The past two months have been tough for all investors, particularly those with exposure to the energy and commodity sectors. But we’ve seen this sort of correction before, and I’m quite certain we’ll see more in the future; no great bull market proceeds in a straight line higher. The good news is that the longer-term bullish factors driving these markets remain intact.

Oil and energy-related stocks have been victims of a panic-driven selloff, which snowballed amid broader stock-market turmoil. See Slippery Oil.

The energy sector has become rather bearish of late. I provide a summary of what’s happened from the beginning of 2008 up to the present and examine what’s led to the sharp drop in oil prices. See What’s Changed?

Because of short-term decoupling that’s started taking place, I suspect that oil-levered stocks are closer to a bottom than crude oil itself. And I explore why many of the best-positioned energy-related stocks are currently trading at discounted levels they haven’t seen for years. See From Oil to Stocks.

Natural gas has been hit hard in tandem with oil, but that’s presented a great buying opportunity for a number of higher-quality plays. See Gas Over Oil.

As this extremely volatile market continues to shake things up in the energy sector, I offer my strategy and include top picks for taking advantage of buying opportunities developing over the coming weeks. See How to Play It.

Many TES recommendations have suffered steep selloffs of late. I explain why it isn’t a company-specific problem. See Portfolio Update.

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

• Schlumberger (NYSE: SLB)
• Enterprise Products Partners (NYSE: EPD)
• Norfolk Southern (NYSE: NSC)
• Seadrill (Oslo: SDRL; OTC: SDRLF)
• Nabors Industries (NYSE: NBR)
• Weatherford (NYSE: WFT)
• EOG Resources (NYSE: EOG)
• Delta Airlines (NYSE: DAL)
• MacroShares $100 Oil Down Fund (AMEX: DOY)
• iShares Dow Jones Transports (NYSE: IYT)
• Linn Energy (NSDQ: LINE)
• Eagle Rock Energy Partners (NSDQ: EROC)

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

For the past month and a half, I’ve kicked off each issue of The Energy Strategist with a discussion of the oil and natural gas markets; I see no reason to break with tradition this issue. Although it makes little or no fundamental sense, the fact is oil prices are currently acting as a barometer for almost all energy-related sectors from oil services to alternatives, biofuels and even coal.

And oil and energy-related stocks are also clearly being negatively impacted by what’s going on more broadly with the US economy, stock market and credit conditions. This isn’t unprecedented. During market-wide panics and selloffs, most sectors and stocks become closely correlated; in other words, most groups tend to fall, regardless of fundamentals.

There’s good news in all of this for patient investors. Historically, panic-driven, indiscriminate selloffs of this nature lead to outstanding opportunities for investors. There’s an old saw on Wall Street to buy “when there’s blood in the streets.” And for many energy-related stocks, Wall Street is clearly flowing red right now.

Investors aren’t being selective right now when it comes to energy stocks; they’re throwing out the proverbial babies with the bathwater. This offers myriad opportunities for investors who understand the fundamentals to selectively pick up high-quality companies that have been beaten down to valuation levels unseen in years.

The primary fundamental driver of the oil market right now is simple: a weak economy. Although it might seem strange to discuss the economy in a newsletter devoted to energy stocks, as investors we simply can’t afford to ignore the trends underway. Since the beginning of 2008, I’ve believed that the US economy is headed for recession; the only real question is how long and deep that slump will be. I have written my basic rationale for that view on several occasions, most recently in the Aug. 6, 2008, issue, The Correction Continues.

Contrary to popular belief, recessions are not defined by two quarters of negative economic growth. The official start and end dates for recessions are set by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee. Often, the start and end dates are announced with a long lag time. The growth rate of gross domestic product (GDP) is a key factor in determining recession; however, the group looks at a long list of data points. Here’s an excerpt from a letter NBER produced earlier this year that sheds some light on their approach:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

In choosing the dates of business-cycle turning points, we follow standard procedures to assure continuity in the chronology. Because a recession influences the economy broadly and is not confined to one sector, we emphasize economy-wide measures of economic activity. We view real GDP as the single best measure of aggregate economic activity. In determining whether a recession has occurred and in identifying the approximate dates of the peak and the trough, we therefore place considerable weight on the estimates of real GDP issued by the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce. The traditional role of the committee is to maintain a monthly chronology, however, and the BEA’s real GDP estimates are only available quarterly. For this reason, we refer to a variety of monthly indicators to determine the months of peaks and troughs.

The committee places particular emphasis on two monthly measures of activity across the entire economy: (1) personal income less transfer payments, in real terms and (2) employment. In addition, we refer to two indicators with coverage primarily of manufacturing and goods: (3) industrial production and (4) the volume of sales of the manufacturing and wholesale-retail sectors adjusted for price changes. We also look at monthly estimates of real GDP such as those prepared by Macroeconomic Advisers (see http://www.macroadvisers.com). Although these indicators are the most important measures considered by the NBER in developing its business cycle chronology, there is no fixed rule about which other measures contribute information to the process.

Source: National Bureau of Economic Research

My point in noting this is simply that investors shouldn’t be tempted into a false sense of security because the reported GDP growth rate in the US remains in positive territory. This doesn’t necessarily mean that the US isn’t already in recession.

As long-term subscribers know, my favorite quick-and-dirty measure of economic health is the Index of Leading Economic Indicators (LEI). Here’s the current chart of the LEI.

The LEI summarizes the performance of a composite of 10 different key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.

The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of–or coincident with–US recessions.

