Just three months ago I said it looked like Patterson-UTI (PTEN) was poised to profit from an eventual rise in oil prices. I liked the fact that its free cash flow yield was much higher than those of its peers Helmerich & Payne (HP) and Grey Wolf (GW - Annual Report). I also said the momentum is clearly with HP, and I wouldn’t blame anyone for wanting to let that winner ride.

Since that time, all three stocks have posted solid gains, and the ranking has largely met my expectations: 57.6% gains for Helmerich and Patterson, and a “mere” 43.7% for Grey Wolf. Meanwhile, the S&P 500 has risen just 4.3%.

With more than 53% outperformance in three months, and a stock price that is way out in front of its 50 day moving average, I think it’s time to take profits on Patterson. The recent relative performance now means its free cash flow yield is less than that of Grey Wolf. While there is a possible catch-up play in Grey Wolf, my inclination is to stay on the sidelines for now.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

The following is a reprint of my January 17, 2008 RealMoney column.

For the last several months, as most of us were complaining about the price of oil at the pump, oil drillers like Patterson-UTI (PTEN), Helmerich & Payne (HP), Grey Wolf (GW - Annual Report) and Unit Corp. (UNT) have been seeing customers push back on the rates they charge for operating rigs. Morgan Keegan analyst J. Michael Drickamer described the fourth quarter as “choppy.”

The latest PPI report backs up that assessment. Despite the rising oil price, price increases for drilling equipment have been quite constrained – in the mid single digits compared to a year ago.

Year/Year Price Change for Oil and Gas Equipment

Source: Bureau of Labor Statistics

Helmerich & Payne has survived the choppiness relatively unscathed, as its FlexRig design is more efficient than traditional rigs and is allowing for higher dayrates. Patterson has been the dog of the group, shedding nearly half its value over the last two years.

From a perfunctory look at valuation using traditional measures such as P/E or Price/Book, Helmerich & Payne and Unit look like the cheapest stocks, while Grey Wolf has the best growth potential. The momentum is clearly with HP, and I wouldn’t blame anyone for wanting to let that winner ride.

Source: Yahoo! Finance, William A. Trent

But Helmerich’s success has come at a significant cost, with capital expenditures exceeding the cash flow provided by operating activities over at least the last four years (free cash flow has been negative). It has made up this gap by piling on half a billion in new debt. Unit has been in similar straits. Thus, my preferred valuation metric of free cash flow yield (free cash flow divided by enterprise value) is rendered meaningless for these companies.  Suddenly, the lower P/E multiples start to make sense.

There are several reasons I like looking at the free cash flow yield. For one thing, doing so avoids some of the most common earnings management ploys. For another, cash represents the real money the company has available for growth, acquisitions, dividends and share repurchases.

And Patterson has been doing plenty of share repurchases. During the three months ended September 30, 2007, the company purchased 2,275,000 shares of its common stock and the Board has authorized approximately $200 million more for repurchases. These buybacks have reduced the share count from 170 million in the first nine months of 2006 to 156 million in the same period of 2007. That is a 10% gain in earnings per share for any given level of net income.

Unfortunately, the net income has been declining due to the lower rig utilization. This is not expected to reverse soon, as analysts are currently expecting revenue to decline a further 5% in 2008. That’s an improvement from the 17.6% decline in 2007, though, so value investors may want to start looking for the bottom around here. The big fear, of course, is the economy. If demand for oil slows, will prices collapse?

I don’t think so. For one thing, most commodity cycles are driven by supply rather than demand. While a reduction in economic activity may have a short term impact and keep a lid on prices, the longer-term outlook is still driven by long-term economic growth and the growth in supply. If $100 oil doesn’t bring new rigs on line, eventually the demand will catch back up to supply and the price of oil will go higher.

The latest inventory data notwithstanding, oil inventories are at a historically low level relative to sales. A downturn would allow inventories to be rebuilt to something in line with the historical average, but in the long term supply - not demand - will dictate price.

