Even better, the basic fundamentals of the energy market haven’t changed, and this pullback looks like a great buying opportunity for many of my favorite stocks.

In recent issues, I’ve focused primarily on the oil market as crude is the most widely followed energy commodity. In this issue, I’ll take a closer look at natural gas and a handful of gas-levered stocks. Gas has many advantages as a fuel: It’s cheaper than oil, more environmentally friendly and the US is far less dependent on imports.

Even better, the North American gas market is in the midst of a period of unprecedented growth and development. Consider that a single world-class gas field in Louisiana may have just more than doubled US gas reserves. There are myriad opportunities for investors.

I recently highlighted the sharp price moves in the natural gas and oil markets we’ve seen since the beginning of the year. My long-term strategy to buy on dips holds true. Pullbacks should still be viewed as buying opportunities going forward. See Tactics vs. Strategy.

Although I’ve focused primarily on the oil market in recent issues, I’m also highlighting an emerging buying opportunity in natural gas, which will come to the foreground in coming weeks. See From Oil to Gas.

Natural gas has seen steep price declines based on over-inflated reactions to supply concerns. Here’s a rundown of my forecast for this sector in the coming months. See The Gas Gushers.

I outline the details of Chesapeake Energy’s recent conference call and explain why the company’s CEO is so fired up. See Think Unconventionally.

Although it’s well-known as a successful unconventional play, the Barnett Shale takes a backseat as I probe the Haynesville Shale’s enormous growth potential. I’ve also added a new stock to the Gushers Portfolio. See Beyond Barnett.

I underline recent activity in three TES holdings. Two remain strong plays, and one rates a hold as it battles water inflow problems. See Portfolio Update.

I’m recommending or reiterating my recommendation in the following stocks:

• Schlumberger (NYSE: SLB)
• Weatherford (NYSE: WFT)
• EOG Resources (NYSE: EOG)
• Chesapeake Energy (NYSE: CHK)
• XTO Energy (NYSE: XTO)
• Talisman Energy (NYSE: TLM)
• Nabors Industries (NYSE: NBR)
• Linn Energy (NSDQ: LINE)

I’m recommending holding or standing aside in the following stocks:

• Cameco (NYSE: CCJ)

Legendary Chinese military strategist Sun Tzu wrote, “Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.”

Over the past few issues of The Energy Strategist and The Energy Letter, I’ve spilled considerable ink discussing the rapid, sharp price moves witnessed in the oil and natural gas markets since the beginning of 2008. Despite the breakneck volatility and trading noise, the long-term strategy remains unchanged: Buy the dip. The energy commodity markets and related stocks remain in the midst of a multiyear rally that will generate tremendous wealth for investors; therefore, pullbacks are an opportunity to buy well-positioned stocks.

I discussed the long-term fundamental factors underlying this strategy in the Aug. 6, 2008, issue of TES, The Correction Continues, and in last week’s issue of TEL, Devil’s Advocate. In particular, I discussed the crude oil market at length in both issues; I won’t bore readers by rehashing those points once again today.

But as Sun Tzu noted, following this long-term strategy isn’t always the fast road to riches. Every great bull market in history has seen violent corrections from time to time, and the energy market rally is no exception; check out the chart of the Philadelphia Oil Services Index below.

Source: Bloomberg

The Philadelphia Oil Services Index summarizes the performance of 15 large companies in the oil services and contract drilling groups. This has long been one of my favorite groups in the energy patch and remains the most direct play on the “end of easy oil” thesis.

Simply put, large onshore reserves of oil globally have been largely depleted, and producers are now going after more complex fields such as those in the deepwater and Arctic. Producing these fields requires use of the latest technologies and techniques; services companies are the most direct play on more complex drilling projects. For a more detailed review of the services industry, check out the Aug. 6, 2008, issue and the Jan. 2, 2007, issue, Taking Stock of 2007.

On a longer-term basis, the services stocks have been big outperformers. Over the past 10 years, the Philadelphia Oil Services Index has returned 575 percent against just a 56 percent return for the S&P 500 and 327 percent for the S&P 500 Energy Index. A simple glance at my chart above reveals that the services stocks have been locked in a classic bull market with higher highs and higher lows.  

Although these long-term returns are impressive, there were considerable bumps along the road. As the chart above shows, the Philadelphia Oil Services Index saw corrections of 30 percent or more in 2000 and again in 2005 on its way to producing those massive gains. Several smaller corrections on the order of 10 to 20 percent are also evident. In the context of this longer-term chart, the latest pullback–measuring about 18 percent from the July 2 high–barely registers as a blip.

I could highlight similar trends in many great rallies throughout history, including tech stocks in the 1990s and metals in the ’70s. I encourage all readers to check out my longtime friend and colleague George Kleinman’s recent issue of the complimentary e-zine Commodities Trends, History Doesn’t Repeat, but It Does Rhyme. He highlights some extreme selloffs that have occurred in other commodity markets, which ultimately gave way to a new leg higher.

My point is simple: The fundamental long-term drivers of the energy markets haven’t changed since July 2, and the recent pullback isn’t unusual action from any historical perspective. Just as with each prior pullback within this uptrend, the recent correction will ultimately offer an extraordinarily profitable buying opportunity. I believe that opportunity is already upon us for some energy-related sectors and soon will be for others.