You can clearly see the trends on this chart. The LEI index dropped well below zero percent in late 1981, signaling the start of a nasty recession that lasted from July 1981 through November 1982. The next spike to the downside occurred in late 1990 and early 1991, coincident with the July 1990 through March 1991 recession. And, most recently, the LEI index pictured above offered a nice signal of the mild recession that transpired early this decade.

Of course, like all indicators, the LEI isn’t an infallible indication of recession. But, the index is correct more often than it’s wrong, so as investors we can’t afford to ignore the signals. For this reason, I continue to believe that the US is already either in a recession or soon will be; I first made this assessment in the Jan. 23, 2008, issue, Strengthening Headwinds, and the LEI has continued to deteriorate since this time. Therefore, I see no reason to change my assessment.

In fact, just consider the news that’s been released over the past two weeks. The government-sponsored mortgage entities Fannie Mae and Freddie Mac have now been effectively nationalized. And some of America’s oldest and most respected financial institutions have either declared bankruptcy, received a government-sponsored bailout or have been acquired outright. The news that 158-year-old investment bank Lehman Brothers was forced to file for bankruptcy this week is just the latest in a long series of shocking news events.

The US is in the process of de-leveraging and weeding out the weak firms that are overly exposed to the credit contagion. The US real estate market is also correcting sharply; based on the Case-Shiller Index of prices for the 10 largest metropolitan areas in the US, home prices are down 20 percent since mid-2006. The futures market based on that index is currently forecasting a further 8 to 12 percent decline by November 2009.

US home prices had become overly stretched and credit conditions too easy; ultimately, these adjustments will put the world’s largest economy on a more secure financial footing. However, short-term adjustments will be painful and could go on for several more months, putting further strains on US growth prospects.

Europe’s major economies held up a bit longer and better than the US. However, there are clearly signs of strain in the European Union (EU) now. The UK housing market is much like the US housing market one year ago, and prices there will continue to adjust lower for some time before there’s any sign of a recovery.

I could put up any number of charts to illustrate deteriorating EU growth, but one of the most straightforward is simply a chart of the euro against the US dollar.

It’s clear that the US dollar has rallied sharply against the euro since midsummer. Granted, the euro was at record highs against the dollar, but the correction has been dramatic to say the very least. This suggests to me one or a combination of the following scenarios:

• Global markets are concerned about global growth and the US dollar and US Treasury bonds are a sort of safe haven.
• The market is looking for the European Central Bank (ECB) to eventually follow the Fed’s lead and start cutting rates aggressively to shore up creaking economies.
• The market believes the US is further along the real estate and credit adjustment process. Therefore, US assets look more attractive than those in the EU.
• A reversal of the long-commodities/short dollar trade is underway.

Bottom line: None of these scenarios suggest that the EU economy is on firm footing. 

This economic weakness in the developed world has been behind a notable contraction in oil demand for 2008. I highlighted this fact in the Aug. 6, 2008, issue of TES, The Correction Continues, noting that data from the US Federal Highway Administration shows that the combination of high energy prices and a faltering economy has been too much for the US consumer. Americans have cut back on their driving, and this summer we didn’t see the normal summertime surge in driving commonly called the “summer driving season.”

The US Energy Information Administration (EIA) released its monthly short-term energy outlook Sept. 9. The agency noted that US oil consumption fell by a whopping 930,000 barrels per day (bbl/day) in the first half of 2008 compared to the same period in 2007; this is a more dramatic drop-off than the EIA had previously estimated. It’s also one of the most dramatic drops in US oil demand since the early 1980s recessionary period.

Weekly EIA data released in July and August suggests that the fall in gasoline prices after midsummer helped to encourage more driving and moderate the rate of decline in US gasoline demand. In those months, the EIA’s preliminary estimate is that US oil demand fell by 660,000 bbl/day year-over-year, and they’re projecting that the decline will moderate still further to the 130,000 bbl/day range for the balance of the year. This estimate makes some sense because US oil demand had already begun to slow late last year; therefore, the year-over-year comparisons will be easier.

However, two points are clear. First, due to broader economic weakness, US gasoline demand is unlikely to bounce back completely even if gasoline prices fall under $3.50 per gallon. And second, the risks to developed world demand estimates are firmly to the downside. The EIA’s revisions to US demand this year have tended to be negative.

The same basic trend is clear in European countries inside the Organization for Economic Cooperation and Development (OECD), a proxy for developed EU nations. Check out the chart below for a closer look.

Early this year, the EIA was actually looking for EU oil demand to rise by 80,000 to 130,000 bbl/day in 2008. As of the most recent report, the EIA is looking for a drop in demand of about 80,000. The steady decline in EU demand estimates throughout 2008 suggests that there’s a meaningful risk of further downside revisions.

As I’ve pointed out before, the US and other OECD nations aren’t the epicenter of global crude oil demand growth. In fact, the EIA estimates that global oil consumption will actually rise by 670,000 bbl/day this year and 920,000 bbl/day in 2009. This growth will come entirely courtesy of developing world (non-OECD) demand growth of 1.37 million bbl/day in 2008 and 1.32 million bbl/day in 2009.

The growth in non-OECD demand is a secular trend driven by the rapid economic growth and development in nations like China and India. The simple fact is that as consumers become wealthier and join the ranks of the middle class they tend to consume more energy and other commodities. As always, there’s some chance that non-OECD demand growth might not fully live up to expectations in 2008 and 2009, but I see that as a minor risk.

