demand for oil-related workover and completion services throughout the Permian Basin, Midcontinent and parts of the Rockies.

In terms of profitability, its margins during the past three to four years have risen from the low 30% to low 40% range. For 2007, we're modeling margins to be in line with the 43.4% the company achieved in 2006.

Investor Pierre, any other technology-driven stocks you like?

Conner Houston-based Particle Drilling Technology Inc. The company operates in Utah's Uinta Basin and provides patented drilling technology that dramatically improves the rate of penetration in hard-rock formations-about 3.5 times faster than what could be achieved with conventional drillbits. So it's a technology that allows an operator to drill wells faster and cheaper.

Investor What kind of cost savings are we talking about?

Conner On a typical onshore well that might cost $600,000 to drill a slow interval, an operator using this technology might only have to spend around $200,000. Besides the Rockies, there's opportunity for this technology to be also used in hard-rock formations in the Permian Basin and the Midcontinent. Collectively, these three regions ultimately represent a $1-billion market for this technology.

Investor Any promising seismic stocks?

Conner Mitcham Industries Inc., a Huntsville, Texas-based provider of seismic lease equipment that operates in every corner of the globe.

The seismic business has faced severe underinvestment during the past decade as operators have focused on development opportunities. But to replace reserves, producers are ultimately going to have to become refocused on exploration where seismic is the primary tool. Mitcham has plenty of spare equipment capacity for companies that shoot seismic-a very profitable business where annual gross margins can average more than 85%. We estimate the company's EBITDA will rise from $20 million in fiscal 2007 to $30 million in fiscal 2008.

Investor Jim, any other small-cap name you like?

Wicklund Houston-based Hanover Compressor, the largest compression-rental company in the U.S. Currently, the company has about 6,700 compression units with 3.37 million horsepower of compression.

The investment thesis is that as the average pressure in U.S. gas reservoirs drops, one has to push or pull more gas out of those reservoirs to meet demand-and the only way to do that is through compression. Currently, the secular trend in the U.S. requiring additional compression horsepower is positive, even in a flat production environment.

However, since gas demand is growing, Hanover gets the benefit of both the declines in reservoir pressure and production consumption growth. This business is one of the strongest growth segments in the service sector, with cash flows more stable than virtually any other part of the sector.

Also, Hanover is expected this year to put half its assets into an MLP format. That would provide the same economic benefit as the company not having to pay taxes on half its income. This would boost the valuation of the combined entities.

Investor Marshall, any equipment manufacturer you like?

Adkins Lufkin Industries in Lufkin, Texas-the largest manufacturer of oilfield pumping units in the world. With a solid outlook for 2007 oil prices, Lufkin should benefit from its leading market presence in building new pumpjacks.

Given the improvement in oil prices in the past several years, the company has seen phenomenal growth in revenues, margins and earnings. We expect that to continue as the company grows in international and North American oil-driven markets.

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