But this is the longer-term strategic picture. On a shorter-term basis, I continue to believe crude is likely to slip a bit further. My reason for projecting this is simple market psychology. Crude hasn’t been able to sustain a rally despite a steady drip of bullish news. Last week’s oil inventory report released by the Energy Information Administration (EIA) is a classic example.

Source: EIA

In last week’s report, the EIA reported a far-larger-than-expected drop in gasoline inventories. And, as you can see from the chart above, gasoline inventories are well below average for this time of year. Although demand for gasoline has waned this year, there’s clearly no glut in the gasoline market. Meanwhile, crude oil inventories are also below average. Refiners are sitting on some of the leanest inventories in years.

Source: StockCharts.com

This chart shows the intraday trading action in the US Oil Fund (AMEX: USO), a decent proxy for the movement of crude. As you can see, oil rallied sharply in the wake of the bullish report released Aug. 13 at 10:35 am Eastern. But that rally quickly faded and the US Oil Fund completely reversed the move by early afternoon the following day. And this was one of the most bullish inventory reports I’ve seen in months.

This is exactly the opposite of the action we saw back in May and June. Back then, the EIA released a series of inventory reports that were quite bearish for crude oil. After a short-term dip in prices, crude continued to march higher.

This is a clear indication of shifting psychology. In May and June, any weakness in crude and related stocks was viewed as a buying opportunity; now rallies are almost immediately attracting sellers. This suggests more downside for crude oil over the next few weeks.

Although fundamental trends usually take many years to play out, market psychology can turn on a proverbial dime just as it did a month and a half ago. I will be carefully watching for a turn higher to occur sometime between now and the first half of October. Specifically, I’ll look for good news in the oil market that will trigger an upturn; in other words, I want to see oil hold a rally based on a bullish inventory report or some other nugget of positive news. In addition, I’ll look for the beginning of stable oil prices and find some sort of floor price or technical support price.

From a short-term tactical perspective, I recommended a few different ways to play this action in the Aug. 6, 2008, issue. To summarize: The transports and, in particular, the airlines are an excellent play on a moderation in crude oil prices. These groups can continue to perform well even if crude just trades broadly sideways in the coming months. As I outlined in last week’s issue of TEL, a broad trading range remains my base case assumption for oil. For specific recommendations, see the Aug. 6, 2008, issue.

In addition, it’s now time to buy internationally-levered oil services companies. My long-term case for buying these stocks relates to the “end of easy oil” thesis described above. But I also see several shorter-term catalysts for the group including a new wave of offshore drilling rigs to be delivered in coming months and an acceleration of exploration spending in Russia and other foreign markets. My two favorites, outlined at length in last week’s issue of TES, are Schlumberger and Weatherford.

The key point to note:  Big, internationally-levered oil services companies have no real fundamental exposure to the recent pullback in crude oil prices. I’ve already explained this with reference to Schlumberger. Management at other big services firms have made similar comments lately. For example, David Lesar, CEO of Halliburton (NYSE: HAL), recently noted in an interview:

Customers are basing decisions on significantly lower oil prices and they plan very long-term projects that don’t switch on or switch off based on the oil price…I don’t really see [the pullback in crude] as having a major impact on our business.

The recent pullback in oil service stocks is a kneejerk reaction for traders. But the reality is that, with oil at $100 or even $80 per barrel, big oil and natural gas development projects will go ahead. In fact, the biggest constraint on growth in the service industry right now isn’t lack of demand for drilling projects but lack of the rigs, skilled labor and equipment needed to undertake those projects.

As a result, I suspect that oil services stocks will find a low before oil and natural gas. Moreover, there’s considerable upside for the group late in 2008 and into 2009 as new offshore rigs are delivered and new international project contracts are awarded. The second wind for the oil services stocks I discussed in the last issue of TES is very much alive.

In recent issues of TES, I’ve focused primarily on the oil market; crude is the most widely followed energy commodity and tends to drive sentiment on energy stocks. However, natural gas is an even more interesting market from a longer-term perspective; I also see an attractive buying opportunity emerging in the group over the next few weeks.

The first point to note about gas: It’s a more volatile commodity than crude oil. Some energy traders call gas the widow-maker; markets don’t get nicknames like that without reason. For a closer look, check out the chart below.

Source: Bloomberg

This chart shows the 12-month NYMEX natural gas strip price. This is the indicator of US gas prices that companies watch, and you’ll hear analysts refer to the gas strip frequently during company conference calls. The current 12-month strip for gas is around $8.75 per million British thermal units (MMBtu).

You may have heard pundits on the news lately talk about gas under $8 per MMBtu. Likely, this price refers to the near-month futures contract; that’s currently the September 2008 natural gas futures trading on NYMEX. This contract is priced at $7.85 per MMBtu.

But this is a common fallacy. Natural gas producers don’t sell all their annual production in the month of September; therefore, there’s absolutely no reason that we should focus solely on one month’s futures price. In fact, most producers use at least some hedging to lock in prices for their production. They average out their gas sales over the course of a year or more.

In addition, the summer months are a period of relatively weak demand for gas, so gas prices tend to be lower in summer. For example, the February 2009 NYMEX futures contract remains above $9 per MMBtu, even as the September contract trades below $8.

