This stock is just waiting to explode. He recommends you take advantage of this investing opportunity and says, “because of its strong dividend policies, investors will be well compensated while they wait for that oil-price rebound.”

This from Horacio:

In the face of the global financial meltdown, the price of oil has plummeted from a record high of almost $150 a barrel in July to less than $40 recently. And now it seems to be bottoming.

Clearly, this isn’t the precise moment to call a market bottom, but it is reasonable to think about a bottom around this range for a few reasons.

For starters, the forward curve of oil futures prices is showing a very marked upward slope, known in the commodities business as a forward curve in “contango.”  This means that – the farther out we go – the higher and higher oil futures prices climb. To see what we mean, let’s take a look at the projected price of oil as depicted by this graph.

A futures curve as upwardly skewed as this one provides a great opportunity for profits:  One can just buy oil today, sell it forward and hold it until December 2016 and make a guaranteed rate of return of about 62%.  In a year, you can make about 11% by just buying now, holding it and delivering in a year.  If you add some leverage to the transaction, you can make a nice return.

Some sophisticated players are doing just that: They’re buying oil, and are holding it in a tanker in port – with the obvious intent of capturing these profits.

However, this very favorable contango arbitrage is not going to last for long, as more players have been jumping into it, thus flattening the futures curve with time.  It is easy to see that, at some point, as oil gets absorbed into storage, and the curve gets inverted, the speculative players that shorted oil by selling futures long ago without having production or physical oil will be squeezed into covering at much higher spot prices.  This spike in spot prices situation will develop in less than a year, as demand recovers.

The slope of the curve also indicates widespread expectations for inflation.

From Stimulus to Inflation

The U.S. government has launched a huge stimulus package and its plan for a $3.6 trillion budget for fiscal 2010 will elevate the fiscal deficit to a staggering $1.75 trillion this year – a numbing 12.3% of gross domestic product (GDP).

And we have yet to deal with the massive social-security and health-care entitlement programs, which pose a huge fiscal threat ahead.

The financing of the announced deficits will come through issuance of U.S. Treasuries, which means that the U.S. Federal Reserve will have to monetize the debt. That is, the U.S. central bank will have to print money in order to make it available to buy the debt, since the level of issuance is so high that foreign buyers will not be able to purchase all the debt.

In addition, the Fed has already been very busy expanding its balance sheet in order to pump liquidity into the markets to buy mortgages and other assets. And it has already lowered its benchmark Federal Funds rate to a range of 0.00%-0.25%.

Why are the Fed and the government so intent in stimulating the economy?

The nightmare scenario for any central bank is falling into the so-called “liquidity trap” – a situation that exists when an economy’s asset prices enter a deflationary spiral and people reach the conclusion that by merely sitting in cash, even at a zero interest rate, they are getting richer by the day.  In that situation, monetary policy becomes ineffective, since rates are already at zero, and since it is very difficult to get out of that deflationary spiral.

That is precisely what happened in Japan during its “Lost Decade.” By the time the Japanese figured out that they needed to do something very dramatic in terms of stimulus, it was too late. The drop in prices had already created too many losses in the banking system and taken the entire system into bankruptcy.

Therefore, the theory goes, very aggressive monetary and fiscal action is needed right at the outset, in order to prevent the deflationary spiral and to actually generate some inflation.  At the same time that the United States, at the epicenter of the global crisis, is acting in this manner, countries around the rest of the world, which have been affected to different degrees, have launched their own stimulus initiatives.

China’s Stimulus Points to Strong Global Demand

China, which is at the forefront of global commodities demand, is of particular interest.  China needs to grow its economy at a minimum rate of 8% a year in order to employ the 18 million workers that join the labor force annually.  This is an imperative for a country that has dictatorial government, in order to avoid massive unrest.  That’s why in November, Beijing announced a $585 billion (4 trillion yuan) stimulus plan. It’s also why the country is taking such aggressive steps to assure access to supplies of key commodities.
Since then, the government has been aggressively buying long term access to commodities in such countries as Brazil and Australia.

