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Arnold Landy is a registered investment advisor and President of New Jersey based Landy Investment Management LLC, where he has managed clients' funds since January, 2006.

Landy uses a top-down approach to investing, based on his outlook for the economy. He invests in individual stocks and long or short exchange-traded funds, consistent with his outlook for stock prices, oil prices and interest rates.

We had the opportunity to ask Arnold about his highest conviction holding in his portfolio, and he selected offshore oil and gas service and equipment provider Oceaneering (NYSE:OII).

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What is your highest conviction stock holding?

My highest conviction stock pick is Oceaneering (OII). Investing in this stock is a focused way to cash in on the upcoming boom in deepwater drilling for oil and gas.

The company provides services and products serving the offshore drilling industry. More than half of its revenues are derived from the operation of remotely operated vehicles (ROVs) in support of drilling in deep waters offshore. ROVs can be thought of as little drone submarines that dive down near the ocean floor, where they extend their mechanical arms to install, maintain and repair drilling equipment. OII manufactures the ROVs, then operates them, collecting day rate fees from their drilling customers. The ROVs are equipped with video cameras and are operated by Oceaneering employees working nearby above the water surface – on drillships or floating drilling rigs.

This may bring to mind TV images of astronauts working on the space shuttle, doing their tasks by remote control. Indeed, about 8% of OII’s revenue does come from its Advanced Technologies division, which provides engineering services and products to NASA, as well as the Navy. Oceaneering also sells tools and equipment for use underwater and engages in diving, dredging, engineering, excavating and inspection services.

To what extent is this an industry pick, as opposed to a pure bottom-up stock pick?

This is really a sub-industry pick (no pun intended). Oceaneering’s stock enables investors to participate in the theme of increased deepwater drilling for oil and gas.

OII’s current focus is on technology in deepwater. ROVs, which provide the lion’s share of the company’s revenues and profits, typically are used in deepwater areas, greater than 1,000 feet deep. They are little used in shallow waters. The severe decline in drilling activity worldwide, including the U.S., has occurred on land and in shallow waters, where jack-up rigs do the drilling. Most of Oceaneering’s revenues come from deepwater drilling, which suffered barely a ripple throughout the economic downturn.

The future looks bright, as the next few years will see increasing numbers of deepwater drilling rigs in operation, as the large number of rigs now under construction are completed and put into service. The majority of these are already under long-term contract to be put into service upon completion.

Maintenance operations, while a relatively small part of the company’s revenue stream, provide a steady flow of revenues, even from the Gulf of Mexico, where shallow water drilling has declined with the energy price slump. The company expects delivery this year of a new dive support vessel for use in the Gulf of Mexico, where its market area for maintenance and repair work includes the 3,500 platforms and 20,000 miles of pipeline now in service in the Gulf. It will have significantly greater capabilities than the old ship that it replaces, and is likely to generate increased revenues.

Why do you have such an optimistic outlook on deepwater drilling?

In the early years of the oil and gas industry, all drilling occurred on dry land and areas of the continental shelf that were in shallow water. In recent years, however, improvements in technology enabled drillers to venture out into deeper and deeper waters, where they have found several areas containing huge quantities of oil and gas. Several of the most productive wells in the Gulf of Mexico lie in deepwater areas and they were drilled and began producing only within the last ten years. Other large deepwater discoveries have been made in the North Sea, off the coast of West Africa, and offshore Brazil.

Oceaneering is active in all those areas. Brazil’s Petrobras has discovered several mega oil fields offshore, lying under more than a mile of water and more than three miles of rock, sand and salt. They are thought to contain many billions of barrels of recoverable oil. Another area thought to contain rich deep-sea reserves is the Arctic Ocean. Intensive development of that potential resource lies in the more distant future. Proof of the viability of deepwater drilling lies in the fact that it increased sharply for several years and then merely leveled off during last year’s collapse in oil prices, even as land drilling and shallow water drilling dropped sharply.

What competitive pressures does OII face?

In its largest sector, contracting out ROVs, Oceaneering is the largest player, accounting for about 35% of the worldwide total of these subsea vehicles used in the energy industry. They own and operate 243 ROVs, all of which were built by Oceaneering. Most of the company’s business is tied to deepwater exploratory drilling and well completion. That is what sets it apart from its competitors. Indeed, Oceaneering accounts for 63% of the ROVs used in the deepwater drilling support market. The company is less of a competitive force in the repair and maintenance end of the oil service business, as well as the installation of pipelines. Competitors include Acergy (ACGY), Subsea 7, Global Industries (NASDAQ:GLBL), Fugro and Saipem, which is controlled by ENI.

How would you assess Oceaneering’s valuation?

Finances are strong, and improving. Debt has declined and is only 9% of capital. Annual net profit in each of the last four years (including the current year) exceeds total debt on the company’s balance sheet as of September 30, 2009.

