The Philadelphia Oil Services Index is now trading roughly 18 percent off its May highs. Back in early May, most stocks in the group rallied in parabolic fashion and valuations became somewhat stretched; that sort of momentum is simply unsustainable.

It seems that by early May even energy bears were giving up and jumping into the sector; greed and the desire not to miss out on big gains were the prime emotions driving the market. Technical analysts (also known as chartists) term such action a “blow-off top.” Normally this sort of parabolic rise and fall leads to a correction that lasts for a few months.

I warned of the possibility of such a correction in early May; I recommend that all subscribers who haven’t already read my May 3 report do so now. I’ve also made several sells during the past few weeks, including Peabody Energy (NYSE: BTU) and Transocean (NYSE: RIG). Subscribers should be out of these and other names with nice gains. The details of these sells have all been posted to the Portfolio tables.

While the fundamentals for the group are undimmed longer term, I’m not convinced we’ve seen the lows of this correction. Every great bull market in history has seen periodic vicious corrections of as much as 30 percent before ultimately rallying to new highs. It’s these ugly selloffs that tend to shake out investors at just the wrong time; investors panic near the lows and bail out of their investments.

And it’s been a long time indeed since the oil and oil services names have corrected to that extent. I suspect we’re currently in the middle of such a cathartic selloff that will end in a bout of panic-driven selling. Eventually this will offer another top-notch buying opportunity, but we’re not at that ideal buy point just yet.

How To Play It

Our first line of defense is to stick with more defensive sub-industries within energy. A perfect example of a defensive group is the master limited partnerships (MLPs) and pipeline plays that I outlined at length in the most recent issue of The Energy Strategist. These income-oriented investments don’t move in line with the rest of the group.

Specifically, when energy stocks were red hot earlier this year, investors totally ignored these “boring,” slow-moving MLPs. But when the energy patch hits a periodic correction, money tends to rotate out of the growth-oriented energy plays and into the steady eddies like the pipeline MLPs.

In addition, the pipeline companies are getting some attention from private equity firms due to the Kinder Morgan buyout plan; speculation regarding the potential for more deal-making activity is helping to put a floor under the group.

While not totally immune to a pullback, the pipeline and coal MLPs I outlined in the most recent TES are the most defensive buys during this pullback. Most are located in the Proven Reserves Portfolio.

Second, if you hedged your portfolio using options according to my May 3 recommendation, I continue to recommend holding on to those hedges for now. I’ll continue to follow these hedge recommendations in upcoming issues of TES as well as via periodic flash alerts as this pullback unfolds.

Finally, it’s important to stick to a risk discipline on more leveraged holdings within the Wildcatters and Gushers Portfolios. Unless you’re hedged using options, it’s important to place and adhere to the stop recommendations I give on all holdings in the portfolios. These stops will protect your downside during selloffs of this nature and are a great way of protecting gains on winners.

However, I’ve heard from a number of subscribers who prefer not to set stops on their holdings for fear that they’ll get stopped out just before the energy patch begins another leg higher. An alternative to the use of stops is to buy put options on your more leveraged holdings–one put option contract for every 100 shares of stock you own.

For example, I recommend Tenaris (NYSE: TS), an oilfield pipe provider. While I like the stock and feel it’ll ultimately head higher, there could be additional downside risk over the next month or so. To protect your downside, I’m recommending a stop loss at $30.75. An alternative would be to buy one September 32 put option (Symbol: TSW UB) for every 100 shares of Tenaris you own. These options currently cost roughly $3.00 ($300 per contract) but will limit your downside below 32 between now and mid-September.

I recommend using stops, but if you are unwilling to do so, consider using puts. Bottom line: To avoid panicking and selling out near the lows, it’s important to follow some form of risk discipline.

Short Recommendations

Finally, more aggressive traders can consider using short positions or puts to directly benefit from further downside in selected issues. One of the most vulnerable groups right now is the offshore drillers.

As I pointed out in the most recent TES, I’m bullish on the drillers longer term. Oil producers have been paying out record day rates to lease rigs because there is a global shortage of rigs. That shortage is particularly acute for the deepwater drillers; development of these reserves has been heating up in recent years as many of the largest new discoveries are in deepwater.

But short term I see downside for the deepwater drillers. Specifically, these drillers sign long-term contracts for their rigs at fixed day rates. During the past six to nine months, the group has benefited from earnings estimate upgrades as older contracts rolled over. In other words, contracts signed three years ago at rates less than half current levels got rolled over to much higher rates. The earnings upside was tremendous.

But the pace of contract rollovers is set to slow during the next few months. Most of the big drillers have already contracted out their rigs for the next few years. The earnings upside from these rollovers is well discounted by the market.

The one hot market I do see developing is the shallow water Gulf of Mexico (GoM). In this region, there’s a major supply crunch because the drillers that own rigs in the area have been slowly moving rigs to other regions. Specifically, Rowan and Global Santa Fe have both moved so-called jackup rigs (designed for drilling in waters less than a few hundred feet in depth) from the GoM to Saudi Arabia; contractors are able to sign long-term contracts in the Middle East at high day rates.

The problem is that there are no jackup rigs anywhere in the world available to be moved back into the GoM at current GoM day rates. This is particularly true because no one wants to move rigs into the region just as hurricane season heats up; many rigs were destroyed and badly damaged last year. Bottom line: Producers will have to fight for a limited supply of jackups in the GoM, which means a bidding up of day rates. This is a major theme I see developing later this year.

To play the divergence between deep-water and shallow-water drillers, I’m recommending what’s known as a pair trade. Basically, I’m recommending you purchase Todco (NYSE: THE) and short Diamond Offshore (NYSE: DO) in equal dollar amounts.

Todco is a major player in the GoM and has a number of rigs currently in storage that could be brought into use relatively quickly. Thus, it is the only player with the capacity to increase its fleet in the GoM in a strong day-rate environment. If an acute shortage of rigs does arise in the GoM as I expect, Todco will benefit. Buy Todco at current prices.

On the downside, Diamond Offshore is a deep-water-focused driller with a fleet of 30 deep-water semisubmersible rigs. With most of its capacity already locked up, I see no near-term catalyst for upside to earnings. And if the correction does continue as I expect, this stock will get hit. Short Diamond Offshore at current levels.

I recommend that you only take this trade as a pair–do not buy Todco unless you’re also shorting Diamond Offshore. And be sure to use equal dollar positions in each, not equal share-size positions. I’ll track this position as a pair trade in the Gushers Portfolio.

Finally, if you’re unwilling to put on short positions, you can use options as an alternative. Specifically, consider buying the December 75 Diamond Offshore put options (Symbol: DO XO) and the December 40 Todco Calls (Symbol: THE LH) in equal dollar amounts. Trade the options only if you’re unwilling to short Diamond.