Aluminum Corp. of China (NYSE ADR: ACH), otherwise known as Chinalco, has invested $19.5 billion in Rio Tinto PLC (NYSE ADR: RTP) to acquire stakes of up to 50% in nine of Rio’s mining assets.

China also struck a deal with Brazil’s Petrobras (NYSE ADR: PBR) for a long-term supply of oil.

China Development Bank, one of China’s largest state-owned enterprises, agreed to lend $10 billion to Petrobras for its ambitious deepwater-development program in order to ensure a long-term daily supply of 160,000 barrels oil. That followed a similar deal with two Russian giants. China Development Bank lent $15 billion to OAO Rosneft Oil Co., Russia’s state-owned oil company, and $10 billion to the Russian state pipeline monopoly Transneft (PINK: TRNFF). In return for the needed financing, Russia agreed to supply China with 15 million tons of oil annually for 20 years.

Hence, the outlook for commodities – given easy global monetary and fiscal policies, and a reflationary bias – is very favorable, and we are going to take advantage of it.

Enter Diamond Offshore Drilling Inc. (NYSE: DO).

Drilling for Profit

Diamond Offshore is the world’s second-largest driller by market capitalization, right after Transocean Ltd. (NYSE: RIG).  It has 31 floating rigs: nine sophisticated deepwater semi-submersibles, one drill ship for very deep water, and 21 other semi-submersibles.  In addition the firm owns only 13 jack-up rigs, of which only seven are in the Gulf of Mexico.

What I like about Diamond Offshore is its conservative, shrewd management and its commitment to shareholders.  The latter is especially ensured because of the situation of its controlling company, the New York conglomerate Loews Corp. (NYSE: L), which owns 54% of the Diamond Offshore’s stock.

Loews, run for half a century by the Tisch family, initially acquired Diamond Offshore’s assets in an opportunistic transaction in 1992.  It then sold 30% of the company to the public in 1995 and later acquired Arethusa (Offshore) Ltd. in 1996, using stock, a move that reduced its participation to the current 54%. Since that time, Diamond Offshore has been using its ample cash flow to repurchase shares from public hands.

Diamond Offshore, also referred to as DO, has been managed very wisely.  As the world’s No. 2 contract driller, DO has concentrated on the higher-priced equipment, that is, the semi-submersible rigs, which operate in deep waters.  And deep water, which require that higher-priced equipment, is where the biggest action is.

And since the specialized deepwater equipment is all taken, DO’s mid-depth equipment benefits because it can be adapted for use on bigger projects.

DO has minimized its exposure to jack-up rigs (those that rest on the ocean floor) and especially to work in the Gulf of Mexico, which has more competition and lower daily rates.

No wonder that DO’s fourth-quarter results handily beat analysts’ consensus estimates of $2.34 per share by posting operating earnings per share of $2.53.  Revenue also beat expectations, showing a 1% increase over the prior quarter.  The company also realized higher day rates and higher utilization rates.

These are all indications of strong management execution.  What is impressive about DO is that the company used the run-up in oil prices last year to enter into long-term contracts at very high prices, registering an impressive $10.3 billion backlog.  That gives Diamond Offshore a great earnings visibility going forward.

But the upside does not stop there.

There is a special situation in the making, because the Loews Group owns CNA Financial Corp. (NYSE: CNA), an insurance company that is trading at half of its book value.  You see, insurance companies have been hit hard financially by markdowns in their fixed-income and hedge-fund holdings, but Loews invested $1.25 billion in CNA last fall in a move to improve the company’s balance sheet.

And in order to be ready to defend debt ratings, a conservative management like Tisch has all the incentive in the world to keep maximizing Diamond Offshore profits to support CNA – should it be needed despite CNA’s current strong liquidity and financial flexibility.

