If you want to see re-turns from investing in the oil and gas services sector, you need two things: a strong stomach and a seatbelt.

In a sector that’s delivers extreme highs and sharp declines, returns will come only to those who can stay strapped in long enough for the prices of the underlying commodities to rebound and who can stomach the volatility in the interim.

Canadian drilling and well services companies’ stocks are currently in a trough. Their contracts were the first to be cut when prices of the underlying commodities dropped in the latter part of 2008. Oil and gas drillers are the middlemen, hired by the major oil producers to build drills, hire rig crews, set up the well, drill and continue extraction on existing wells.

Because the price of crude oil has plummeted to US$47 a barrel in mid-March from its high of US$145 in July 2008, drilling activity — as measured by the utilization rate, or the number of active rigs as a percentage of the total rigs available in Western Canada — fell to its lowest level in 16 years. The UR stood at 43% in February, with an average monthly drilling count of 372 active rigs out of 866 rigs in Western Canada, says Nancy Malone, economic analysis manager with the Calgary-based Canadian Association of Oilwell Drilling Contractors. This is in stark contrast to February 2006, when the UR was closer to 95%.

But there’s no reason to be alarmed, analysts say. That’s because low prices are only one part of the oil and gas services sector’s roller-coaster ride. “If you are investing in companies that are sustainable inside and outside of the industry’s cyclicality,” says Jeff Fetterly, an oil and gas drilling analyst with Toronto-based CIBC World Markets Inc. in Calgary, “you can afford to be patient.”

And looking to the long term, now is the time to buy into the sector, Fetterly says, with the stocks of Canada’s largest drillers and well contractors in the gutter, and opportunities for acquisitions and real growth in technology on the horizon. Also, he expects oil and gas prices to improve as soon as late 2009 or early 2010.

Natural gas drilled in Alberta, British Columbia, Saskatchewan and, to a lesser extent, Manitoba comprises the majority of the Canadian services market, accounting for more than half of the 16,000 wells drilled in 2008. “Right now we are in the down part of our cycle,” says Malone. “But it is the economic engine of our country, and people are finding that out now.” She points out that Canada is the world’s third-largest producer of natural gas and the No. 1 supplier of energy to the U.S.

Fetterly believes unconventional resources plays, such as horizontal drilling, will play a part in fuelling the next upturn. Vertical drilling, in which contractors drill straight down through layers of sedimentary rock to the reservoir, has been the norm historically.

“Lots of those layers won’t have oil and gas in them,” says Ian Bruce, CEO of Calgary-based Peters & Co. Ltd., an investment dealer that specializes in the energy sector. “Some of them will. The new drills are able to turn into these wells and drill horizontally, allowing you to drill into the layer that you like.”

Although horizontal drilling has been around since the 1990s, in the past it was too expensive. But with advances in technology, it has become more affordable — and more popular. “Using horizontal drilling,” says Bruce, “in one well, you are getting more exposure than what would have taken a pile of vertical wells, or may not have been economical on a vertical well basis.”

With the North American economy running out of gas, contrac-tors can’t afford to be behind on the latest drilling technology, Fetterly says: “There’s a scarcity of natural gas in North America, whether that’s a function of diminishing amounts of supply or excess demand. Supply is a function of technology, technically, So, the more advanced the drilling technology, the more supply we will have.”

For investors, this means looking out for players that use their excess cash during the good times to fund new drilling technology, which will give their clients, the oil and natural gas producers, more bang for their bucks.

@page_break@One tech-savvy driller to watch is Calgary-based Trican Well Service Ltd. Rather than focusing on drilling new wells, it’s one of the few oil and gas drilling and services companies based in North America that provides technology for re-entering existing wells. It has clients in Western Canada, Russia and Kazakhstan. For the year ended Dec. 31, 2008, Trican reported a rise in revenue to $1 billion from $836.4 million in 2007. In the same period, however, it reported a net loss of $70.4 million, vs net income of $111.8 million in 2007.

