Simply put, I firmly believe that the bull market in energy commodities and related stocks is far from over. As I’ve explained in TES, global oil supply growth just isn’t keeping pace with demand, particularly fast-growing demand from Asia and other emerging markets. We’ve seen several corrections in the energy patch over the past few years, and each has proven an outstanding buying opportunity for investors; I have no doubt the current selloff will prove to be yet another example. As any experienced investor will tell you, the most painful and volatile markets historically offer the most opportunity. 

But we’re clearly not yet at that golden buying opportunity for all energy-related stocks; selectivity will be key in coming weeks. Although there are some valid fundamental concerns about sluggish oil demand in the US and strong US gas supply growth, in my view the action in energy isn’t driven by fundamentals at this time. And although the fundamentals of supply, demand and growth always win out eventually, in the short run it’s the market’s animal spirits that drive price action.

To gauge the current state of those emotions, you only have to look at how the market’s reacting to newsflow. Natural gas prices perked up two weeks ahead of the landfall of Hurricane Gustav, right into the heart of the Gulf Coast. But once the hurricane passed, the market chose to focus on the fact that the storm didn’t make landfall as a Category 3 or 4 storm. The fact that nearly 7 billion cubic feet (bcf) per day of US gas production as offline nearly one week after the storm hit has barely received a mention, nor did the fact that there’s still close to 5 bcf per day offline as of Monday. This is classic weak market action: Ignore the bullish news, and focus on the bearish take.

And on the oil front, a series of bullish oil and gasoline inventory reports have produced–at best–temporary spikes in crude; traders have used each of those rallies as an opportunity to sell.

And then there’s the silliest price action of all: coal mining stocks. Although most coal price benchmarks have doubled over the past year and remain close to all-time highs, coal-levered stocks have seen some of the most volatile trading action of the past three years. Case in point: Wildcatter Portfolio bellwether Peabody Energy (NYSE: BTU) traded close to $70 Aug. 21 and late last week dipped under $50 for the first time since last spring.

This is despite the fact that Peabody’s management believes that US coal miners could export 100 million tons of coal this year, well above current estimates for 76 million tons in exports. There has never been a stronger environment for coal prices and coal stocks.

As I explained in the July 29, 2008, flash alert Neither Here nor There, and in the subsequent issue, The Correction Continues, I see oil fundamentally well-supported near current levels.  However, in panicky selloffs such as this one, markets often overshoot sensible levels by a significant margin.

Here’s my current take on oil and gas and my advice on how to play this market. The current 12-month NYMEX natural gas strip is trading at around $8 per million British thermal units (MMBtu) right now with the near-month futures barely holding $7/MMBtu. Based on what I’m hearing from natural gas exploration firms, the marginal cost for US gas—the basic minimum price below which many producers start to become unprofitable—is $7.50 to $8/MMBtu.

It’s important to remember that many of the shale producers I outlined in the most recent issue of TES, Unlocking Shale, are profitable even at much lower prices than that. However, there are legions of producers of all sizes that target expensive-to-produce reservoirs or only own a couple of marginal wells. These firms start to become unprofitable under the $7.50 to $8 level. On moves to or below that band, natural gas production would tend to be shut-in, reducing supply.  

Bottom line: I suspect natural gas prices are at, or very close to, a bottom. This is why I’ve featured natural gas in the past two issues of The Energy Strategist. I suspect the North American gas-levered names will be the first to turn higher.

If you’re looking to invest new money in the energy sector right now, I’d recommend putting some cash to work in gas. My top plays right now would include land drilling giant Nabors Industries (NYSE: NBR), Haynesville Shale producer PetroHawk Energy (NYSE: HK) and diversified unconventional explorers EOG Resources (NYSE: EOG) and Talisman Energy (NYSE: TLM). All four stocks are buys at current levels and were discussed in the most recent issue of TES.

I’m less confident about crude oil right now. The weak sell-the-news action in crude and the failure to mount a meaningful rally in the face of good news suggests that there could be some more downside ahead for oil prices. Although I continue to believe that oil prices will trade generally in a broad range between $105 and $145 per barrel over the next year, I’m increasingly confident that we’ll need to see a short-term spike below this level before the oil market is on firmer footing.

Specifically, I’m looking for a spike to the $90 to $95 per barrel level over the next few weeks; such a move would undoubtedly hit a lot of stop loss orders and precipitate a sort of mini-panic in crude. Most of the big selloffs in crude over the past few years have ended with a short-term, panic-driven spike. The bottom in crude at the beginning of 2007 is a perfect example.

To play crude, I’m recommending a two-part strategy. First, I recommended Delta Airlines (NYSE: DAL) in a July 29, 2008, flash alert, Neither Here nor There. The biggest cost center for airlines is fuel. Therefore, the group tends to do well when oil prices fall or, at least, stabilize.

In addition, the airlines are starting to take steps to shore up profitability such as cutting back on unprofitable routes and retiring fuel-inefficient planes. Delta is an excellent hedge against further falls in crude and rates a buy under $9.75 for those not yet in the stock.

I’m also adding the MacroShares $100 Oil Down Exchange Traded Fund (ETF) (AMEX: DOY, DOY) to the Wildcatters Portfolio as a hedge. This exchange traded security moves inversely to the price of crude oil. When crude oil falls in price, the fund rallies.

The MacroShares Oil Down is paired with another fund called MacroShares Oil Up (AMEX: UOY, UOY). This fund moves up when oil prices rise. Basically, both funds hold US Treasury bonds; when oil rise, bonds are moved from the DOY to the UOY fund according to a pre-set formula. When oil falls, the opposite happens. Buy the MacroShares Oil Down under 26.50.

Second, although the oil services stocks have been hit price-wise, there’s absolutely no sign of a slowdown in their base business. I regard Schlumberger (NYSE: SLB) at current prices under $85 as one of the best buying opportunities we’re likely to see for the remainder of the year.

The stock could see downside to the mid- to upper $70s if oil falls to $90 near term, but my target is $150 per share before the end of 2009. As new deepwater rigs are deployed late this year and into early next year, Schlumberger’s growth rate is likely to pick up. I explained this story in great depth in the Aug. 6, 2008 issue, of TES, The Correction Continues. Buy Schlumberger.

Over the past two days, Peabody Energy (NYSE: BTU) and Acergy (NSDQ: ACGY, Norway: ACY) touched my recommended stop orders. Peabody was stopped out for a significant profit while Acergy was stopped out for a loss. The portfolio will be updated to reflect these stops. As I noted earlier, I don’t see any real change in the fundamentals for either stock; both names simply have been caught up in a panic-driven selloff.

My stops are designed to take us out of stocks before losses mount too far or we give back too much profit. My strategy on stop-outs is to use them as a cue to re-evaluate a holding; for this reason, I’m recommending you stand aside from both names for now. I will issue a flash alert over the next week updating my recommendations on both names.

Also note that subscribers who took my hedging advice for Peabody in the June 12, 2008, flash alert, Unsteady as She Goes, have preserved almost the entire profit in Peabody and have experienced almost none of the volatility over the past three months.

 If you’re not already familiar with this strategy, I encourage all readers to check out that flash alert and my free special report on hedging risk, The ABCs of Options to Hedge Risk.