To replicate a more realistic scenario for gas prices, the strip averages together the next 12 months of futures prices. The strip is the most useful indicator of the gas prices producers face and are able to lock in using hedging. The strip is also the gas price I watch most closely in TES.

The gas strip has had a rocky ride over the past several years. The root of much of that volatility is simple: the weather. As the chart shows, natural gas prices rallied steadily from 2002 through mid-2005, nearly tripling from less than $3 per MMBtu in early 2002 to more than $8 per MMBtu in mid-2005.

Hurricanes Katrina and Rita in late summer 2005 severely disrupted natural gas production from the Gulf of Mexico, sending gas prices sharply higher in a short period of time. The strip touched highs above $12 per MMBtu in late 2005, rallying 50 percent in just a few weeks’ time.

The warm winter of 2005-06 changed the picture entirely. Inventories of gas in storage built up to unprecedented levels because of low demand for gas to heat homes that winter. Prices collapsed, and the strip spent most of 2006 and 2007 in a range between $7 per MMBtu and $9 per MMBtu. Of course, the more recent action is familiar to most investors. Gas prices spiked in the first half of 2008, touching new highs, then got hit hard in early July.

The fundamental driver for the gas market in the first half of 2008 was, once again, the weather. Specifically, a cooler-than-average winter in 2007-08 across much of the US drove higher demand for gas to heat homes. This had the effect of bringing previously bloated US gas inventories back under control, which is obvious in the chart below.

Source: National Weather Service

This chart shows heating degree days (HDD) for New York State over the past few winters. The calculation of HDD is simple: Compare the mean daily temperature to a base level of 65 degrees Fahrenheit. For every degree the mean temperature is below 65, you log one HDD. For example, on a January day in New York, the mean daily temperature might be 25 degrees Fahrenheit, equating to 40 HDDs (65 minus 25).

The higher the HDD total, the colder the winter and the higher natural gas demand. I’m using New York as a proxy for conditions in the Northeast, though the same basic pattern is obvious across a number of states in the Northeast, Mid-Atlantic and upper Midwest.

The blue bar on this chart represents this past winter season, and the brick-red bar represents the long-term average. As you can see, this past winter was basically average for every month from November through March. This past season was also much colder than both the winter of 2005-06 and 2006-07. The result: Higher gas demand finally eliminated the bloated inventories built up in the previous two warm winters.

And it isn’t just weather in the US that helped draw down US natural gas inventories. Colder winter conditions in Europe and Asia pushed up natural gas prices in those markets as well; gas prices abroad have been consistently higher than in the US this year. In fact, natural gas prices in London are currently double prices in the US. That meant that shipments of liquefied natural gas (LNG) that might have normally been sent to the US market were instead diverted to Asia and Europe.

For those unfamiliar with LNG, I offer a detailed explanation of the market in the Oct. 24, 2007, issue, Liquid Gold. To summarize, LNG is nothing more than super-cooled natural gas that can be loaded onto specialized tanker ships for transport over long distances, just like crude oil. LNG frees gas from the pipeline network.

The latest estimates from the EIA suggest that US LNG imports will total just 390 billion cubic feet (bcf) this year, down from 771 bcf in 2007. Next year, the EIA is projecting only a modest increase to 480 bcf in imports. And even that estimate looks shaky; with overseas gas demand so much stronger than in the US, I see little reason to expect an increase in LNG imports.

The weather and an uptick in weather-driven gas demand was the main driving force behind rising natural gas prices in the first half of this year. But neither weather nor demand can explain the collapse in gas prices since the beginning of July; summer cooling demand has remained firm this year. And although this August looks cooler than last year’s record-setting scorcher, it’s hardly been a cool summer.

The fundamental catalyst for the selloff in gas: an extreme overreaction to natural gas supply concerns.

Specifically, before you scroll down to read the next paragraph of today’s report, answer one simple question: Which country was the world’s fastest growing natural gas producer in both 2007 and, quite likely, for 2008? To frame the question, think in terms of actual volumes of gas, not in percentage terms.

The correct answer to that isn’t Russia, any of the former Soviet countries or, in fact, any country in the Middle East. By far, the US was the fastest growing gas producer in the world last year. The US is actually the world’s second largest natural gas producer, only slightly behind Russia. The US produced 52.8 bcf per day of gas in 2007 compared to 58.8 for Russia. The next largest producer: Canada, which produced 17.8 bcf per day. For reference, the entire Middle East produced only 34.4 bcf per day of gas in 2007. 

Moreover, production in Canada and Russia actually shrank in 2007, and US production rose a whopping 2.2 bcf per day. The US accounted for a third of the world’s 6.6 bcf per day in natural gas production growth last year.

This production isn’t just some one-off event or fluke. According to EIA projections, US natural gas production is slated to rise an even more impressive 4.4 bcf per day in 2008 and another 2.2 bcf per day in 2009. With projected production of 61.8 bcf per day in 2009, it’s quite possible that the US will be the world’s largest gas producer depending on how quickly Russia can ramp up supplies.

The fundamental fear has been that rapid growth in US gas supplies will swamp demand and once again result in a natural gas glut that depresses prices. Although rapid growth in demand for gas in Europe and Asia could easily absorb the excess supply, there’s absolutely no way for US gas to be exported to those regions because the US doesn’t have LNG liquefaction capacity.

In other words, the US has plenty of LNG import terminals but doesn’t have export capacity. Contrary to some early expectations, just because we’ve built terminal capacity for LNG imports in the US doesn’t mean that more LNG shipments are headed to US shores.

As you may have already guessed, I believe that fears of a gas glut and long-term depressed gas prices are terribly overblown. Just as with oil, market psychology on all commodities soured in early July and, for the most part, traders have simply seized on strong US production growth as a fundamental rationale for the selloff.

My long-held expectation for gas prices is that we’re entering a new, higher range for gas. For most of 2006 and 2007, the strip traded between around $7 and $9; going forward, I expect gas prices to average in roughly the $9 to $12 range. The basis of this projection is simply the comments we’re hearing from the largest US gas producers. These are the companies actually generating the growth in gas supplies that have pressured the market in recent weeks.

Just as I highlighted and debated the bear case for crude oil in last week’s issue of TEL, let’s take a closer look at the case for a glut of US gas.

First up, if it’s a gas glut the market is worried about, the most obvious starting point in any analysis is a look at US natural gas inventories in storage.

Source: EIA

This chart shows total US gas inventories compared to the five-year average, the five-year maximum and the five-year minimum. As I noted earlier in today’s report, gas inventories have actually normalized this year from bloated levels in 2006 and 2007.

Based on the chart above, there’s certainly no obvious glut of gas inventories in the US market right now. In fact, current US gas inventories are running slightly below average for this time of year.

Certainly, this summer isn’t as hot as last year. But since June 6, US natural gas inventories have risen at an average rate of just more than 75 bcf per week. It’s normal for inventories to rise in summer; demand for gas in summer is lower than in the winter months. The build in inventories so far this summer is only about 1 bcf per week above average.

To put 1 bcf per week into perspective, consider that current natural gas inventories in the US stand at 2,567 bcf, or 2.57 trillion cubic feet (tcf). These are such small deviations from average that it’s quite literally a rounding error.

The bear case for gas is that a quantum leap in US gas production will result in a glut of US supplies. I do believe we’re seeing strong growth in US gas production. As I’ll detail later, US unconventional natural gas fields are truly a world class resource and one of the most exciting growth markets in the energy patch.

But the equation is simple: If US gas production is up 4.4 bcf per day in 2008, that gas must be going somewhere. If it’s not pouring into storage as the chart above suggests, there must be some other offsetting items.

I see four main offsets: declining Canadian gas exports, plummeting LNG imports, higher US exports and rising US demand. All four factors are helping to offset the big jump in US gas production this year.

As for the first point, declining Canadian exports are a function of rising Canadian demand and falling production. Canadian demand for gas is rising because of Canada’s strong economic growth in recent years coupled with rising demand for gas in the oil sands industry. Canadian gas production is falling because of weak drilling activity in recent years, maturing gas fields and tax law changes that have impacted investments in mature fields.

According to the Canadian National Energy Board (NEB), Canadian gas production totaled 17.06 bcf per day in 2006, and total demand was around 8.04 bcf per day, leaving 9.02 bcf per day available for export. In 2009, the NEB projects total gas deliverability of 14.97 bcf per day and total Canadian demand of 8.91 bcf per day, leaving just 6.06 bcf per day available for export.

I highlighted the situation with LNG imports in my comments earlier. The following chart tells all.

Source: Bloomberg

This chart shows the NYMEX 12–month strip compared to London-traded natural gas futures. I’ve made the necessary conversions so that both prices are in terms of dollar per MMBtu. As you can see, London-traded gas is significantly more expensive than gas in the US.

Gas prices in Europe have fallen alongside those in the US. However, the decline in gas prices overseas has been nowhere close to the same magnitude; the gap between US and UK prices is actually widening. As long as this situation persists, US LNG imports will remain depressed. In fact, I suspect the EIA’s estimate of 390 bcf in imports this year remains too high; the agency hass already lowered its estimates for 2008 US LNG imports on several occasions. In fact, late last year the EIA was looking for imports to actually grow in 2008.

Bottom line: The change in LNG imports from 2007 to 2008 has tightened gas markets by more than 1 bcf per day this year.

Finally, there’s US exports and US demand. US demand is rising for gas, particularly in the electric power sector. As I detailed at length in the April 23, 2008, issue, Electric Charge, I suspect that trend will continue in coming years.

As for US exports, most are pipeline shipments to Mexico. Mexico exports oil and imports gas. The EIA projects that US gas exports rose by around half a bcf per day this year.

To make a long story short, US gas production growth is impressive, but it’s not really showing up in inventories. The most bearish projection for gas inventories I heard this reporting season came from Wildcatters Portfolio recommendation EOG Resources. This company projected that US gas inventories in storage would top out this year–normally early November–at about 3.3 tcf to 3.4 tcf. The five-year average peak for inventories is about 3.35 tcf, and the five-year high in inventories is about 3.54 tcf.

In other words, US natural gas inventories will finish the injection season at normal levels, not in a glut. Although this is the highest estimate I heard mentioned this reporting season, it’s hardly a bearish forecast for gas. And, obviously, hurricane activity is picking up and could turn this picture even more bullish for gas.