Calgary-based Ensign Energy Services Inc. is another firm to watch. It is Canada’s second-largest land-based drilling contractor and third-largest well-servicing contractor. Ensign’s revenue increased by $6 million in the nine months ended Sept. 30, 2008, to $1.3 billion. It also reported year-over-year increase in net income, to $186 million from $177 million in the same period a year earlier.

Calgary-based Precision Drilling Trust has both Trican and Ensign beat in terms of the number of service and drilling rigs, Malone says. Its revenue increased slightly, to $766.8 million for the nine months ended Sept. 30 from $760.5 million in the same period a year earlier. However, its net income fell to $210.4 million in the nine months vs $253.5 million a year earlier.

Drops in profits are to be expected, analysts say, as oil prices are too low to continue drilling. That said, adds Mike Mazar, an equities research analyst with Toronto-based BMO Nesbitt Burns Inc. in Calgary, the large players are not expected to go under during this downturn.

Instead, you will see these companies act countercyclically. “They build their businesses when they’re in a trough and buy smaller companies when things are cheaper,” Mazar says. “They build up their cash when things are good and use it to get the balance sheet in shape.”

Adds Fetterly: “People need to appreciate the cyclicality of the business.

“For the past five years,” he continues, “North American demand for gas has increased, while supply hasn’t.” As a result, drilling occurred in more expensive areas and riggers had to employ extra crew to cope with the excess demand, which added to the expense.

“It’s a chicken-and-egg type of scenario,” Fetterly says, adding that increases in global demand caused energy prices to soar. As prices hit a peak, consumers began to power down consumption. The financial crisis exacerbated the oil and gas sector’s natural trough, he adds, causing an even sharper drop in demand.

But that’s not the end of the story. “When the economy grows again,” Fetterly maintains, “so will demand for commodities. And we will start the cycle all over.”

In the next upturn, a rise in demand should come from the emerging economies of China and India, Bruce says, as it was their increased consumption of commodities that put the pressure on prices originally. “Supply and demand,” he says, “were very closely matched before the global downturn.”

Once the recession began to take hold, however, drops in demand from those economies, along with a small increase in worldwide supply, caused prices to plummet, Bruce says. Suppliers are now shutting down oil and gas wells worldwide to cope, a strategy which should drive up prices again.

And when prices rise in the future, they will do so with a vengeance, says Ron Swenson, publisher and editor of the Hubbert Peak of Oil Production website (www.hubbertpeak.com), which is dedicated to covering the “peak oil” hypothesis.

This theory is based on U.S. geophysicist King Hubbert’s observation that the amount of oil and natural gas in sedimentary rock is finite. The rate of discovery, therefore, will begin to decline and cause the price of excavating it to rise over time. “Oil prices will go above US$145 a barrel,” Swenson says. “The question is: when? The volatility of the price of oil has increased. It goes up again and then down again. But at some point, it will hit a brick wall and skyrocket far higher than what we’ve seen.”

When that day comes, drilling and well services companies such as Ensign, Trican and Precision Drilling will be there to embrace the upswing. In the meantime, says Malone: “The biggest thing on everyone’s plate is the new royalty framework that was put into place in Alberta [on Jan. 1]. If it’s not a stable, open business environment for producers, it’s very difficult to encourage investment and get companies drilling.”

B.C. and Saskatchewan remain stable regulatory environments, but the effects of Alberta’s framework are “all over the map” right now, Malone adds. However, in March, the Alberta government introduced a short-term, three-point incentive program for the energy sector that includes royalty credits for the development and clean-up of oil wells on a sliding scale, starting on April 1 and ending on March 31, 2010.

As for future threats from the development of alternative sources of energy, such as corn-based ethanol fuel, Swenson says, people will probably stick with oil — no matter how expensive it gets.

“It takes more energy to make ethanol fuel,” he says, “than the energy you can extract from the ethanol itself.” IE