With oil cruising above $140 per barrel and natural gas at its highest levels since late 2005, it’s hard to imagine that there could be any energy-related sectors that aren’t flying higher.

But that’s not the case. As I have often noted, the energy sector isn’t a homogenous group; not all sub-sectors of the industry move in the same direction at the same time. And not all energy-related groups actually follow crude oil.

These fundamental distinctions are all-too-often ignored. Consider 2007, the best year out of the past five years for energy related stocks. The Philadelphia Oil Services Index returned an impressive 51.5 percent for the year. However, not all oil services and drilling stocks performed well last year; for example, BJ Services and Nabors Industries fell 17 and 8 percent, respectively.

The reason for that poor performance: BJ Services and Nabors both have significant leverage to the North American drilling market and, in particular, drilling for natural gas in the US and Canada. With natural gas prices weak for most of 2007, drilling activity remained depressed and firms such as BJ Services and Nabors sold off even as internationally levered services names soared to new all-time highs.

Another example of this sort of divergence is the coal market. July of last year most US coal mining firms got hit hard, even though energy stocks in general continued to perform well. Stocks such as Peabody Energy and Arch Coal were trading at–or near–multi-year lows.

These sorts of divergences and inconsistencies often conceal great opportunities for investors. Although I certainly believe in playing strong sectors, investors can also benefit from sifting through the bargain rack, looking for weak sectors with emerging catalysts for a turnaround. In The Energy Strategist, I always keep an eye on value-oriented sectors as well as tracking the high-flyers.

Coal and natural gas offer a perfect example of this sort of value play in action; the potential for returns are archived in this newsletter. I discussed the outlook for the US coal miners at great length last summer. See TEL, July 27, 2007, Coal Earnings.

In that issue, I acknowledged the issues facing the US coal mining firms; these headwinds included glutted coal inventories in the US and cost inflation. But I also highlighted two major points that I believed most investors had been ignoring: falling coal production in the eastern US and a rapidly strengthening coal export market.

Both factors have been key drivers of the coal bull market over the past nine months. Eastern coal production was troubled late last year because of more stringent mine regulations; many higher-cost mines in Appalachia were shuttered.

And, even more important, the export market is truly booming. US coal exports rose to 59.2 million short tons in 2007, up from 49.6 million in 2006. And according to current EIA projections, exports should top 76 million tons this year; judging from bullish comments from many of the big miners, this projection looks conservative.

As these factors became more apparent, coal stocks went from being among the worst sectors in the energy patch a year ago to being among the best performers this summer. Arch and Peabody, the two largest US miners, are both up more than 80 percent since I penned that issue last July.

And as noted above, natural gas levered stocks also under performed for much of last year. I highlighted Nabors Industries as a potential value/turnaround play late last summer. (See TEL, Aug. 10, 2007, Opportunities Knock Again). I won’t belabor the point by reviewing the investment case for Nabors at the time; those interested can check out the issue for details.

To make a long story short: after some initial volatility, the Nabors play worked out and the stock is up 63 percent since early August 2007.

Certainly, I don’t always call stocks correctly, and I have made plenty of mistakes in both TEL and TES. Also, sometimes buying turnaround plays takes patience. It took four months before the Nabors recommendation began to work for us. However, these two examples highlight the potential rewards of keeping an eye on beaten up sub-sectors in the energy patch.

New Value

One value sectors to watch right now is the refiners. The refiners are perhaps the most misunderstood sub-sector in the energy business. To many investors, the chart below is puzzling.

Source: Bloomberg, The Energy Strategist

To produce this chart, I compared the performance of West Texas Intermediate (WTI) crude oil prices, the S&P 500 Energy Index, The Philadelphia Oil Services Index and the largest independent US refiner, Valero Energy. For ease of comparison, I set all of these commodities and securities equal to 100 on the last trading day of 2007.

As you can see, crude–represented by the purple line–is up around 50 percent this year, while the Oil Services and Energy indexes are up between roughly 10 and 20 percent, respectively. Meanwhile, the price of Valero has plummeted over the same time period.

