As I highlighted in the most recent issue of The Energy Strategist, Crude Realities, I see the fundamentals of the oil and natural gas markets supportive to current prices.

Yesterday’s report from the Energy Information Administration (EIA) showed a 4.6 million barrel crude drawdown, considerably higher than the 1.5 million barrel draw expected.

Meanwhile, gasoline inventories also rose at a slower-than-expected pace; these data points show a further tightening in the US inventory picture. The oil and gasoline markets are no longer facing a glut as they were around the end of the first quarter. The same basic pattern is increasingly evident across the developed world.

Also this week, the EIA released its June Short-Term Energy Outlook (STEO). Some in the media seized on the EIA’s prediction that US demand for oil will fall by 290,000 barrels per day (bbl/d) this year because of high prices and a weak economic outlook. This was down from the EIA’s prior projection of flat year-over-year US demand in 2008. Historically, such a decline in US demand would be extremely bearish for oil prices.

But there was another side to the STEO report. Consider that the EIA sees total global oil consumption growing a robust 1 million bbl/d this year, with a 1.2 million bbl/d increase in demand from China, India and the Middle East offsetting the weakness in the developed world.

Moreover, on the all-too-often ignored supply side, the EIA slashed its estimates for 2008 non-OPEC oil production growth. Late last year, the EIA was looking for a 1 million bbl/d increase in non-OPEC production for 2008; the organization had cut that estimate to 600,000 bbl/d by May and to just 310,000 bbl/d in the June report. And even that looks overly optimistic when you consider that non-OPEC production fell by 250,000 bbl/d in the first quarter and a projected 200,000 bbl/d in the second quarter.

Despite the continued bullish news from the energy patch, we must remain cognizant of broader market trends. Specifically, crude oil prices remain volatile and subject to short-term headline risk; bullish talk surrounding the dollar or news out of a proposed Saudi summit on oil are just two examples. These data points translate into wild day-to-day swings in energy-oriented stocks.

Fortunately, over the past several months, we have some significant gains built up in the TES Portfolio. It’s only natural that we look to lock in and hedge some of these winners, if for no other reason than to help us sleep better. Longtime TES subscribers are familiar with my use of options as a cheap, convenient means to hedge your risks while preserving upside.

Don’t be tempted to look at options as a purely speculative trading instrument. Options can be employed in that manner, but that’s far from the whole story.

I highlight two of my favorite options strategies—put insurance and call replacement—in a special report, The ABCs of Options to Hedge Risk, available on the TES Web site. I encourage all readers unfamiliar with defensive options strategies to read this report carefully. I also outlined another favored strategy, the collar, Feb. 26, 2008, in Flash Alert: Insurance with Collars.

Those unfamiliar with options will find it difficult to understand the following recommendations unless they consult these referenced reports. Please remember these are hedges to existing stock holdings, not separate trades. Don’t execute any of these hedges unless you own the stock. Here’s a rundown of five possible hedges for current portfolio recommendations:

Peabody Energy (NYSE: BTU)—The coal giant is up more than 100 percent since my original recommendation, more if you include the performance of Patriot Coal, a stock spun out of Peabody late last year.

Options are expensive in Peabody, so I suggest using a collar to hedge that big gain. Buy the Peabody December $75 put options (BTU XO) for around $10.80, and sell the December $105 calls (BTU LA) for $5.40. Buy one put, and sell one call—a collar contract—for each 100 shares owned. Each collar contract will cost around $550 to $600.

Weatherford International (NYSE: WFT)—It’s the fastest-growing services company out there, with outstanding leverage to the recovery in North American gas drilling. This stock is up 85 percent from my recommendation last year.

I’d recommend using simple put insurance to hedge your exposure. Buy the November $42.50 put options (WFT WV) for roughly $4.10. Buy one put contract costing about $400 to $450 for each 100 shares owned.

XTO Energy (NYSE: XTO)—This fast-growing unconventional gas producer has a proven record as a low-cost producer. The stock is up 75 percent from my recommended price.

To hedge, consider a simple put-insurance strategy. Buy the November $65 put options (XTO WM) for roughly $5.30. Buy one put contract, which costs $500 to $550, per 100 shares owned.

Sasol (NYSE: SSL)—This South African energy giant is a market leader in coal- and gas-to-liquids. The stock is up about 65 percent since first recommended.

To hedge, consider the December collars. Buy the December $60 put options (SSL XL) for $8, and sell the December $70 calls (SSL LN) for $3.70. Buy one put, and sell one call—a collar contract—for each 100 shares owned. Each collar contract will cost roughly $400 to $470.

Nabors Industries (NYSE: NBR)—This land rig contract drilling giant benefits from strong exposure to the North American gas drilling recovery and a fast-growing international unit. This stock has rallied 65 percent since my recommendation last August.

To hedge, straight put insurance is the best play. Buy the December $40 put options (NBR XH) for around $2.70. Buy one contract, which cost roughly $250 to $300, for every 100 shares owned.