For most energy-related stocks, 2007 got off to a rough start. For that matter, just about all commodity-related markets got hit by selling early in the new year. I see two primary catalysts for the selloff in energy stocks: warm weather across most of the eastern half of the US and an earnings warning from Nabors Industries (NYSE: NBR). In fact, these two factors are inextricably related.

Since early fall, I’ve been writing about the developing El Niño phenomenon and its effect on winter weather. Basically, El Niño is a warm current in the tropical Pacific Ocean; El Niño years tend to bring warmer-than-average temperatures to the eastern US.

As a result of the developing El Niño, the National Oceanographic and Atmospheric Association (NOAA) has been forecasting a warmer-than-average season that will, however, be somewhat cooler than last year’s record-breaking winter. Warm temperatures spell lower heating demand and, therefore, lower gas demand. I won’t belabor this point here as I discussed it at some length in the Dec. 20, 2006, issue of The Energy Strategist, Oil And Gas.

The market is already pricing in a warmer-than-average winter but remains sensitive shorter term to wintertime “heat waves”, such as we saw last week. Moreover, we’re already seeing an impact on gas supplies resulting from the weather.

The Canadian drilling market looks very weak right now; activity has really fallen off a cliff in comparison to the past few years. As the No. 1 supplier of imported natural gas to the US, Canada’s slowdown will have an effect on gas inventories.

This is exactly what we heard last week from Nabors. I’ve never recommended Nabors in any of the TES model Portfolios; in fact, I’ve rated the stock a “sell” for nearly a year now. The reason is simple: Nabors is leveraged to the North American land-drilling business.

North America is the drilling market that’s most vulnerable to short-term swings in commodity prices. There are a number of reasons for this. Basically, North American drilling is dominated by a number of smaller, independent producers undertaking relatively small-scale projects; these projects don’t require a great deal of lead time and can be delayed.

In addition, many (not all) North American projects require relatively high gas prices (above $7/million British Thermal Units) to be profitable. Canadian shallow gas drilling is a classic example of a high-cost resource.

I’ve been speculating for some time that falling gas prices would eventually moderate the red-hot North American drilling market. Nabor’s cited weakness in both Canada and the lower 48 states as the main reason for the warning.

In recent years, Nabors has also expanded into key international markets such as the Middle East; it’s important to note that this warning has absolutely nothing to do with these markets. International drilling activity is, unlike the US, not particularly sensitive to commodity prices. There isn’t even an inkling of a slowdown outside the US and Canada.

As I pointed out in the Jan. 3, 2007, issue of TES, The Deep End, deepwater drillers operate in a very different market to contract drillers like Nabors. Not only is deepwater activity insensitive to commodity prices, but there’s also a shortage of rigs–all available rigs are booked for the next three years.

Land rigs are relatively inexpensive and simple to build; a downturn in demand in North America could quickly lead to a glut, particularly for low-power rigs. But that’s not the case for deepwater rigs. These $500 million-plus rigs take considerable lead time and expertise to build; the potential for a glut is negligible.

Therefore, while there could well be some sympathy selling in TES recommended services and drilling names such as Seadrill (Oslo: SDRL; OTC: SDRLF) and FMC Technologies (NYSE: FTI), these companies won’t see any significant fallout from the slowdown in North American drilling activity that clipped Nabors.

I’d recommend continuing to avoid names like Bronco Drilling, Patterson-UTI, BJ Services and CalFrac Well Services. All of these stocks are vulnerable to weakness in North America and are rated sells.

Coal Miners

The warm winter weather is also having an effect on coal demand. Because coal is the most-important source of fuel for electricity generation in the US, warm winter weather spells low demand for coal. This is precisely why we’ve seen a selloff in most coal-related stocks since the end of November.

The key in the coal mining business is to avoid companies that are overexposed to the Central Appalachian coal-mining region (CAPP). CAPP is an extremely mature coal-mining region that’s been exploited for more than 100 years. As coal seams become smaller and deeper underground, mining costs have been steadily rising.

Moreover, all the miners with exposure to the region have reported significant difficulty recruiting and retaining labor. After all, few younger workers want to enter the underground mining business, and there’s a shortage of older, experienced miners; such specialists command top dollar.

In addition to labor, the costs of transport, steel and diesel fuel have also been driving mining cost inflation.

Thinner coal seams in the east are also driving a major deterioration in productivity. According to James River Coal Co (NSDQ: JRCC), each 5 percent decline in mining productivity drives a $1.50 increase in cash mining costs per short ton produced. Overall, James River estimates that mine productivity is off 20 to 25 percent in just the past two years.

With mining costs rising and productivity and coal prices falling, CAPP producers are in trouble. Several smaller producers have already gone bankrupt or simply abandoned high-cost mines. In fact, before summer I expect to hear rumors of bankruptcy for at least one of the major publicly traded CAPP-focused miners.

I’ve rated most of these stocks a sell for more than a year now but it’s worth re-iterating that James River Coal Co, International Coal Group (NYSE: ICO), Alpha Natural Resources (NYSE: ANR) and Massey Energy (NYSE: MEE) all rate sells.