The far more likely scenario is that demand in the US and developed European countries will fall more than the EIA is forecasting as a result of the economic challenges I outlined above. This would offset growth in the developing world and temporarily slow global oil demand growth more than many are projecting.

The important point to note is that whether developed world consumption continues to slump or not, the market is now firmly focused on that risk. In the stock and commodity markets, perception is reality; the market will continue to focus on the downside risk to OECD oil demand until there’s conclusive evidence to the contrary.

Also, it’s worth noting that non-OECD crude oil demand doesn’t have to decline in order for crude oil prices to continue falling. Check out the two charts below.

Source: BP

The first chart is actually a chart I highlighted in the Aug. 6, 2008, issue of TES. It shows contribution to global demand for oil from the US, OECD countries and non-OECD countries over the past few years. The OECD countries are a proxy for the developed world, while the non-OECD nations include emerging markets such as China and India. I excluded the US from the OECD data and charted that data separately.

As you can see, the yellow bar representing the growth in demand from the developing world has been far and away the most important source of demand growth over the past decade. In fact, over the past few years, US and other OECD countries have actually had a negative impact on global demand; OECD demand–excluding the US–actually declined by nearly 400,000 bbl/day last year, offset only by a near 1.4 million-barrel-per-day jump from the developed world.

The key point to note here is that US and OECD demand was flat to negative in 2000, 2001 and 2002. However, in these years, non-OECD oil demand never turned negative; in each year, the developed world generated at least 500,000 bbl/day of growth. Although this jump in demand pales in comparison to what the world has experienced over the past four years, it’s worth noting that the developing world resisted the 2001 recession in the US and other OECD countries.

But despite the positive developing world growth over this time period, my second chart shows that oil didn’t perform well. Oil prices peaked out near $38 per barrel in late 2000 and then fell under $18 a year later. Just as now, the market focused its attention on falling OECD and US oil demand, not on the fact that global demand was still holding up well.

That low in late 2001 and early 2002 marked a historic buying opportunity: Crude oil prices soared to fresh new highs barely one year later. And oil saw only minor corrections on its way to $80 per barrel in 2006. But that correction was painful indeed at the time and lasted a lot longer than many market participants expected. I suspect we’re in for a similar scenario this time around: a temporary slump in oil prices that ultimately results in a historic buying opportunity.

At this juncture, you’re might be wondering why I haven’t been more bearish on oil prices this year. After all, I pointed out these very same risks in several issues toward the beginning of 2008 and even in late 2007. Some longer-term subscribers will even recall that we held a few short positions in oil and energy stocks earlier this year as a hedge against these risks.

The simple fact is that a few key trends converged in the first half of this year that pushed crude oil steadily higher. I’ve covered these factors in great depth in several prior issues, including in the Aug. 15, 2008, issue of The Energy Letter, Devil’s Advocate, and in the June 4, 2008, issue, Crude Realities. Here’s a quick summary:

• A sharp drop in the value of the US dollar. The dollar fell sharply against the euro and other major currencies from early February through mid-July. Since oil is priced in dollars, a falling dollar tends to be bullish for oil.
• Accelerating inflation numbers. Measures of inflation in several key economies appeared to spike this year; some traders use commodities as a hedge against rising inflation.
• Disappointing non-OPEC (Organization of the Petroleum Exporting Countries) production growth. For at least the past five years, growth in oil production from outside OPEC has consistently disappointed projections, keeping global oil supplies tight.
• OPEC’s spare capacity of crude oil production steadily declined. Due to weak non-OPEC supply growth and strong growth in oil demand, OPEC was required to supply more oil to balance the market. But the more oil OPEC pumps the less idled swing capacity it has available to handle short-term supply and demand shocks. OPEC spare capacity fell from 4.5 to 5.5 million bbl/day in 2001-02 to 1.2 million bbl/day earlier this summer.
• Inventories across the developed world remained tight. Typically, crude oil inventories rise in the second quarter as refiners prepare for the upcoming summer driving season. But in the second quarter of 2008, inventories in the OECD climbed just 120,000 bbl/day against a long-term average of 910,000 bbl/day. There was no glut of crude.  
• Strong non-OECD demand growth. I highlighted this factor at length above.

Clearly, not all of these factors have turned against oil. Check out the chart of oil and gasoline inventories below.

The charts depict US oil and gasoline inventories compared to the five-year maximum level, the five-year average and the five-year minimum. It’s clear from these charts that in the US both oil and gasoline inventories remain very tight.

Thanks to the shutdown of a number of refiners because of Hurricanes Gustav and Ike, gasoline inventories look particularly tight. Inventories are actually setting new record lows for this time of year. So although demand may be off, the US market certainly isn’t oversupplied.

In addition, I continue to see very real risks of further disappointments in non-OPEC supply growth. In fact, earlier this month Russian oil producer OAO Rosneft lowered its 2008 production forecast because of a delay in the start of one of its key oil projects in Eastern Siberia. And delays in Africa are also likely to crimp growth more than originally expected this year.

But enough has changed to shift sentiment. The most important bearish factor for oil right now is the fact that OPEC is actually cutting production. That isn’t a typo; cuts to OPEC output are actually bearish–not bullish–for crude oil.

The reason is the effect of production changes on OPEC’s spare capacity. Spare capacity is defined as unused production capacity that can be brought online with a month and produce sustained flows for at least three months. When OPEC spare capacity is high, this tends to put a cap on oil prices because it means there’s plenty of oil to handle supply and demand shocks.

When oil demand rises and non-OPEC production doesn’t keep pace, OPEC can boost output to balance the market. But boosting output means putting spare capacity into production. An output hike results in falling spare capacity within OEPC. This is exactly what we’ve been seeing in recent years.