This fundamental picture is bullish for gas. At the very least, with inventories near average levels, US gas prices should be closer to $10 per MMBtu. Prices probably overshot the fundamentals to the upside in June and are now way overshooting reality on the downside. Extremes of emotion have ruled on both sides.

But I think we’re nearing at least a short-term turn. Check out the chart below for a closer look.

Source: Bloomberg

To create this chart, I simply plotted the natural gas strip price over the past several years. Prices are normalized for comparison with the Jan. 1 price set each year at 100.

This chart shows the inherent seasonality of the natural gas market. It’s clear that, in most years, natural gas prices are weak going into late summer and then rebound starting in late-August and early September. There are a few exceptions–mainly 2001 and 2002.

But during both of those years, inventories were bloated, so the seasonal upturn was naturally less impressive. In most other years covered on the chart, gas rallied in the final months of the year or, at the very least, remained broadly flat.

Once again, I’m referring readers to George Kleinman’s outstanding piece in this week’s issue of CT. George notes that some of the weakness is commodities generally may be the result of the Olympic Games. Specifically, he notes:

I’ve been looking for commodities as an asset class to bottom out as the Olympics come to an end. Beijing has effectively shut down 350 industries and an estimated 7 million cars are off the roads. No wonder world oil consumption is down. Just a 1-million-barrel swing in demand can swing the world’s marginal demand from a shortage to a surplus condition.

This argument has considerable logic to it, especially when you consider that commodities began to turn lower about a month before the Olympics kicked off. That’s exactly when Beijing started really shutting down in an effort to clear air pollution. At the very least, when it comes to natural gas, the end of the Olympics corresponds to what’s normally a seasonal upturn in natural gas prices.

Given the seasonal shift for gas coming over the next few weeks coupled with the still-bullish inventory picture, I see extremely limited downside for gas prices and related stocks at current levels. The carnage witnessed over the past six weeks is based primarily on overblown fears of a US gas glut and spillover selling from the crude oil market. This has pushed many gas-levered stocks to levels I consider highly attractive.

The big growth in US natural gas production is coming from so-called unconventional gas fields. Broadly speaking, the term unconventional–or non-conventional–refers to any field that can’t be produced economically using traditional well technologies.

Unconventional gas production already makes up close to 40 percent of US gas output. And that number is only going to rise in the coming years. I highlighted and defined unconventional reserves in the Feb. 20, 2008, issue, Growing Unconventionally.

I won’t repeat that entire explanation here. Suffice it to say that two techniques have totally revolutionized unconventional field production: horizontal drilling and fracturing. By drilling horizontally through unconventional rock formations, producers can expose more of their well to productive zones.

And increasingly effective fracturing techniques allow producers to vastly improve the permeability of unconventional fields. This is a fancy way of saying that fracturing makes it easier for gas in a reservoir to flow into a well. Most of my favorite plays on natural gas are either directly or indirectly related to unconventional reserves in the US.

Long-time readers know that I always carefully watch earnings from a handful of key energy-related firms each quarter. One of my favorites is oil services giant Schlumberger; the company operates in just about every imaginable oil- and gas-producing region of the world and gives an excellent bird’s-eye view of trends in the energy patch.

When it comes to the North American natural gas market, one of the earnings reports and conference calls I most look forward to are those of Chesapeake Energy. I really knew I was in for a particularly interesting release this quarter when Chesapeake’s CEO Aubrey McClendon kicked off the conference call saying that he hasn’t been this “fired up” for a call in a long while. Chesapeake is one of the largest gas producers in North America and has its hands in some of the hottest and fastest growing unconventional gas reserves in the US.

Earlier in today’s report, I noted why I don’t see this year’s big jump in gas production leading to a glut in gas inventories for 2008. In this quarter’s call, McClendon addressed concerns that a rush of new production from unconventional fields would swamp the US gas market on a longer-term basis. Specifically, he noted that US unconventional reservoirs offer an exciting growth prospect, but there’s a tendency for many analysts to exaggerate the rush of gas to come from these fields over the next three to five years.

McClendon spent considerable time discussing the Barnett Shale, one of the larger unconventional reserves in the US. The Barnett is centered in Johnson and Tarrant Counties of Texas and the city of Fort Worth itself. The following map shows the location of the Barnett Shale and several other unconventional shale gas plays in the US.

Source: Schlumberger

According to the Texas Railroad Commission, total 2007 natural gas production from the Barnett Shale was just below 1.1 tcf in 2007, or roughly 3 bcf per day. Production is up nearly fourfold since 2003 alone, and the Barnett now accounts for close to 8 percent of total US gas production.

According to Chesapeake’s call, total production from the Barnett has actually jumped 1.5 to 1.7 bcf per day in the past year alone, an amazing pace of growth. Management estimates that the Barnett will ultimately yield about 60 tcf of natural gas, equivalent to an entire year of US production.

Although growth from the Barnett is impressive, analysts have a tendency to project trends linearly into the future in ways that don’t conform to reality. Specifically, Chesapeake believes it will take more than 50 years to produce that 60 tcf of gas. And although some have projected continued strong growth in Barnett, Chesapeake indicated that Barnett production growth is likely to slow notably in the coming years. McClendon stated that he sees roughly 750 million cubic feet (MMcf) per year of growth from Barnett and total production will level off between approximately 6 bcf to 6.5 bcf per day in 2012.