And I’m not picking Valero to make the comparison more dramatic. Other refiners such as Tesoro and Alon USA have actually underperformed Valero handily.

As I noted in a flash alert to TES subscribers earlier today, there’s absolutely nothing unusual about Valero’s action in the current environment. Refiners don’t make money from rising oil or natural gas prices. In fact, these companies are often actually hurt by rising crude.

I explained the refining industry in the Oct. 12, 2007, issue of TEL, Looking Refined. To review, independent refiners such as Valero buy crude oil on the open markets as feedstock for their refineries; these companies have no way to produce oil internally, so they must buy the oil from producers.

These companies then convert that crude oil into a host of refined products. The most common products refiners produce would include gasoline, jet fuel, heating oil and diesel. Refiners then sell these refined products to earn revenue.

When oil prices rise, refiners’ costs rise because they have to pay a higher price for their crude oil feedstock. If the price of the gasoline and jet fuel these refiners produce doesn’t also rise, profit margins get squeezed. And that is exactly what has happened so far in 2008.

This might be difficult for many consumers to imagine, with retail gasoline prices well above $4 per gallon across most of the US. But crude oil futures are up roughly 51 percent so far in 2008 while gasoline futures are up less than 40 percent.

Although heating oil futures–a good proxy for diesel–are up roughly in line with oil, your typical US refiner processes far more gasoline than heating oil. Therefore, rising oil prices are offsetting any benefit from rising gasoline and diesel prices. Refiners’ profit margins, known as crack spreads, are unusually depressed this year.

In the short run, Valero and the other refiners could continue to see price weakness as rising oil prices crimp margins. However, just as with coal and natural gas one year ago, I do see some potential catalysts on the horizon.

First, analysts have been consistently revising their earnings estimates for the refiners lower in 2008. At the beginning of the year, the consensus was that Valero would earn $8 per share in 2008; now that consensus is for about $5.15. And the lowest estimate for 2008 earnings is closer to $4 per share. This means that the bar of expectations for Valero is adjusting to the reality of weak refining margins and high oil prices, so a great deal of this bad news is already priced into the stock.

Price-to-earnings (P/E) isn’t a particularly useful valuation measure for Valero and the other refiners because of their cyclicality. Like all cyclicals, refiners will look cheapest on a P/E near the top of each refining cycle. This is when earnings per share are highest.

Instead, I prefer to keep an eye on price-to-book as a quick measure of valuation. Currently, Valero trades at less than 1.2 times book value; the last time the stock traded at this level was in 2003 and early 2004. But back then, refining margins were far weaker than is the case today.

This makes Valero a potential tinderbox. The first whiff of good news would make the stock look like an irresistible value, likely sending the shares flying higher.

I see two potential catalysts: a moderation in oil prices and the upcoming earnings season. As I noted in the most recent issue of TEL, I disagree with the notion that oil is a bubble set to burst; there’s little real question that supply and demand fundamentals are driving the majority of recent price gains. However, crude has been a parabolic mover in recent weeks, and I do expect some sort of a correction over the next six to nine months.

This correction would be a pullback in the context of a multi-year uptrend. But we could easily see oil trade into the $100- to $110-per-barrel range on such a move. This would instantly take some of the cost pressures off the refiners and improve sentiment toward the group.

Alternatively, as I noted earlier, expectations for the refiners are low right now. Most report earnings at the end of July or early August. I’ll be watching carefully how these stocks react to their releases; if the news is as expected or even negative, but the stocks don’t selloff, it will be a good indication that the group has hit rock bottom.

Speaking Engagements

Be sure to wear a flower in your hair when you venture west to San Francisco. My colleagues Neil George, Roger Conrad and I will be heading to “The City” Aug. 7-10, 2008, for the San Francisco Money Show.

We’ll discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.

Click here or call 800-970-4355 and refer to priority code 011361 to attend as our guest.

Also, be sure to check out our blog, At These Levels, for more noteworthy stories.

Special Invitation

We have a special invitation for our readers. KCI Communications, Inc., publisher of The Energy Letter, is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Roger Conrad, Gregg Early and Neil George and myself.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 800-832-2330.