But with OECD demand slackening and oil prices falling, OPEC now faces the opposite scenario. It can cut production without sending prices sky high. This is exactly what we saw earlier this month when OPEC decided to reduce supplies by 520,000 bbl/day. This cut will effectively boost the cartel’s spare capacity from dangerously low midsummer levels of just 1.5 million bbl/day. The point is that rising spare capacity is bearish for oil prices, not bullish. And the International Energy Agency (IEA) and EIA are forecasting that spare capacity could rise further still between now and the end of 2009 as OPEC brings new projects onstream and OECD oil demand continues to moderate.

Bottom line: Up until last week, I was forecasting oil prices would remain in a volatile range above $100 per barrel. That forecast was predicated on the idea that many of the bullish trends I just outlined would persist.

In last week’s flash alert, Fundamentals, Psychology and the Overshoot, I became incrementally more bearish, forecasting a spike in crude to the $90 to $95 per barrel level and recommending the Macroshares Oil Down Fund (AMEX: DOY) as a hedge against falling oil prices. That spike to the low $90s came to pass this week.

What’s even more telling is that oil prices continue to fall despite a bullish gasoline inventory report last week, two hurricanes hitting the heart of Gulf Coast energy infrastructure, continued delays in non-OPEC production, and a small pullback in the dollar. As I’ve repeated in TES, TEL and on the blog At These Levels, the crude oil market’s continued failure to respond positively to what should be bullish news suggests a good deal of underlying weakness.

Finally, any traders who were long oil futures in the first half of the year and are still holding on to their positions are feeling the pain. There are plenty of rumors circulating about commodity hedge funds that are heavily leveraged–some have borrowed more than 10 times their capital–and are now selling indiscriminately on any sign of oil strength simply to raise cash.

Given that backdrop, I’m looking for a deeper correction in crude oil prices before we see stabilization. Although we could see some short-term spikes and will definitely see plenty of volatility, I’m looking for crude to trade down into the $70- to $80-per-barrel range, most likely within the next three to six months.

It’s important to recognize this move for what it is: a pause in the context of a long-term uptrend. Check out the chart below for a closer look.

Although I rarely discuss charts and technical analysis in this newsletter, these inputs clearly do have significant import for traders. As you can see, a move for oil to as low as $70 per barrel wouldn’t even crack the long-term uptrend in prices from the 1998 lows to the present day. Such a move would only reverse the past year’s worth of price increases.

I’m primarily looking at three factors to determine when the slide in oil prices is complete. First, I’m looking for some real sign of a turn in the US and other OECD economies; the leading economic indicator data I explained earlier in today’s report is a useful data point to watch in assessing the health of the US economy. Some sort of stabilization in the housing and credit markets might also signal a turn.

I won’t venture a guess as to exactly when an economic improvement will occur. However, sometime toward the middle of 2009 is about the earliest window for such a recovery I can imagine given the state of current economic data. Crude oil prices will likely begin to rise months before the recovery fully takes hold.

Second, from a shorter-term perspective, I’m looking for bullish oil news to start “working” again. In other words, when the EIA issues an incredibly bullish oil and gasoline inventory report, crude should rally and hold on to those gains for more than a day. Until traders stop selling every rally, I’m unwilling to call a floor. This suggests there are more broken oil bulls looking to head for the exits at the first possible opportunity.

Finally, I’m looking for news of further delays in OPEC and non-OPEC projects. I suspect we will see more big delays in projects; this is a symptom of the fact that producers are targeting ever more complex fields located in increasingly hostile environments. Bringing such fields online is prone to delay. In my view, it’s quite possible that OPEC’s spare capacity won’t rise as much as the EIA and IEA are forecasting next year; this would quickly change sentiment on oil prices.

Although we’re unlikely to see all three of these factors line up perfectly, these are the main points to keep in mind in coming weeks as we look for a floor in oil prices.

Clearly, continued extreme weakness in crude oil prices isn’t good news for many energy-related stocks. But I suspect that many oil-levered stocks are closer to a low than crude itself. In fact, there’s already somewhat of a decoupling underway. Check out the chart below for a closer look.

This chart shows the performance of West Texas Intermediate crude oil (represented by the light purple line) compared to the S&P 500 Energy Index (represented by the dark blue line). As you can see, energy-related stocks never fully participated in the big run-up in crude oil prices that began early this year.

At this time, crude oil prices are still up more than 15 percent over the same date one year ago, compared to a decline of around 13 percent for energy-related stocks. This suggests that most energy-related equities never priced in $147 per barrel crude; rather, these stocks are trading below the levels they were last September when oil was in the $75- to $80-per-barrel range and natural gas was at around $6 per million British thermal units (MMBtu).

And, no matter which valuation metric you’d care to examine, many of the best-positioned energy-related stocks are as cheap as they’ve been in years. Check out the chart below for a closer look at the historical pattern of valuation for one of my favorite oil services firms.

On a shorter-term basis, we’re also seeing evidence of decoupling. For example, on Tuesday, Sept. 16, crude oil sold off more than $4.50 per barrel during the regular trading session. The S&P 500 Energy Index sold off hard in the morning only to rally and close 3.9 percent higher on the day.

Although this is obviously only one day’s trading, we’ve seen several examples of this divergence in recent weeks. And, more broadly, the S&P 500 Energy index is off less than 10 percent since Aug. 1, while crude has fallen 27 percent, nearly three times as much. I suspect you will see this divergence and decoupling continue with stocks continuing to outperform the commodities themselves.