Oil Stocks: Days Sales in Inventory (Including SPR)

Source: Energy Information Administration, compiled by William A. Trent

A recent Howard Simons article on what really moves energy stocks showed that Patterson is one of the most sensitive names to crude oil prices, natural gas prices, and even the crack spread. Little of that has applied in the last two years, of course. But it might be well worth speculating that in the long term, Patterson again benefits from the higher energy prices.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

Mid Cap Watch List (Track at Marketocracy) member Grey Wolf, Inc. (GW - Annual Report) reported earnings:

Grey Wolf, Inc. reported net income of $58.6 million, or $0.27 per share on a diluted basis, for the three months ended March 31, 2007 compared with net income of $54.2 million, or $0.24 per share on a diluted basis, for the first quarter of 2006. Revenues for the first quarter of 2007 were $242.0 million compared with revenues for the first quarter of 2006 of $222.9 million. The first quarter 2006 results included an after tax gain of $5.9 million ($0.03 per diluted share) for the sale of five rigs formerly held for refurbishment.

Analysts were expecting the company to earn $0.23 on $235 million in revenues. CEO Tom Richards commented:

“The addition of newly built rigs into the land drilling market has created some excess rig capacity which has led to a decline in spot market dayrates. This downward pressure could continue as additional new rigs enter the market, however, Grey Wolf’s portfolio of term contracts and our premium quality equipment coupled with our skilled rig crews have helped buffer our exposure to the erosion in spot market dayrates. Because of strong commodity prices for both oil and natural gas, we believe there will be demand for additional land rigs later this year.”

For the second quarter, Grey Wolf expects to operate fewer rigs on average and to achieve lower day rates due to the factors mentioned above. Analyst estimates of $235 million in revenue for the quarter may thus be too high, although the stock was trading up after market hours.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

Superior Energy Services (SPN) issued the following statement in an 8K filing:

On April 11, 2007, the Board of Directors of Superior Energy Services, Inc., upon recommendation of its Nominating and Corporate Governance Committee, approved increases in the cash and equity compensation payable to non-management directors. The Nominating and Corporate Governance Committee received input from an independent compensation consultant in order to ensure that non-management director compensation reflected current competitive market conditions.Effective May 1, 2007, the amount of the annual retainer for non-management directors will be increased from $30,000 to $40,000 per year. In addition, the dollar amount of restricted stock units awarded to non-management directors following the 2007 annual meeting of stockholders will be increased to $140,000 from $100,000 awarded in 2006.

That sounded awfully generous to us, but looking through the recent proxies for other small- and mid- size oil and oil services companies on our watch lists it looks pretty much in line, if not at the low end.

If there are any such companies in need of a new director, we hereby offer our services.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Mid Cap Watch List (Track at Marketocracy).

As with the Small Cap Watch List (Track at Marketocracy), we were surprised at the amount of turnover in our screens. Only 7 of the original 29 names made the cut for the new list (which comes in at only 24 names.) Part of the reason for the turnover was to reduce the overlap between the Small Cap and Mid Cap Watch List (Track at Marketocracy)s. Now there is only one-third overlapping names rather than two thirds. Furthermore, given the level of outperformance we saw in the first quarter (actually just two months) and the fact that much of those gains were achieved early, perhaps the turnover is warranted.

So without further ado, the names on the chopping block from the previous list are:

Silgan Holdings (SLGN - Annual Report); Middleby (MIDD); Olin (OLN); Vector Group (VGR); Sanderson Farms (SAFM); Tesoro (TSO); Downey Financial (DSL); Waddell & Reed (WDR); Gamco (GBL); Apria Healthcare (AHG); Quest Diagnostics (DGX); ITT Educational Services (ESI); Equifax (EFX); Delhaize Group (DEG); Papa John’s (PZZA); Rent-a-Center (RCII); Cato Corp (CTR); Dassault Systemes (DASTY); Ingram Micro (IM); Energy East (EAS); South Jersey Industries (SJI - Annual Report); and American States Water (AWR).

The new list is: