For the past few weeks, the stock and credit markets have been taking their cue from Washington and the fate of the proposed Paulson plan to buy up troubled mortgage assets from banks.

This could remain the case for a while longer. That said, I do expect passage of a bill this week, and we’re setting up for a classic yearend rally. If history is any guide, energy stocks will be among the best performers in such a move. Rhetoric out of politicians has been downright frightening as was this Monday’s near 800-point selloff in the Dow Industrials. However, now isn’t the time to panic and sell; it’s time to look for opportunities.

There’s a direct connection between credit market conditions and the energy sector. I explore the fear investors are clearly showing toward many companies with solid cash flow and credit ratings simply because they have debt on their balance sheets. I also offer a lesson on the easiest way to gauge health in the credit markets. See The Coiled Spring.

There will be continued downside risk to global oil demand near term until we begin to see some stabilization. I explain why the International Energy Agency recently revised oil demand growth estimates for 2008 and 2009. See Fundamental Backdrop.

The largest E&P firm in the US has cut production in infrastructure strained areas, which will ultimately shore up cash and allow the company to pay down debt. See Chesapeake Announcement.

I monitor technical factors and indicators affecting portfolio plays and recommend focusing on a handful of the best-placed, highest-confidence stocks until I see an opportunity to get more aggressive. See Playing the Trends.

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

• EOG Resources (NYSE: EOG)
• Weatherford International (NYSE: WFT)
• Schlumberger (NYSE: SLB)
• Nabors Industries (NYSE: NBR)
• Enterprise Products Partners (NYSE: EPD)

This has undoubtedly been the most challenging and unsettled market in recent history for the stock, bond, currency and credit markets. Monday’s selloff in the major averages was the largest in percentage terms since the October 1987 stock market crash, and the meltdown in the credit markets is drawing some comparisons with the Great Depression.

Whether you approve of the Paulson “bailout” plan or think it’s an unnecessary government intrusion, it’s fair to say that the only factor holding the market aloft last week was the potential for some sort of plan to be passed. Predictably, the market didn’t react well to the House’s narrow rejection of the bill Monday afternoon.

To make matters worse, politicians have been selling the bill as a way of preventing an outright collapse in the US financial system. The rhetoric about the consequences of no action has been scary in recent weeks. When the Federal Reserve, Treasury and everyone else under the sun tell you that the market will collapse without a bill, it shouldn’t come as a surprise that we got a mini-crash when the bill didn’t pass.

Although the rally Tuesday erased a good portion of Monday’s losses, there’s still significant nervousness in the credit markets. And much of that rally was predicated on rhetoric out of Washington that some form of the legislation would be up for a second vote later on this week.

Not surprisingly, the energy sector and the stocks recommended in The Energy Strategist portfolios haven’t been immune to the selling pressure. As I’ve noted in the past few issues of TES, the selloff in most stocks I cover has little or nothing to do with fundamentals and everything to do with market sentiment and a pervasive sense of panic.

Institutions are dumping stocks to raise cash and the primary fear infecting the energy markets is that a dramatic global economic slowdown coupled with a seizing up of credit markets will destroy demand for energy commodities. I highlighted that very risk in this newsletter two weeks ago and won’t belabor that point again in this issue.

It is, however, worth highlighting a more direct connection between credit market conditions and the energy sector. Investors are clearly showing an aversion to any company with debt on the balance sheet. The fear is that extraordinarily weak credit markets will limit access to capital even for companies with solid cash flow and credit ratings.

The easiest gauge of health in the credit markets is a measure known as the TED Spread. The credit markets are the epicenter of the selloff in the stock market; the TED spread is one of the most important indicators to watch on a day-to-day basis. This spread is the difference between the yield on three-month US Treasuries and the three-month London Interbank Offered Rate (LIBOR). Check out the chart of the TED spread below.

The three-month US Treasury yield is essentially a risk-free interest rate. LIBOR is the rate that banks charge to lend each other money. The more elevated the TED spread, the more pervasive the sense of fear in credit markets.

As you can see, the TED spread has tracked the credit crisis fairly accurately since it began in the summer of 2007. As the chart shows, the TED spread was only around 50 basis points (one-half of 1 percent) for most of 2006 and early 2007. That means that banks were only paying a small premium to the risk-free rate to lend money to one another.

You can also clearly see the spikes in the TED spread during July and August 2007, December 2007 and again in March of this year. These spikes were all caused by various panics; in each case, the government sought to calm the credit market’s jitters. But these one-off pragmatic responses had only a limited, short-term effect.

The latest move in the TED spread is more pronounced than the prior spikes. The spread topped out at more than 350 basis points (3.5 percent) on Monday and remains elevated. That means that banks are totally unwilling to lend to one another at this time. Banks are hoarding cash and are questioning the financial solvency of other institutions. This is exactly what’s meant by the often-heard refrain that the credit markets are “frozen.”

Although it might seem to be totally irrelevant to discuss the credit markets in a newsletter devoted to energy, it isn’t. The turmoil in the credit markets has a very real effect on the relative performance of stocks in my coverage universe.

For example, Chesapeake Energy (NYSE: CHK) is a solid Exploration and Production (E&P) firm with an outstanding acreage position in the best unconventional plays in the US. For those unfamiliar with US unconventional oil and gas reserves, check out the Sept. 3, 2008, issue of TES, Unlocking Shale. Although it’s not currently in the model portfolios, I consider it a bellwether, and I believe its competitive positioning in US shale is nearly unparalleled.

However, Chesapeake has about $13.7 billion in debt on its balance sheet compared to a market capitalization–total value of all the outstanding shares–of just more than $20 billion. Compare that to TES recommendation EOG Resources, which has outstanding debt of $1.15 billion, compared to a market capitalization of just more than $22 billion.

This leverage is one reason I believe that EOG has outperformed Chesapeake over the past month. Although both stocks are trading lower, EOG is only down by about half as much as Chesapeake since the end of August when turmoil in the credit markets began to really accelerate. These firms’ relative leverage doesn’t explain that entire performance gap, but it’s certainly a factor right now.

And this same factor goes a long way toward explaining the relative performance of other stocks in my universe. For example, in the oil services sub-sector, more heavily levered Weatherford International has been underperforming Schlumberger amid the recent turmoil. This is despite the fact that Weatherford’s earnings are likely to grow faster than any of the other major services firms over the next few years. In effect, this balance sheet risk is totally separate and distinct from the underlying business conditions and growth prospects of the firm itself.

The good news: As I pointed out in the last issue of TES, last week’s The Energy Letter, and this week’s flash alert, panicky markets typically offer investors the best opportunities. Although timing the exact bottom is next to impossible, I would liken the energy sector at this time to a coiled spring; bullish fundamentals are being totally overshadowed by general market and credit fears. When those fears are allayed, even partly and temporarily, the snap-back rally in the group will be tremendous.

I expect we’ll have just such a snap-back rally in the fourth quarter of 2008. With most stocks in the group trading at fire-sale valuations unseen since the late 1990s and the 2001-02 lows, a return to more normal valuations could mean a rally of 50 to 80 percent in some cases. Although it’s tough to peg the exact bottom, I suspect a few months from now we’ll look back on this week as a great buying opportunity.

Moreover, the extreme aversion to leverage should begin to reverse as the credit markets stabilize. The fact is that most energy-related firms have extremely strong free cash flow in the current market environment and have scope to actually reduce leverage in coming years. For example, as I’ll detail later, Chesapeake’s recent decision to scale back its capital spending plans and sell partial stakes in some of its plays is partly an attempt to reduce the need to access debt markets. If there’s any group that will keep getting credit, it’s energy.

In fact, the so-called “bailout” bill is really aimed at stabilizing credit markets and, in effect, reducing the TED spread. The proposed legislation will definitely not cure America’s economic problems, but it would likely help to ease conditions in the interbank lending market. At the very least, the creation of some sort of market for mortgage-backed assets would serve to enhance credit market confidence.

That means that energy stocks that have been hit by debt aversion—such as Chesapeake and Weatherford—actually stand to benefit most from a return to normal credit conditions. Please note, this doesn’t mean that we’re headed back to the easy credit conditions that prevailed in early 2007, but it does mean that the financial and credit systems won’t collapse outright; companies–and individuals–who are creditworthy will be able to borrow.

One of the factors I’m watching before getting more aggressive in adding stocks back to the TES portfolios is a normalization of that TED spread. I don’t make a habit of offering political commentary in TES; rather, I simply look to interpret trends and highlight expectations. In that regard, I do expect a “bailout” bill to pass at some point this week, and that bill will include some facility for the US Treasury to buy up mortgage assets from banks. Although the ultimate effects of such legislation will take months to play out, I suspect that passage will restore confidence in credit markets and narrow the TED spread.