OII’s trailing P/E is 17, slightly higher than its competitor, Acergy (ACGY), and much higher than that of Global Industries (GLBL), which is bouncing back from losses. As one would expect, companies in the more depressed areas of oilfield services have lower price/earnings ratios, due to the decline in drilling that resulted from the collapse of energy prices. The average P/E of contract drillers, for example, is about 1/3 lower than that of OII. Even Transocean (NYSE:RIG), which we might expect to benefit from its strength in deepwater drilling, finds its valuation dragged down by its participation in the weak shallow waters drilling market, where many jack-up rigs sit idle and more are nearing completion while lacking long-term contracts.

Oceaneering, on the other hand, experiences relatively little drag on earnings from its exposure to the slump in the oilfield business in shallow waters and on land. The superior prospects for deepwater drilling account for Oceaneering having a high P/E compared to the rest of the oilfield services industry. However, at 17, Oceaneering’s P/E is reasonable, considering the company’s recent earnings stability in the face of difficult energy industry conditions, impressive financial strength and superior long-term growth prospects.

Analysts’ earnings estimates for Oceaneering over the next year are pretty much flat, as deepwater drilling has leveled off, if only temporarily. Too, the company faces weakness in some of its areas of business and continues to suffer from difficult comparisons with results in 2008 and early 2009, which included substantial repair revenues generated by hurricane damage to oil and gas platforms in the Gulf of Mexico. Inspection revenues have also been soft. And diving service revenues from the shallow water areas of the Gulf of Mexico continue down, as well. The company’s strength in deepwater does not make it totally immune to the ill winds buffeting much of the oilfield services industry.

But prospects for increases in deepwater drilling, Oceaneering’s bread and butter, are bright. Deepwater drilling increased steadily since 2004, only to level off late in 2009. As drillers became successful finding large quantities of oil in deep water, they ordered more and more deepwater rigs. Since design and construction is measured in years, the order backlog has been increasing rapidly at shipyards and the worldwide fleet is about to expand rapidly. According to management, there are now 208 floating drilling rigs worldwide drilling in deep water; and, as of September 30, there were 80 more under construction, 51 of which already had long-term drilling contracts (> 6 years). Management expects 30-35 of these to be placed into service from 4Q, 2009 through the end of 2010. For those nearing completion, drillers have already contracted for the use of 21 ROVs, 12 of which are to be furnished by Oceaneering. This will extend the company’s dominance of the ROV market associated with deepwater drilling. Indeed, according to management, since late 2007, the company has garnered a 76% share of ROVs contracted for use on deepwater rigs.

What is the current sentiment on the stock?

Eight analysts rate this stock a “buy,” Five call it a “hold.’ None are in the negative camp. Most recently, Capital One Southcoast downgraded its rating on OII from “add” to “neutral,’ due to its 20% rise since early December. The stock price has fallen since that downgrade. Fully 92% of the float is held by a total of 280 institutions and mutual funds. So the stock is little owned and little known among the investing public.

What catalysts could move this stock?

A substantial increase in oil prices would, of course, be bullish for this stock. Deepwater drilling has focused more on oil than gas, since the monster fields discovered there, so far, have contained oil, primarily. Some deepwater projects could be speeded up, given the incentive provided by higher oil prices. However, I view Oceaneering as a long-term holding that will prosper even with an oil price that rises only gradually over time. As demand for oil increases, outstripping production from old fields on land and offshore, more and more drilling will occur in deepwater areas, spurred by recent discoveries of giant oil fields in such areas.

What could go wrong with this stock?

The main competitive threat to Oceaneering’s prospects would be the discovery of larger pools of easy to find, cheap to produce oil on land in politically secure countries. This would be a bonanza to the world economy, but would leave high-cost producers worse off. Deepwater drilling is necessarily a high cost endeavor. So a prolonged period of cheap oil would send deepwater drilling into a severe decline. This could possibly occur should scientists develop a low-cost method for extracting oil from the Canadian tar sands. Or if new technology would suddenly enable oil shale reserves in the Rocky Mountains to be extracted in huge quantities at low cost.

The natural gas industry has recently experienced major changes of this kind. Vast shale gas reserves, previously not commercially viable, are suddenly coming onto the market at low cost, enabled by recent technological advances in drilling methods. These supplies have placed in doubt the likelihood of increasing liquefied natural gas (NYSEMKT:LNG) imports into the U.S. And recent low natural gas prices have contributed to the decline in drilling for new supplies of gas.

It is highly unlikely that vast new sources of cheap oil will be found, but anything is possible. So, buyers of Oceaneering have to be of the opinion that the more likely event is that world economic growth will drive oil demand higher, while steadily rising oil prices will enable the pace of deepwater drilling to continue on its upward trajectory.

Disclosure: Arnold Landy and clients of Landy Investment Management LLC own shares of OII.

Source: Arnold Landy's Highest Conviction Pick: A Focused, Deepwater Drilling Leader