Peabody Energy (NYSE: BTU) is the best-positioned coal mining company. The company has the most exposure to the Powder River Basin (PRB) in the western US. Production costs in the PRB aren’t rising as quickly as in CAPP, and production from the region has significant room for further expansion. Moreover, Peabody is protected from the worst swings in the coal market because of its term supply contracts with utilities. While the stock may require patience shorter term, Peabody remains a buy.

Other Plays

After a big run-up toward the end of 2006, uranium stocks saw some profit-taking on light volume in the new year. But the nuclear power/uranium bull market has little or no correlation to US weather, oil or natural gas prices. The primary catalyst here continues to be ongoing, long-term nuclear plant construction and an acute shortage of uranium.

I highlighted the uranium secular bull market story in the Dec. 20, 2006, issue of TES. I recommend using the minor weakness in these uranium stocks as an opportunity to add to your positions.

I recommended buying Duke Energy (NYSE: DUK) ahead of the company’s Spectra Energy spin-off this year. My basic thesis is unchanged since the Nov. 13, 2006, flash alert, A Holiday Gift. I continue to recommend buying both Duke and Spectra at current prices.

For the record, if you bought Duke on my original recommendation in November, you likely paid around $31.50 per share. For illustrative purposes, if you bought 100 shares of Duke, you paid $3,150.

After the January 3 spin-off, you now own 100 shares of Duke trading at roughly $18.75 and 50 shares of Spectra trading at just shy of $28. The combined value of those holdings is $3,275; the stock is up slightly from my original recommendation.

A New Trade

As I’ve pointed out before, oil prices will remain well supported in the $50-to-$55 region unless there’s a major global economic contraction this year; at this point, I just don’t see that happening. However, high inventories of crude should keep a lid on price advances beyond the $65 region during the next few months.

One of the best plays on range-bound or falling oil prices is the airline industry. Fuel is one of the largest cost centers for airlines. And rising fuel costs have been masking a renaissance in the industry during the past few years.

Although airlines have traditionally been poor investments, in recent years, they’ve been taking steps to improve their fate. The biggest problem airlines have faced is overcapacity; too many planes flying too many routes. Overcapacity leads to fierce competition and falling fares. This is the prime reason few airline stocks have made money traditionally.

But domestic air carriers have been rationalizing capacity in recent years, cutting flights and retiring planes. With demand still rising, planes are fuller than they’ve been in any year since 2000.

Fuller planes and less capacity have spelled solid fares and rising profitability. This is particularly true on international flights; most of the big US carriers have profitably expanded their international service while cutting out unprofitable domestic routes.

Even labor unions have been relatively well-behaved, accepting significant wage reduction to help restore profitability. Falling jet fuel costs will just aid airlines’ renaissance.

I’ve been recommending UAL Corp (NSDQ: UAUA) as a play on this trend since early October. Recall that I recommended taking solid profits on half the position in November; at the time, the UAL recommendation was showing a profit of about 30 percent. Since that time, the stock has continued to rally and is now up nearly 60 percent from my original recommendation.

I recommend holding UAL, as there’s more upside potential. And I fully expect to hear more rumors that the company is a takeover or merger target. But don’t buy any more at this time.

As an alternative, consider Netherlands-based AerCap Holdings (NYSE: AER). This company isn’t an airline at all; it’s the world’s largest publicly traded aircraft leasing firm.

The company owns 109 aircrafts and 61 aircraft engines. In addition, AerCap has close to 100 new planes on order and manages an additional 110 airplanes. In short, within a few years, the company will have a total fleet of more than 300 planes and some 70 aircraft engines.

AerCap rents these planes and engines to major airline carriers under terms known as an operating lease. Under an operating lease, the lessee (the airline) bears all the ongoing costs of maintenance; the lessor (AerCap) gets the plane back at the end of the lease’s term and can re-lease the plane or sell it.

Therefore, AerCap gets to retain the terminal value of the plane at the expiration of the lease. In total, the company currently leases its planes to 100 different air and cargo carriers based all over the world.

Aircraft leasing has become more popular in recent years. According to AerCap, about 30 percent of the world’s fleet of airplanes are currently under operating leases; that number is expected to expand to more than 40 percent by 2020.

The reason is that the purchase of a plane outright requires the airline to put up the capital for the plane immediately. Under a lease, the airline can spread the cost of the plane out over time. Meanwhile, AerCap gets a steady stream of attractive lease payments for renting the plane.

A number of factors should continue to drive AerCap’s growth. First, the renaissance of the airline business means that aircraft values are on the rise; AerCap has been able to demand higher leasing fees for its airplanes. In addition, the residual values of these planes upon termination of the lease is rising.

Better still, demand for air travel in markets like China and India is truly booming. Millions of developing market consumers are now able to afford air travel for the first time. AerCap has focused a good deal of its recent leasing activity on these markets; growth is particularly strong in Asia/Pacific markets.

Finally, because of rising demand for airplanes, most of the major manufacturers are already booked up for the next few years. They can’t build any more planes than they’ve already committed to. Therefore, if airlines wish to expand their fleet, they have to deal with leasing operators like AerCap that have some spare capacity.

As a new initial public offering, the company can be volatile. AerCap is added to the aggressive Gushers Portfolio as a buy under 27 with a stop at 21.