And, no matter which valuation metric you’d care to examine, many of the best-positioned energy-related stocks are as cheap as they’ve been in years. Check out the chart below for a closer look at the historical pattern of valuation for the Philadelphia Oil Services Index (OSX).

Long-time readers know that the oil and gas services group is one of my favorite sub-sectors in the energy patch. This is the group most levered to my “end of easy oil thesis” that I outline in more depth in this issue.

The first chart is a weekly chart of the estimated price-to-earnings (P/E) ratio for the Philadelphia Oil Services Index (OSX). This is simply the current price of the index divided by the estimated full-year earnings.

The average estimated price-to-earnings multiple for the Oil Services Index is 12.5 based on this data, while the low was 8.95, touched briefly in October 2006. The current value based on this chart is 10.85 and the P/E did drop below 10 intraday on one of the big selloffs earlier this week. 

But, consider that on Oct. 6, 2006, crude oil traded at less than $60 per barrel compared to more than $90 per barrel at the current time. More importantly, the international rig count–a measure of global drilling activity–stood at 3,134 compared to more than 3,500 today. Bottom line: I doubt the Oil Services Index will trade under 9 times earnings as they did in late 2006, but if that were to happen, downside is still highly limited.

On a price-to-cashflow basis, you have to go back even further in time to find a period when the Oil Services Index was trading at current valuations. In July 2002, the OSX hit a valuation low of 7.95 times cash flow; today that ratio is at less than 8.3. And from an overall market standpoint, the comparison with 2002 is even more ridiculous than the comparison with late 2006. Back then, oil traded at $27.02 per barrel, and the global rig count stood at 1,822, barely half the current level.

And these figures just give you an idea of the index as a whole; some of my absolute favorite companies in the space are trading at levels unseen since 2002.

Over the past two issues of TES, I’ve written extensively about natural gas and some natural gas-levered stocks. I won’t repeat all my arguments here; suffice it to say that I see less downside in the North American natural gas market than I do in crude oil.

Natural gas demand is far less economy-sensitive than oil demand; the EIA is projecting that overall US gas demand will grow 2.7 percent in 2008 and 2.2 percent in 2009.

As I outlined at great length in the Aug. 20, 2008, issue of TES, The Natural Gas Boom, the main fundamental factor behind the decline in gas prices over the past month and a half isn’t demand but supply. Specifically, strong production growth from the North American unconventional reserves I outlined in the Sept. 3, 2008, issue, Unlocking Shale, has many worried that US gas inventories will move from current average levels to a glut condition. That would put downward pressure on gas prices just as it did back in 2006 and 2007.

Although I do expect unconventional gas production in the US to remain strong, there are counterbalancing factors. First, infrastructure constraints–the lack of pipeline capacity, drilling rigs and processing capacity–will limit North American unconventional production from many promising fields over the next few years.

In addition, natural gas prices in the UK and Asia remain far above US levels. The EIA projects imports of liquefied natural gas (LNG) will plummet by a massive 420 billion cubic feet (bcf) this year compared to 2007.

And finally, although the mainstream media has painted both Hurricane Gustav and Hurricane Ike as non-events for energy, that’s not exactly the case. Although it’s true that only a handful of rigs and platforms sustained major damage, the two storms still largely shut in US natural gas production for more than two weeks. Here’s a chart showing the shut-in of US natural gas production since late August.

Source: Minerals Management Service

As you can see, the amount of gas production shut in ahead of Gustav quickly accelerated to 7 bcf/day. Roughly one week after Gustav hit, producers had inspected rigs and restarted significant production, but nearly 5 bcf/day of gas production remained shut in.

At that time, you can see we ramped up to a second peak on the chart as producers again started evacuating rigs ahead of Ike. The result was that for five straight days–from Sept. 11 through Sept. 16–close to 7 bcf/day of gas production was shut-in in the Gulf.

We’re finally seeing that production come back online. But it takes time to inspect rigs and reposition crews. My guess would be that we won’t see Gulf gas production back to normal until sometime in the middle of next week. So far, the cumulative impact of these storms has been shut-in production totaling 109 bcf.

A far cooler-than-normal August across much of the US crimped electric power demand for gas and pushed inventories about 100 bcf above the five-year average level. Although gas inventories were still around 150 bcf below last year’s levels and 100 bcf of excess supplies is hardly a serious glut, this buildup of gas in storage helped push prices down last month. But, it looks as if the impact of Gulf Coast storms will erase much of that overhang. Last week’s report, for example, brought gas inventories back to around 80 bcf, above average.

Bottom line: If we enter the winter heating season at or near average levels, prices could see a significant run-up above $10/MMBtu this winter. Since natural gas-levered stocks have been hit hard alongside oil despite these bullish fundamentals, now is a good opportunity to buy a few of the highest-quality names.

Back to In This Issue

TES model portfolios clearly haven’t been immune to the recent selloff in energy-related stocks or to market turmoil in general. Fortunately, we did take some steps to stem the damage and book gains built up earlier this year, including selling some overextended big winners back before the July top such as Australian coal miner MacArthur Coal and gas producer Quicksilver Resources.

In addition, the options hedges and partial sales recommended in the June 12 and July 16 flash alerts, Unsteady as She Goes and Oil’s Rollercoaster, helped preserve profits in several key recommendations. Nonetheless, a number of TES recommendations have experienced tremendous volatility in recent weeks and have touched my recommended stops. Some of these stops locked in nice profits, but many have simply served to limit our losses.

Of course, that’s not to say I didn’t also make my fair share of mistakes. For example, I wasn’t sufficiently aggressive in locking in profits or recommending options to hedge big winners like shallow-water driller Hercules Offshore; we ended up giving up a big profit in that stock when it finally touched my stop late last week. Unfortunately, mistakes and miscalculations are part of the investing process, and although it might be psychologically gratifying to sweep such missteps under the proverbial carpet, it would be a mistake to do so.

All that said, the longer-term performance of the portfolios remains solid overall, and I continue to firmly believe in the case for owning energy stocks. In fact, there is no better time to commit money to the sector; previous corrections of this nature have proven to be outstanding opportunities to jump into the group.

The obvious question is how we should handle the current shaky market and extreme volatility while taking advantage of the attractive valuations and growth prospects of many energy stocks. In addition, I’ve received e-mails from many newer subscribers noting my near-term caution, asking how they should start to commit funds to the portfolios to take advantage of the buying opportunities I see developing over the next few weeks.

My strategy for handling the current turmoil is two-fold. First, the table below offers seven must-own energy stocks along with three hedge recommendations designed to profit from the moderation of oil prices. New money should be committed first to these 10 names, all of which are existing TES recommendations.

I’ve chosen these stocks because I believe they’re excellent plays on key energy growth themes. I believe all have important catalysts for upside over the next few months and, based on current valuations, have limited downside risk. Even if I’m right about oil prices slipping a bit further, these stocks can perform well.

Second, I continue to favor many of the stocks that have stopped us out over the past few weeks. In my view, the selloff in the majority of these names has little to do with deteriorating fundamentals; for the most part, these stocks have been the victim of indiscriminate selling on the part of hedge funds and other market players looking to raise cash. Many of these market players are heavily leveraged and must meet margin calls and redemption requests from their investors by selling stocks, regardless of fundamental prospects. 

In a normal market, I review stocks that stop us out and recommend reentering if the prospects still look promising. However, in the current shaky market, that’s not the prudent course. Some of these plays can be volatile, and I’d rather wait until the selling pressure from panicky institutions shows signs of subsiding. I suspect that process is well underway, and these names will be the first I look to add back to the portfolio in coming weeks as energy-related stocks bottom.

Here’s my current Fresh Money Buy List.

Schlumberger (NYSE: SLB)–I offered a detailed look at Schlumberger in the Aug. 6, 2008, issue, The Correction Continues. In this issue, I’ll offer only a brief overview.

Schlumberger is the world’s largest oil services company. The term services is loosely defined and can refer to a large number of very different functions related to exploring, drilling and producing oil and gas fields.

The key point to remember is that Schlumberger has a solid market position in a wide array of high-tech service offerings. This makes it an outstanding play on my “end of easy oil thesis.” Specifically, the large onshore oil reserves that the world has relied on for decades to meet demand are mature and seeing declining production. To generate growth in output, producers are increasingly turning to more complex and tough-to-produce fields such as those located in deepwater or in the Arctic. Producing these fields requires more complex services such as those provided by Schlumberger.

One headwind that’s been holding back Schlumberger’s growth over the past year is the bottleneck in new deepwater drilling rig supply. There simply aren’t enough deepwater rigs worldwide to handle all the projects producers would like to tackle. Deepwater projects are extremely profitable for Schlumberger; a shortage of rigs has crimped growth somewhat. Schlumberger has managed to generate plenty of growth even with that rig shortage, but management has indicated that more deepwater drilling activity would accelerate its growth rate.

That bottleneck is set to ease significantly. Between now and 2010, a large number of newbuild deepwater rigs currently under construction are scheduled to leave shipyards and be put to work on deepwater projects. To make a long story short: More deepwater projects spell acceleration in Schlumberger’s growth over the next four quarters. Trading at less than 18 times this year’s projected earnings, Schlumberger is as cheap as it’s been at any time since early 2007, right before the stock took off on a 70 percent run-up. Buy Schlumberger.

Enterprise Products Partners (NYSE: EPD)–Enterprise is a Master Limited Partnership (MLP); I discussed the stock and MLPs in general at length in the Nov. 22, 2006, issue, Leading Income.

Enterprise owns basic infrastructure primarily related to the transport, processing and storage of natural gas in and around the US. Enterprise also owns a series of production platforms in the Gulf of Mexico designed to collect and process gas produced from deepwater fields.

The key point to remember about Enterprise is that its businesses are primarily fee-based, meaning that the company is paid based mainly on the volumes of gas transported or stored, not the value of the gas itself. That means that the company has very little leverage to commodity prices on the upside or downside.

And don’t overlook the importance of natural gas infrastructure. The US will need to build plenty of pipelines and processing facilities in coming years to handle gas produced from unconventional fields; Enterprise is well-placed to participate.

Enterprise pays a tax-advantaged distribution (the MLP equivalent of dividends) of 8.2 percent; for details on those advantages, check out the “Leading Income” issue referenced above. Although the stock has pulled back lately, that’s largely due to general market spillover and nothing specific to Enterprise. Buy Enterprise Products Partners.

Norfolk Southern (NYSE: NSC)—Norfolk Southern is a railroad; I profiled the group and Norfolk at great length in the July 2, 2008, issue, Take a Ride. Since recommended in that issue, Norfolk has been an outstanding performer in a weak market.

The railroads are in the midst of a renaissance. Rail is the most fuel efficient form of freight transport; with energy prices still elevated, you’re likely to see more freight volume shift from trucks to trains to save fuel.

Railroad’s biggest single freight by total volume is coal. Trains move coal both from mines to power plants and from mines to export terminals. With US coal exports booming and demand for coal at home robust, Norfolk has seen a sizeable uptick in coal volumes move across its lines in recent years. Other important commodities for the rails include corn and other grains. Demand for agricultural exports is booming as is demand for corn in the biofuels industry.

The rails are also successfully lowering their operating costs by streamlining their operations. And because of strong demand, the best rails are raising prices. The combination of good volumes, falling costs and rising profits is generating explosive profit margins.

I’m still a big believer in coal as a long-term investment. But the coal stocks were among the best performers earlier this year, and we’re currently seeing institutional players sell these stocks as a source of cash. The rails are an outstanding backdoor play on coal, agriculture and ethanol demand and have not seen the same level of volatility. Buy Norfolk Southern.

Seadrill (Oslo: SDRL; OTC: SDRLF)–Seadrill is a contract driller, meaning that it owns drilling rigs and leases them to producers for a fee known as a day-rate. Although the company owns a mix of rigs, its most valuable assets are its deepwater rigs; demand for deepwater rigs is soaring and global supply is severely limited.

Many investors are more familiar with Transocean (NYSE: RIG), a firm in the same basic business. Transocean isn’t a bad company; the one issue I have with the firm is that it leased most of its valuable deepwater rigs under long-term contracts signed several years ago. Back then, prevailing day-rates for rigs were lower than they are today. Transocean has locked in substandard rates for many of its best rigs.

Seadrill doesn’t have the same problem. Most of the company’s rigs are relatively new or are still under construction. In most cases, Seadrill has only recently signed long-term contracts. The day-rates it was able to demand are much higher.

To put numbers into context, Seadrill is earning a day-rate of $630,000 per day on a couple of its most advanced rigs. Its average day-rate for such rigs is in the mid-$500,000-per-day range. In contrast, Transocean has locked in a number of ultra-deepwater rigs at rates under $500,000 per day.

As Seadrill’s rigs are delivered and put out on contract, the company has a steady, reliable source of cash flow. These are long-term contracts guaranteeing the day-rate over the term of the deal; most of the companies leasing such rigs would be large integrated oils that have solid financial positions. To make a long story short, there isn’t much risk to cash flow.

Seadrill has a highly attractive dividend policy. Management has committed to return a good deal of the firm’s earnings to shareholders as quarterly dividends. As new rigs are completed and put on contract, the cash flows and dividends will continue to expand. This is another distinction with Transocean; the latter firm doesn’t pay a quarterly dividend.

Seadrill recently paid $0.60 per share for shareholders, equivalent to an annualized yield of 11.5 percent. But I’m looking for the company to pay out closer to $1 per quarter by the end of next year. That would be equivalent to close to a 20 percent yield at the current quote. Buy Seadrill.

Nabors Industries (NYSE: NBR)–Nabors is also a contract driller that primarily owns land rigs.

Drilling the relatively complex horizontal wells needed to produce unconventional gas plays (see the Sept. 3, 2008, issue of TES for an explanation) 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.

And Nabors is also a major player in complex international oil and gas fields. The list includes supplying rigs capable of handling the extraordinarily harsh operating conditions in Russia’s Siberian expanses. One of Nabors largest projects to date is a deal it won in late 2007 to do work with services provider Weatherford in Western Siberia for TNK-BP. Weatherford is providing some major services for the deal, while Nabors is supplying the drilling rigs necessary to conduct the project.

Nabors has been hit because just a few years ago it derived almost all of its revenue from the North American market; weak natural gas prices have some worried that Nabors will see a slowdown in activity. But too many investors are ignoring the fact that Nabors’ international business will soon account for half the company’s earnings and is growing north of 40 percent per year. Meanwhile, of course, I see natural gas as fundamentally attractive right now and believe those fears of a slowdown are overblown. Buy Nabors Industries.

Weatherford (NYSE: WFT)–Like Schlumberger, Weatherford is a services firm. Traditionally, Weatherford has been heavily exposed to the volatile North American gas drilling market. But in recent years, Weatherford has been expanding rapidly internationally.

North America has a large number of older mature fields. Many of Weatherford’s services are aimed at maximizing or improving production from mature wells. But increasingly these services are in high demand internationally; Weatherford’s international growth is booming. In fact, Weatherford is the fastest-growing major service company in my coverage universe.

I also like the company’s integrated project management (IPM) business. In an IPM deal, a producer actually contracts with a service firm to handle a project. Depending upon how the deal is structured, the services firm may provide the rigs, contract with engineering companies or provide some of its own in-house service functions, as well as contract with third-party providers for other services.

In many ways, IPM deals are replacing production-sharing deals with major international integrated oil companies. Many state-owned national oil companies (NOC) prefer not to give up rights to some of the production from their fields; this was the norm under production-sharing deals. In an IPM, the NOCs can simply pay the services companies to handle the work.

IPM is also good for the services firms because these deals typically represent major contracts and can carry healthy profit margins. The growth in this market is exploding as producers switch from partnership deals to IPMs. IPMs are powering growth for Weatherford as well as Schlumberger. Buy Weatherford.

EOG Resources (NYSE: EOG)–I offered a detailed take on EOG in the most recent issue of TES, Unlocking Shale. Suffice it to say that EOG has its hands in most of the hottest, most promising unconventional oil and gas plays in the US and Canada.

A major catalyst for the firm could be new information it’s likely to release on its new Canadian gas finds later on this year or early in 2009.

Delta Airlines (NYSE: DAL)–Delta and competitor US Airways (NYSE: LCC) can continue to perform well as long as oil prices remain stable. I outlined the case for the airlines in the July 29, 2008 flash alert, Neither Here nor There.

My rationale for buying the airlines is two-fold. Fuel prices are the group’s No. 1 cost by a huge margin. Though the airlines cut costs to try and cope, the rapid rise in oil prices from early 2007 through mid-2008 was just too much for these firms and the stocks got slammed. Oil prices don’t need to collapse for the airlines to rally; these stocks can do well as long as oil stabilizes at levels well under the highs witnessed earlier this year.

Second, the airlines are rapidly retiring older planes and eliminating unprofitable routes. As capacity across the industry falls, the airlines are filling more planes and can get by with raising fares. Falling costs and reduced capacity should help shore up profitability, at least for the next few quarters.

The airlines are a risky play but make an outstanding hedge for an energy-oriented portfolio. Buy Delta Airlines.

MacroShares $100 Oil Down Fund (AMEX: DOY)—I first recommended the MacroShares in last week’s flash alert, Fundamentals, Psychology and the Overshoot.

The MacroShares are always issued in pairs. In this case, the Oil Down Fund is paired with the MacroShares Oil Up Fund (AMEX: UOY). At an oil price of $100 per barrel, both funds should trade around $25 per share (one-quarter of the per barrel price). Both funds hold primarily Treasury bonds.

When oil prices rise, the Oil Down Fund transfers assets to the Oil Up Fund according to a predetermined formula. This lowers the value of Down and increases Up. Conversely, when oil prices fall, the Down Fund picks up assets from the Up Fund. Thus, the MacroShares represent a quick and clean hedge against falling oil prices. Buy the MacroShares $100 Oil Down Fund.

iShares Dow Jones Transports (NYSE: IYT)—This exchange-traded fund (ETF) represents ownership in a basket of stocks in the transport industry including package delivery, airlines, truckers and railroads.

I highlighted my rationale for playing airlines and rail above. In addition, package delivery firms such as Federal Express also benefit from moderating oil prices; the main reason FedEx raised guidance last week is a weakening fuel cost headwind. Buy the iShares Dow Jones Transports.

Back to In This Issue

As I noted earlier, we’ve seen several stocks stopped out in the model portfolios over the past few weeks. All are accounted for in the portfolio tables, and I’ve reviewed these picks in recent flash alerts.

Although I’m recommending that you stand aside from these stocks for now, the main reason for the drops in TES recommendations is sectorwide, not company-specific. Energy stocks have been hit by a wave of institutional selling from investors desperately looking to raise cash.

Peabody Energy (NYSE: BTU)–Peabody got hit hard in early September on record volume. Those huge volume spikes are a sure sign of panicky liquidation. Meanwhile, there’s little fundamental rationale for the selling.

In its recent earnings report, the company noted that it’s seeing huge demand for coal exports from the US. The reason is simple: The US is the only market in the world with unconstrained coal production and export capacity. Peabody believes that US exports could top 100 million tons next year and eventually surge to 125 million tons without the need to construct new export facilities.

The EIA seems to be shifting its expectations more in line with Peabody’s comments. In its Short-Term Energy Outlook (STEO) issued earlier this month, the agency hiked estimates for 2008 and 2009 coal exports markedly. This represents potential growth of more than 50 percent this year in exports.

Coal spot prices have pulled back lately in sympathy with other commodities. But most coal isn’t traded under spot deals. Most utilities contract for coal under multi-year contracts at fixed prices or prices that adjust to account for inflation. Peabody noted that it’s signing many contracts at a significant premium to the widely-quoted spot prices.

It appears that the decline in spot prices doesn’t represent true market supply and demand; if there were a build-up in coal inventories or a surfeit of production, it’s highly unlikely Peabody would be signing contracts at premium prices. As Peabody continues to roll off contracts it signed years ago at much lower prices, its margins will continue to improve. The quoted spot price of coal hardly enters into that equation.

Peabody is also ramping up its Australian production. Because of de-bottlenecking at its facilities, Australian production volumes are up 15 percent year-over-year.

And profit margins are sure to improve markedly from this operation in 2009. Peabody’s position in Australia is a result of its acquisition of Excel Coal. Excel is still producing and selling coal under long-term deals it signed years ago at much lower coal prices. But Peabody has only half as many long-term contracts covering 2009 production as it does this year. Next year it will sell far more coal at current sky-high prices.

Because some funds need to raise cash in the current market, we could see Peabody slip further, and it’s likely the stock will remain highly volatile. Longer-term, the stock should see little or no real impact on its bottom line.

It’s also worth commenting on the recent slides in some of our limited partnership (LP) recommendations, particularly Linn Energy and Eagle Rock Energy Partners. Both have performed poorly, despite the fact that neither has major exposure to commodity prices, and both cover their distributions by an extremely healthy margin.

Although I’m obviously not happy to see these stocks slide, my main concern with LPs is to evaluate the sustainability of the distribution payout; as long as it’s solid, I’m willing to hold on to the stocks as part of a broader portfolio. Here’s my stock-specific take on both Linn and Eagle Rock:

Linn Energy (NSDQ: LINE)–I highlighted this partnership’s hedging program and business position in the most recent issue of The Energy Letter, Your Guide to Understanding the Hedges. I believe that what’s pressuring the stock this week is fears over potential exposure to the Lehman Brothers failure.

Linn has several credit lines that it’s arranged wi