Hurricane Rita is bearing down on the Texas Gulf Coast after slowly swirling across the northern Gulf of Mexico. While the storm is now packing winds of 135 miles per hour, down from over 180 at one point, it’s still a very dangerous and potentially destructive storm.

The hurricane has passed directly through the heart of key producing regions for both oil and natural gas. Some of these areas were NOT affected by Hurricane Katrina so it’ll likely cause damage to facilities that had not previously been damaged. This further reduces Gulf production capacity. For now, most of the northern Gulf production region is simply shut down.

On the refining front, the Galveston area is very important, at least as important as the New Orleans area. Many of these refineries have already been shut down as the storm approaches, reducing gasoline supplies in the US.

But these problems and the potential fallout are already very well known. The financial media has talked of little else for the past three days but the potential catastrophic effects of this storm on America’s oil infrastructure and the bullish impact on energy prices.

I’m certainly no weather expert and do not mean to diminish the dangers associated with Rita; however, the risks for short-term oil prices are balanced to the downside.

The energy markets are understandably sensitive to the hurricane issue because Katrina caused such a spike in gasoline prices and had a devastating impact on import terminals in the New Orleans area. And Katrina did indeed reveal some major weaknesses and supply problems in the US, issues such as a shortage of refining capacity and over reliance on Gulf Coast facilities. These are all factors I’ve discussed at length in The Energy Strategist.

It would seem that the market has now priced in the idea that Rita will be every bit as devastating as Katrina. Keep in mind that hurricanes affect the Gulf almost every year and that many offshore rigs and most offshore production facilities in the area are designed to withstand the impact of even a Category 5 hurricane. Furthermore, this isn’t the first time the region has seen the landfall of a major, devastating hurricane. But damage from Katrina resulted mainly from the flooding in the New Orleans area, and a very specific set of circumstances. Katrina was, in many ways, a unique or at least a rather rare storm.

With the worst possible news already priced into energy prices the risk is that the storm will be less damaging that expected. If that happens, look for a short-lived yet rather sharp drop in crude oil and gas prices.

Please note that my longer-term view on energy is unchanged: The bull market remains intact and the passage of Rita will not change the global supply crunch in these commodities. But I would be remiss if I didn’t highlight the shorter-term risks to some stocks within The Energy Strategist Portfolios, stocks that have gone straight up over the past few months.

How To Protect Yourself

In the last issue of The Energy Strategist, I highlighted an options strategy for hedging your risk in some of the stocks most vulnerable to a temporary drop in energy prices. I encourage all readers to read and consider implementing this strategy.

For those of you unwilling to tackle the options market, I encourage the use of stop-loss orders to hedge your risks on these stocks. I’m raising the recommended stop in Marathon to 64.25 and am cutting the stock from a buy to a hold. I’m also raising the stops in Weatherford (NYSE: WFT) and Cooper Cameron (NYSE: CAM) to 64 and 66.50, respectively.

In addition, I recommended a trade in shallow-water driller Todco (NYSE: THE) back in June, taking partial profits of more than 30 percent in August. All subscribers still in Todco should raise their stops to 31.50 to lock in further gains on the remaining position.

As for investing new money, I would recommend shifting focus away from oil-leveraged plays. My favorite plays right now are the uraniums, tankers, coal stocks and the master limited partnerships (MLPs).

Cameco (NYSE: CCJ) and Denison (Toronto: DEN) will see little negative impact if oil prices pull back $5 to $10 near term. These stocks are also not terribly extended and spent much of the summer trading sideways–I’m looking for a run into the winter heating season.

On the coal front, my trade recommendation in railroad Burlington Northern SantaFe (NYSE: BNI) is starting to work out–those not yet in the stock should enter now. To see my full rationale, check out the last issue of TES.

Coal MLPs Penn-Virginia (NYSE: PVR) and Natural Resource Partners (NYSE: NRP) both remain excellent buys at current prices.

Finally, the tankers are now entering a period of seasonal strength; the stocks look to have put in important bottoms. General Maritime (NYSE: GMR) is a buy right now, and I continue to recommend shorting OMI (NYSE: OMM) as a hedge for Genmar.

A Short-Term Speculation

The Energy Strategist focuses on finding and recommending the best stocks to play the long-term bull market in the energy patch. But the impact of energy prices extends far beyond drillers and producers of oil and gas. Other industries are also affected quite dramatically by oil prices.

For those of you interested in playing the short-term pullback in oil prices, I am issuing a recommendation to buy America West Airlines (NYSE: AWA). I must reiterate that this is a speculative trade recommendation only, NOT a portfolio pick. I’ll continue to track the recommendation and give updated advice via flash alerts and in your regular issues of TES. You should commit only a relatively small amount of speculative capital to the trade. Also be aware that this trade will likely last no more than one to three months.

The US airline industry is fundamentally unsound and has been for some time–these companies (with a few notable exceptions) consistently lose money. But lately they’ve been losing even more than normal because fuel costs have really hit the group’s margins. In fact, energy prices were the nail in the coffin that drove Delta (NYSE: DAL) and Northwest (OTC: NWACQ) into bankruptcy recently.

While I believe that there will be some longer-term pain in the airlines, in the short run a drop in crude prices will trigger a sharp rally. This has happened on many occasions. And because the group is heavily shorted, short covering can lead to some very dramatic spikes to the upside.

The stronger airlines–like Southwest (NYSE: LUV)–are not a good way to play the move. These stocks will not see the dramatic moves of the weaker carriers; Southwest has also hedged its fuel costs at significantly lower prices. Nor do we want to play the carriers with one foot in the grave.

America West is a good compromise. The stock is benefiting from positive sentiment surrounding the coming merger with bankrupt carrier US Airways. Buy America West under 8.75 with a stop at 6.75, using a small position size. My target here is 15 to 16.

I’m not recommending shorts in oil and gas related stocks at this time as a play on falling energy prices. While some will undoubtedly pull back, the short-term downside is limited and there remain too many shorts in the group. Violent short-covering rallies have consistently hit investors looking to pick a top in this group over the past few years.