DO recently paid one of its regular special dividends of $1.85 a share, bringing the dividend yield to almost 13%.  If this dividend is safe – and we believe that it is – this is a winning strategy for the group, given the current financial environment, and it will greatly help to maximize profits and cash flow from Diamond Offshore.

Mark Urness, a friend of mine at Calyon Financial, one of the leading energy research specialists on Wall Street, concurs with our assessment of this sky-high dividend. He estimates that DO will continue to offer the 12.5% dividend yield, which is unparalleled in the oilfield-services segment. We, like Mark, expect the company to distribute $8 a share in 2009 in the form of both the regular and the special dividends that DO has been using.

DO has been extremely disciplined with costs and with new investments, maximizing free-cash flow to almost $900 million last year.  In fact, with the ample backlog at higher prices of the contracts signed, DO should increase its free cash flow and net income to about $1.4 billion to $1.5 billion in 2009.

DO’s profit margins are impressive – and exorbitant – thanks to the shortage in rigs: Gross margins are 64% and operating margins are 54%.

These margins are likely to keep growing as management continues to execute thoroughly and oil prices rebound.  This strong growth in revenue and earnings – driven by DO’s savvy positioning in deepwater and mid-water rigs, and bolstered by rebounding oil prices thanks to global monetary and fiscal conditions – will surely help deliver much higher multiples than the meager six times earnings that Diamond Offshore’s shares are currently trading around these days.

Diamond Offshore’s shares closed Friday at $55.58. They are down 62% from their 52-week high of $147.77.

This cash-rich, profit-fountain company is a resounding “Strong Buy,” as its stock is waiting to explode to the upside.

Recommendation: Buy Diamond Offshore Drilling Inc. (NYSE: DO), a top player in its sector, and a company that is poised to capitalize on a projected resurgence in oil prices. Because of its strong dividend policies, investors will be well compensated while they wait for that oil-price rebound (**).

(**)  Special Note of Disclosure: Horacio Marquez holds no interest in Diamond Offshore Drilling Inc. (NYSE: DO).

Source: Buy, Sell, or Hold: Profit From the Projected Oil-Price Rebound With Diamond Offshore

Oil Shortages Within 5 Years

The Financial Times wrote: “Fears of a shortage within five years propelled long-term oil futures prices well above $130 yesterday, further stoking inflationary pressures in the global economy. Investors rushed to buy oil futures contracts as far forward as December 2016, pushing prices as high as $139.50 per barrel, up $9 on the day.”

Wow. The price rises $9 in just one day? People are rushing to trade out eight years. I had to e-mail Kevin Kerr to find out if that really happens in trader land (yes). Oil traders are saying that they have never seen such a jump.

Apparently, investors are betting that oil production will soon peak due to geopolitical and geological constraints. According to Robert Hirsch, who wrote a major energy study for the U.S. Department of Energy in 2005, we are more likely to see a several-year-long plateau than an actual “peak.” Still, the Peak Oil viewpoint is establishing a beachhead in the futures markets and supporting high prices. Greed and fear are just plain hitting the fan on this one.

Veteran oilman T. Boone Pickens has been beating the drum on this topic for quite a while. In Houston last October, Mr. Pickens told me, “All the world can produce is 85 million barrels of oil per day. But the world demand is nearer 87 million. Something has to give. It’s the price.” And Mr. Pickens has repeated that comment many times since then.

Apparently, the markets are listening to Mr. Pickens. On a large scale, investors are shifting their energy focus from the short to the medium term. Beyond the medium term, fears for future oil supply dominate the thinking. Since January 2008, long-term futures oil contracts, such as those for delivery in 2016, have jumped almost 60%. Near-term prices have gone up 35%.

I just hope that you have been following the Outstanding Investments energy recommendations over the past year or so. My goal has always been to align the portfolio with the energy-scarce future. I want you to benefit from these macro trends.

The View From Chevron

I had the recent opportunity to interview Peter Robertson, vice chairman of the giant oil company Chevron Corp. The American Petroleum Institute arranged the call. Mr. Robertson was in Washington, D.C., to testify before the U.S. Congress on — you guessed it — energy issues. Mr. Robertson made some time available to talk about the oil business with your humble editor.