And, it’s not just McClendon and Chesapeake predicting a peak in Barnett gas production. Wildcatter EOG Resources hosted its conference call July 30, a day before Chesapeake. EOG’s CEO Mark Papa noted some bottlenecks with pipeline capacity in parts of the Barnett; these are preventing producers from maximizing output. Management also noted that Tarrant County sits right at the heart of the Barnett play, but drilling in the county won’t proceed as quickly as in neighboring Johnson County.

The reason is simple: Tarrant is an urban country. In fact, the county seat of Tarrant is Fort Worth, one of the fastest growing cities in the US. Operators are drilling inside the city limits of Forth Worth; however, setting up a drilling operation in the middle of a sizeable city isn’t the easiest process, to say the very least.

Bottom line: EOG predicts Barnett production seeing just one more year of growth with gas production peaking next year at 5 bcf per day and hitting a plateau at that level out through 2011. Papa noted:

The Barnett Shale, which has been far and away the biggest single growth driver of domestic production growth the last three or four years, I think a lot of people believe the Barnett Shale is just going to continue to grow indefinitely year after year after year. And our view is that the Barnett Shale, as an aggregate, has one more year of decent growth and that’s 2009. And by year-end 2009, we believe Johnson County is going to be pretty well drilled up by all operators on about 35 acre spacing. And that’s going to remove a lot of the thrust.

Finally, consider XTO Energy, another major player in the Barnett. Management at XTO didn’t offer an exact peak for Barnett gas production but noted that just to sustain growth requires putting 10 to 15 percent more rigs in the region each and every year. Since the Barnett requires use of some fairly sophisticated land rigs, sustaining rig count growth of that level is tough indeed. XTO believes that the Barnett has two to three more years of growth ahead. Management also noted that peak production is likely to be lower than many analysts expect.

Actually, Chesapeake made a similar observation. McClendon noted that in the first 12 months of production, the average well in the Barnett sees production plummet by an astounding 65 percent. In the first two years, the dropoff is 80 percent. Many conventional fields have decline rates of half that level. America’s increasing reliance on unconventional reserves spells a boom of unprecedented proportions in drilling activity. Producers are literally running on a treadmill that’s moving at top speed. If gas prices fall too far and drilling activity falls off a touch, it doesn’t take long for that to show up in production statistics.

Again, my point in bringing up these comments about Barnett isn’t to disparage the play. The Barnett absolutely remains one of the most exciting onshore gas developments in the US today. Some producers in the region, including Wildcatter EOG Resources and Chesapeake, will continue to see considerable growth in production as they execute current drilling plans. Well economics in the region are outstanding.

For example, Chesapeake stated that its production for the Barnett stood at 466 MMcf per day at the end of the second quarter, up 126 percent over the same quarter one year ago and up 13 percent from the first quarter. By the end of 2008, Chesapeake expects production of at least 675 MMcf per day. That’s about a 45 percent jump in production over current levels. In the best core areas of Tarrant County, Chesapeake books about 3.8 bcf in estimated ultimately recoverable (EUR) reserves per Barnett well drilled. At $7 per MMBtu gas, those 3.8 bcf are worth upwards of $20 million. Since these wells cost less than $3 million to drill, this all amounts to some attractive economics even when you factor in leasing, maintenance, transport and other costs.

Another way to look at this is that, if Chesapeake’s average Barnett well yields 2.65 bcf in recoverable gas and costs about $2.6 million to drill, their development cost is a little less than $1 per thousand cubic feet (mcf)–roughly equivalent to 1 million Btu. It’s easy to see how these economics work and add value.

There was wide agreement among the major gas producers that analysts’ estimates are too aggressive for growth in Barnett production. But the Barnett Shale is just the most advanced and mature of the major North American unconventional plays. There are a number of other promising up-and-coming shale reservoirs at various stages of development.

Just as with the Barnett Shale, some analysts are being far too aggressive in projecting growth in these newer shale plays. Although these plays will result in a prolonged expansion in gas output, it’s likely to be a relatively gradual ramp up over many years. Wells take time to drill, and pipelines and processing facilities take time to build. Chesapeake’s McClendon summed up the situation best in answering one analyst’s query about US gas production:

Yeah, I saw something the other day, where some analyst had come up with production in 2010 was going to be up something like eight to 10 bcf a day, and gas prices were going to be $6.25 [per million Btu]. Now that’s that kind of analysis I think can only come at the dangerous intersection of [Microsoft] Excel and PowerPoint. It can’t happen in reality.

Source: Chesapeake Energy Second Quarter Conference Call, Aug. 1, 2008

In other words, there are promising new shale plays out there that will generate impressive production growth. But the gas glut is truly a figment of the imagination created by some Wall Street production models rather than real world experience. 

Although new shale plays won’t depress gas prices, these world-class plays offer boundless opportunities for investors. One of the more talked-about shale plays today is the Haynesville Shale centered in Louisiana and eastern parts of Texas. (See the map above for a more exact location). Several of the major producers have stakes in this promising region but Chesapeake has been the most vocal in terms of hailing the potential of the Haynesville play.

Chesapeake began studying the Haynesville play about two years ago and was one of the first movers in the region. The company’s engineers delineated an area they considered the core of the play. Internally, Chesapeake calls this sweet spot “The Blob.”

At any rate, as of the end of the second quarter, Chesapeake had drilled 11 wells in The Blob. Some are brand new wells and some are what’s known as re-entries. Basically, there are conventional gas fields located in other geologic layers in the Haynesville area; wells had already been drilled by other producers targeting these conventional gas fields. Chesapeake was able to drill back into these existing wells and then drill a horizontal well through the Haynesville Shale segment. The company then used fracturing techniques to improve the permeability of the shale.

The results from these first 11 wells look impressive. The first few wells Chesapeake drilled were basically test wells; Chesapeake was experimenting with different fracturing techniques and horizontal well designs. The company is purposely limiting production from some of these early wells in an effort to test pressures and productivity.

But, the final two wells–which came online about two months–are actually being produced at more or less full throttle. Chesapeake has also used a more advanced fracturing technique on the final well drilled in the Haynesville play. The result: The final two wells Chesapeake drilled are producing at a rate of 20 MMcf of gas per day.

This is truly an amazing initial production (IP) rate. The IP rate for wells in the Barnett is typically closer to 2 MMcf to 4 MMcf per day. Chesapeake stated quite clearly in its call that it’s never seen any other shale play produce at more than 9 MMcf per day for several weeks straight. This means a lot as Chesapeake is one of the most active driller in just about every imaginable shale play in the US.

Based on these initial drilling results and some core samples of the shale play Chesapeake has reviewed, the company is estimating as much as 245 tcf of reserves in the Haynesville Shale. To put that into perspective, that’s about five times what Chesapeake stated will be ultimately recoverable from the Barnett, the largest shale play in the US at this time. In fact, Chesapeake’s estimate for Haynesville alone exceeds the total current estimate for US gas reserves across all reservoirs.

It’s worth noting that Chesapeake has received some criticism for over-hyping this play; however, I definitely wouldn’t discount the potential because Chesapeake is a large, experienced operator, not a fly-by-night operation. And even if the Haynesville Shale turns out to be a third that size, it’s still a truly gigantic find. And apparently other producers agree with Chesapeake’s optimism. Plains Exploration and Production (NYSE: PXP) agreed to purchase a 20 percent stake in Chesapeake’s 550,000 net acres in Haynesville for $3.3 billion. By inference, that values the land Chesapeake has at $30,000 per acre, a valuation that would be considered high by any historical comparison.

Another way to look at this: Chesapeake’s full Haynesville position is worth about $16.5 billion based on the Plains valuation. When you consider it only spent $4 billion acquiring the acreage when it was still an unknown play, Chesapeake obviously made an outstanding deal.

As you’ve probably gathered, I like Chesapeake’s position in both the Haynesville Shale and Barnett Shale plays. Chesapeake Energy’s stock is rated a buy in my How They Rate Coverage Universe, and I’m looking to add the stock to the portfolios on further signs of stabilization in gas prices.

For now, however, I’m adding another, more direct play on the Haynesville Shale to my aggressive Gushers Portfolio, Petrohawk Energy (NYSE: HK). I’ve been waiting to add this stock for some time; in light of the recent drop resulting from the fall in gas prices, now’s a great time to jump in.

The Haynesville is still an early-stage play, but as more information comes on over the next few quarters about well tests in the region, I suspect stocks with exposure to the region will perform particularly well. And Petrohawk is the stock in my coverage universe that’s most levered to the Haynesville Shale.

Petrohawk has a total of about 300,000 acres leased in the Haynesville area. The company acquired this acreage at an average cost of just $5,000 per acre. Recall that Plains paid about $30,000 for a minority stake in Chesapeake’s Haynesville acreage; Chesapeake has stated that full control is worth around $50,000 an acre. If we apply that same valuation to Petrohawk’s acreage, it’s worth $9 billion to $15 billion.

But Petrohawk is tiny in comparison to Chesapeake, with an enterprise value–the total value of all outstanding debt and stock–of just $7.5 billion. Admittedly, this is just a back-of-the-envelope calculation, but it’s not hard to imagine that Petrohawk’s Haynesville asset alone is worth considerably more than the entire market value of the stock right now.

Petrohawk has already drilled two wells on its Haynesville acreage, and the results were even more amazing than on Chesapeake’s initial well tests. The first well had an initial production rate of 16.8 MMcf per day and the second well produced just slightly less at 16.7 MMcf per day. As management noted, of the 2,000 shale wells drilled in the first half of 2008 by a variety of operators, these are the two best-known wells.

Petrohawk has promising acreage in other gas fields, including the hot unconventional Fayetteville Shale and a number of conventional plays. As you might expect, the company is reallocating significant capital for investing in these plays to pumping more cash into Haynesville. During 2008, Petrohawk has plans for a total of 30 Haynesville wells with 10 drilling rigs. For 2009, Petrohawk has plans to have 20 drilling rigs in place during 2009 and to drill a total of 140 wells.

Management expects to generate 30 to 40 percent organic production growth over 2008 levels. But the rapid planned ramp-up in the rig count and drilling activity in Haynesville makes this growth estimate look conservative. Certainly, if these wells pan out at anything close to the level of its first two wells, Petrohawk will grow a good deal faster.

