Crude oil prices may have finally seen their peak. Recent industry data indicate higher prices are starting to temper economic growth. This could lead to a loosening of supply and demand fundamentals heading into 2008.

Meanwhile, the outlook for natural gas fundamentals heading into 2008 is still questionable due to record high storage levels and increasing supply. Also, the start-up of Independence Hub in the Gulf of Mexico, the completion of the Rex-West pipeline coming out of the Rockies and the possibility of increased year-on-year liquefied natural gas (LNG) imports could depress prices further.

A look at Tristone Capital’s Large- and Small/Mid-Cap U.S. E&P indices shows the groups were both up some 40% year to date as of late November, essentially in line with the firm’s 50/50 Gas/Oil Commodity Price Index. Importantly, the groups have meaningfully outperformed the broader S&P 500 index that was up some 3% at the time.

Although oil-weighted names performed the best, gas producers also performed well. Most gas companies proactively hedged a large portion of their production at attractive prices to lock in project economics, thus allowing them to maintain cash flows and activity levels during periods of weaker prices.

Deepwater drilling contractors are a good bet in today’s uncertain times when most investors are concerned about U.S. and global economic health. Deepwater drillers have locked up most of their 2008 and 2009 earnings per share and are attractively priced while offering 50% to 70% earnings per share (EPS) growth in 2008 and 20% to 50% in 2009.

They have sizeable, cumulative, free-cash-flow yields (39% to 45% through 2010; 70%-plus through 2012), which, if used for growth activities like buying back shares or acquiring assets, would grow EPS even more, lowering PEG (price/earnings to growth) ratios from an attractive 0.8 to 1.7 range to an unbelievable 0.2 to 0.6.

The market for deepwater rigs remains very tight and an under-supply of 15 to 20 rigs is seen for most of 2008. While 67 new rigs are being built, all but 20 of them are already under contract for five-year-plus terms. Only five of the uncontracted rigs are scheduled for delivery prior to the end of 2009.

Currently advertised demand should more than absorb all new capacity that is under construction. Significant unadvertised demand also exists and that should keep fundamentals tight through 2012. Recommended are stocks with exposure to deepwater drilling and to deepwater subsea construction businesses. Deepwater projects have long lead times and customers typically do not react to short-term changes in commodity prices. Companies with deepwater exposure will remain a good bet for 2008.

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