Mr. Robertson focused on the oil markets from the perspective of what he knows best. That is, what does he see every day as he runs Chevron? “The U.S. market is well supplied” with oil and refined products, he said. In fact, “gasoline demand is down” in the U.S. That is, Chevron has seen a 1.5% decrease in gasoline demand. (Exxon has reported as much as 4% demand drop in some parts of the country.)

“What is causing angst is crude prices,” Mr. Robertson added. But Chevron has no control over the world price of oil. Chevron just accepts whatever price the world marketplace sets. With 9,800 gas stations nestled among the 160,000 total in the U.S., Chevron is hardly in a position to move the U.S. market for motor fuel one way or the other. Chevron just reacts to demand trends. Chevron does not cause them.

Chevron buys and sells about 2 million barrels of oil per day, according to Mr. Robertson. But these are “real” barrels, as opposed to trading futures. That is, Chevron either takes delivery or releases crude from inventory. So the company gets its hands dirty in the old-fashioned oil business. It does not speculate in the futures markets.

According to Mr. Robertson, in the first quarter of 2008, Chevron “made no money in the downstream business,” referring to the refining and marketing of refined products. He characterized it this way: “Downstream operations are not taking money out of the market. It’s all the cost of crude oil and taxes.”

This made me wonder how much higher fuel prices would be if refining DID take money out of the market. From what I know, gasoline at $3.75 per gallon reflects oil at $110-115 per barrel. At $140? The price of gasoline has more to go on the upside. Time to stop driving that SUV down to the strip mall to buy a box of Kleenex, right?

As an aside to Mr. Robertson’s comment on taxes, let me note that one recent study reviewed the total taxes paid by the top 27 energy-producing companies in the U.S. In 2006, the 27 largest energy companies paid more than $81 billion in income taxes, resulting in a 37% overall effective tax rate. That figure is higher than the top U.S. corporate tax rate of 35%.

Mr. Robertson notes that over the past six years, Chevron has earned about $72 billion total in after-tax profits. And it has invested over $73 billion in new energy and energy-related projects. So Chevron is investing more into its future asset base than it earns.

Interestingly, Chevron is the largest private producer of geothermal power in the world. Chevron sees a solid investment climate and return for geothermal in the U.S. This is of interest to me because I have five much smaller geothermal companies listed in my Energy & Scarcity Investor publication. All five aspire to be the Chevrons of the geothermal future. I won’t list the five names here, but I have recommended geothermal player Ormat (ORA: NYSE) for Outstanding Investments.

Mr. Robertson discussed Chevron’s efforts to assure future supplies of oil and natural gas. In the Gulf of Mexico alone, Chevron is the lead player or interest-holding partner to 40 different projects. Each project represents a commitment in excess of $1 billion by Chevron. The major constraint for Chevron to invest more hinges on its ability to obtain skilled personnel and to find vendors that can supply equipment and services.

According to Mr. Robertson, “Our personnel constraints are not just within Chevron, but with our contractors. The contracting community shrank in the days of cheap oil. Now the contractor community needs to grow.”

Of interest, about two-thirds of the total Chevron investment of $73 billion over the past six years has been outside the U.S. This is because of the level of restrictions on investing in energy projects domestically. Chevron would like to invest more in the U.S., but the national (and some state) investment policies discourage it.

For example, Chevron has struggled for several years just to obtain permits to upgrade its refinery at Richmond, Calif. Chevron is still waiting for approvals, but meanwhile, it’s operating one of the oldest refineries on the West Coast.

During this same time, India’s Reliance Industries Ltd. has constructed a new, state-of-the-art 600,000 barrel per day refinery in India. That refinery exports product to the U.S. West Coast market. So instead of having a more efficient Chevron refinery near San Francisco, drivers in California are buying fuel imported from India.