Current proven reserves for Petrohawk are 1.3 tcf. But this includes absolutely no reserves in Haynesville. Management believes it can establish as much as 14 tcf in proven reserves in coming years as it drills its promising acreage and meets the official definition for proven reserves. This is an amazing statistic. Petrohawk has a realistic chance to increase its proven reserve base ten-fold over the coming years. To put it mildly, that’s an impressive rate of growth.

Petrohawk is a volatile stock that’s traded as low as $14 and as high as $54 over the past 52 weeks alone. This is exactly why I’m adding it to the aggressive Gushers Portfolio, rather than to Wildcatters or Proven Reserves. This is also why I’m setting a very wide stop recommendation on Petrohawk for now; investors should take this risk into account when deciding how much to commit to the stock. Buy Petrohawk Energy below 33 with a stop at 21.50.

I’ll be covering more interesting unconventional plays in upcoming issues. In closing, I’m also referring readers to my two other producers with exposure to unconventional resources: Talisman Energy and EOG Resources. These stocks were covered at length in the April 23, 2008, issue and the Feb. 20, 2008, issue, respectively.

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Nabors Industries is a contract driller that owns primarily land rigs that re-leased out to producers in exchange for a daily fee or day rate. Nabors is up nicely since my recommendation roughly one year ago, particularly if you followed my advice to take profits off the table or hedge in mid-June when the stock was trading at sky-high prices.

In light of the recent pullback and the company’s strong earnings release, I see a second opportunity to jump into Nabors. I see plenty of upside for Nabors from two drivers: US unconventional plays and a fast-growing international business.

As to the first point, drilling the relatively complex horizontal wells needed to produce in unconventional gas plays requires fairly sophisticated and powerful land rigs. Producers typically contract with Nabors to build fit-for-purpose rigs to handle their specific needs; these producers are paying high guaranteed day rates under locked-in, long-term contracts for these purpose-built rigs. Nabors has added 20 such rigs this year at highly attractive rates and expects to add even more. For example, Nabors is a play on Haynesville; the company has 32 rigs operating in Haynesville up from 20 at the beginning of the year.

Strong international demand means that Nabors business outside North America is growing at 40 to 50 percent annualized. Nabors Industries remains a buy.

Linn Energy is an oil and gas producer that’s organized as a limited liability company (LLC). LLCs are taxed much like Master Limited Partnerships (MLP); I explained this sector at some depth in the Nov. 22, 2006, issue, Leading Income.

Unlike producers such as Petrohawk and Chesapeake, Linn is less focused on production growth potential and more focused on generating cash flows from its wells. These cash flows back up its tax-advantaged yield of more than 12 percent at current levels.

One very important point to note about Linn’s earnings releases: You should completely ignore the actual earnings per share (EPS) figure. You’ll see EPS referenced on some news services and Web sites, but it’s utterly meaningless for Linn. The reason is that General Acceptable Accounting Principles (GAAP) requires that Linn–and other exploration and production (E&P) companies–mark-to-market all oil and natural gas hedge positions. Hedges are designed to gain in value when commodity prices fall; Linn has a large amount of its expected production hedged through 2013 because it must guarantee its cash flows to maintain distributions. However, by definition, hedges lose value when commodity price rise.

The bottom line: Linn will always report a huge mark-to-market loss when commodity prices rise. This is an accounting entry mandated by one-size-fits-all accounting standards, not a cash cost. Linn noted on its conference call in early August that it’s never “subject to any margin calls at all, ever” on any of its hedge contracts.

Based on real numbers, Linn is taking exactly the right steps for an LLC. It’s selling off some of its higher risk acreage such as in the Marcellus Shale and Verden plays. It’s then redeploying that cash to develop low-risk, high-cashflow wells in its core acres.

The result: In the second quarter, Linn covered its distribution 1.57 times, a very high coverage ration for the MLP/LLC industry. And Linn has extremely limited exposure to near-term falls in commodity prices. The company has hedged most of its production years into the future. Offering a rock-solid yield of more than 12 percent, Linn Energy is a buy.

Canada-based Cameco is the world’s largest uranium mining firm. I’ve recommended the stock for years in the Wildcatters Portfolio, though it’s been rated a hold for nearly two years now. I’ve also recommended taking profits off the table in Cameco on several occasions. The stock finally touched my recommended stop, generating a 56 percent gain on my initial entry price of $18.88.

The catalyst for the selloff in Cameco: The company reported last week that its Cigar Lake mine is encountering severe water inflow problems. Cigar Lake is the largest single uranium mine scheduled to go into production over the next five years. In late 2006, the same mine experienced a rockfall that severely delayed the expected startup of the mine; this problem precipitated the gigantic run-up in uranium prices and related stocks in late 2006 and early 2007.

This water inflow problem will further delay the mine. The mine was originally expected to start producing uranium last year; the rockfall in 2006 delayed that until the end of 2011. This water problem sounds like it will result in yet another significant delay.

But Cameco’s pain is actually uranium’s gain. Another Cigar Lake delay means that uranium supply looks very tight until at least the middle of the coming decade. Summer trading in uranium is quiet, but this will undoubtedly help push prices higher later this year. We’ve seen a pop in some of the uranium stocks, and I’ll take a more careful look at the sector as soon as Cameco releases more news about the water problem. For now, stand aside from Cameco.

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Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat if the federal government.

Join me and my colleagues Neil George and Roger Conrad for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011361 to register as our guest.