The Energy Strategist is published twice per month, 24 times per year. Four times annually, we take a production break and this week marks one of those breaks. That doesn’t mean we ignore what’s going on in the energy markets or my recommended picks. Below I take a look at current trends in the oil and gas markets and a few of my favorite stocks.

Most energy stocks have seen a significant correction since late January/early February of this year. Depending upon which index you look at, the pullback measures roughly 12 to 18 percent from high to low. As I’ve outlined a few times in the newsletter, this is certainly not the first time we’ve witnessed a correction of this magnitude for the energy patch–and the correction doesn’t change the long-term bullish outlook for the oil and gas markets.

If history is any guide the recent pullback is healthy for the group. Last year there were two corrections of roughly the same magnitude, first in May then in October. Both served up an excellent buying opportunity for investors.

And the last major bull market for commodities was in the 1970s. If you look back at charts of oil stocks from that era, you’ll see several corrections of the very same magnitude in the context of a more than decade-long bull run that created immense wealth for well-positioned investors. I expect that to be the case again this spring.

That said, as I outlined in depth in the February 22nd and March 8th issues, I don’t see a major new advance for the group until April or May. We’re still a few weeks away from that ideal buying opportunity. To summarize, the warm winter weather across the US cut winter energy demand–inventories of oil, natural gas and refined products are far higher than average for this time of year.

Meanwhile, we’re entering a demand lull as winter wraps up in the northern states and the summer driving and cooling season isn’t yet upon us. As I outlined in the March 8th issue, the market isn’t yet focused on the potential for another major hurricane season this year that could disrupt supplies–hurricane season doesn’t enter its most dangerous season until July and August. These factors will keep pressure on energy prices and limit the scope of any rallies in the short term. I see a floor for oil prices at roughly $50 to $55 and for gas between $6 and $8 per million British thermal units. Thus, I see more downside risk from current levels for oil than for natural gas.

My favorite plays in this environment fit into one of a few key themes. I like drilling and services companies with significant leverage to international exploration and development projects. While domestic (North American) development projects are occasionally delayed when oil or gas prices fall, this is rarely the case for large multi-year international projects. Moreover demand for drilling rigs and various oil services is very high–day-rates and prices are on the rise. My favorite plays are deepwater drilling specialist Transocean (NYSE: RIG) and services giant Weatherford (NYSE: WFT). Interestingly, Weatherford has held up during this correction far better than the rest of the group, a sign of the underlying strength of its business.

The world’s largest manufacturer of compressors, Dresser-Rand (NYSE: DRC), narrowly touched my recommended stop at $23. The dip in the stock was due mainly to overall weakness in the energy patch rather than any fundamental change in prospects. I see Dresser-Rand as a good buy at current levels and am adding it back to the portfolio with a stop at 19. I’ll update the case for this stock in more depth in next week’s issue.

The majors tend to outperform most other energy stocks during corrections due to their size and diversification. My favorites here include ExxonMobil (NYSE: XOM) and Total (NYSE: TOT). I also view Occidental Petroleum (NYSE: OXY) as an undervalued and well-positioned producer with exposure to some attractive reserves.

The other group that tends to perform reasonably well during pullbacks are the Master Limited Partnerships (MLPs) such as Enterprise Products Partners (NYSE: EPD), Penn-Virginia Resources (NYSE: PVR) and Teekay LNG (NYSE: TGP). All of these companies are relatively sheltered from commodity price volatility and they offer large tax-advantaged yields for investors (See TES, October 26, 2005, The Next Big Income Investment for more on the MLPs).

Energy means far more than just oil and natural gas, and not all energy-related commodities will follow the oil patch lower during corrections. Two major themes of this newsletter have been coal and uranium for nuclear power. My favorite stocks here include the world’s largest uranium miner Cameco (NYSE: CCJ) and coal mining giant Peabody Energy (NYSE: BTU). The other related theme is, of course, the coal transportation stocks–railroads and coal barges. Our most recent recommendation in this area is Wabtec (NYSE: WAB), one of the world’s largest suppliers of brakes, signaling equipment and communications gear to the railroad industry. For a full rundown of Wabtec’s fundamental story, check out the March 8th issue.

Finally, there are plenty of ways to play and profit from the downside in energy prices near term. In the February 22nd issue I recommended avoiding most refiners and especially Sunoco over the next few months. I also looked at how airlines benefit from falling crude prices.

The Myth Of Speculation

A common refrain among longer-term oil bears is that the oil market is driven not by fundamentals of supply and demand but by rank speculation on the part of hedge funds and other large traders. That argument simply doesn’t hold up under review. In fact, the position of speculators in the futures market offers another reason to believe that we’re nearing the end of the current energy correction.

The Commodities Futures Trading Commission (CFTC) publishes a report every week known as the Commitment of Traders (COT) report. Basically, this report reviews all of the open interest in various futures contracts by both position type and type of trader. In other words, every week, the CFTC tells us how many futures contracts traders hold in a particular market and whether they’re long or short that market. The report also divides speculators into large speculators (mainly hedge funds and institutions) and smaller traders. And there’s also a section that covers commercial traders–mainly these are large companies that are using futures to hedge their exposure to a particular commodity.

One of the more interesting bits of data is the commitment of large speculators. In most markets, large speculators are basically trend followers, but they tend to get overly bearish (and extremely net short) near major lows and overly bullish (extremely net long) near major highs. Extreme positions can give us an early warning of potential turning points.

The way I keep tabs on this data for the crude oil markets is simple. I look at the total long position held by large speculators and then subtract the total short position held by large speculators. This gives me the net position–negative numbers suggest traders are net short while positive numbers occur when traders are net long. I then divide this number by the total open interest (OI)–the total number of contracts outstanding–for the crude oil contract (the OI number is included in the COT report).

Since 2000 large speculators have oscillated between about 10 percent net long crude oil and 10 to 12 percent net short. Interestingly, spikes below -3 to -5 percent tend to mark key turning points for the oil market–at these points, speculators are heavily short the futures. There are a couple of possible reasons why these turning points exist. One is that if funds are very short crude oil and there’s some turn higher they’ll have to buy back those futures, pushing crude higher. Another is simple emotion: Huge net short positions suggest extremes in sentiment, classic turning points for any market.

To make a long story short, we saw two extreme spikes in 2003 to under -10 percent. Neither called the low exactly but both marked important turning points for crude oil. We also saw downside spikes at the end of 2004, in May 2005 and last October/November–most investors are well aware that each of these periods marked a key intermediate term low.

Large speculators are once again net short crude oil futures. Earlier this year, the ratio stood at about -4 percent and it’s now at -2 percent. While these aren’t quite the extreme levels normally seen at key lows for oil, they are certainly close. And while the talking heads may blame speculators for bidding up the price of oil, nothing could be further from the truth. In fact, these traders are actually betting on a decline this spring.