The latest news from Washington is that the US Senate will vote on a new version of the bill tonight, Wednesday, Oct. 1; the earliest the House of Representatives could take up the measure is tomorrow. The Senate has a few vocal opponents to the bill, including Sen. Richard Shelby of Alabama; however, based on comments from both the Republican and Democratic Senate leadership, the basic plan will have no trouble whatsoever passing the Senate.

Senate leaders from both parties have decided to take a new tack to try to ensure the legislation’s passage through the House. The bill only needs to attract about a dozen new votes in the House to become law so Majority leader Harry Reid and Minority leader Mitch McConnell have decided to sweeten the bill to make it more palatable.

Specifically, the Senate version of the law includes provisions to exempt about 20 million Americans from the Alternative Minimum Tax (AMT) as well as some tax relief for businesses. The bill also will include a provision to raise the deposits insured by the Federal Deposit Insurance Corporation (FDIC) from $100,000 to $250,000 and to renew the alternative energy tax credits and incentives that are set to expire at the end of this year.

Tax breaks are designed to appeal to Republicans in the House, while the renewable energy tax credit is quite popular with Democrats and some Republicans alike. Since both Presidential candidates have supported the same basic FDIC insurance change, this is also a bipartisan sweetener.

The Senate’s plan seems to be to pass this revised version of the bill, likely by a significant majority, on Wednesday. This will then offer some additional push for the more-reluctant House to approve the deal on Thursday or Friday. The Senate’s gambit is that the tax sweeteners will serve to attract additional Republican votes and, quite possibly, a few extra Democratic votes. In addition, both Sen. McCain and Sen. Obama are expected to vote in favor of the legislation. A “Yes” vote by Presidential candidates will also act as an additional incentive.

Bottom line: I believe this move to change the legislation and vote on it in the Senate today actually increases the chances the bill will pass by this weekend. Whether you like the bill or hate it, I suspect it will, at least over the next few weeks, serve to calm the credit markets and restore some confidence to interbank lending.

I’m also keeping a careful eye on the S&P Volatility Index (VIX), a measure of how much volatility is priced into the S&P options market. Suffice it to say that when the VIX is elevated, S&P options traders expect large moves to occur in the underlying index. A high reading on the VIX indicates significant market uncertainty.

The VIX often spikes because traders are buying put insurance en masse. For those interested, I explain put insurance at great length in a special report available to all subscribers entitled The ABCs of Options to Hedge Risk. To make a long story short, traders are buying puts on the S&P at high prices to insure their portfolios against major loss. A high VIX reading means elevated levels of fear in the broader market.

The VIX is a contrary indicator, meaning that high readings tend to correspond with lows in the major market averages. Check out the chart of the VIX below for a closer look.

This chart shows daily closing values on the VIX over the past nine years. With the VIX, you’re looking for a big spike to indicate an extreme of fear.

For example, you can clearly see the big spike in the VIX to the low 40s in the wake of the terrorist attacks Sept. 11, 2001. In that cycle, the VIX actually topped out Sept. 20, 2001. The US economy was very weak at the time, and the bear market in stocks still had more than another year to run; however, that VIX spike signaled the start of an impressive fourth quarter rally in the S&P 500 that carried the index up 17 percent by yearend.

The next spikes occurred in the summer and autumn of 2002, followed by another mini-spike in early 2003. Of course, these moves in the VIX signaled the bottom of the 2000 through 2002 bear market. The S&P 500 ultimately enjoyed a near five-year rally off those lows.

The recent spike looks similar. You can clearly see on the chart that the VIX actually reached highs that were slightly above the elevated levels registered back in 2002-03. When some are talking about the Great Depression Part Two, it’s not surprising that the VIX is registering elevated fear.

This spike in the VIX is indicative of a bottom in the stock market. If history is any guide, the VIX should begin to plummet to more normal levels in the mid-20s as the rally takes hold this quarter. Such a move would indicate a return of willingness to take on risk.

In addition, it’s worth noting that the fourth quarter of the year tends to be positive for the stock market in general. This is equally true for energy stocks; in eight out of the past 11 years, the fourth quarter has brought a positive return for the Philadelphia Oil Services Index (OSX).

Furthermore, the best fourth quarters of all for the OSX during this 11-year time span were 2001, 2002 and 2006. In all of these years, the index saw a significant decline in the third quarter. In other words, the fourth quarter marked a big snap-back rally for the index. This is a similar setup to what we’re seeing again this year.

Bottom line: All of the ingredients are in place for a strong finish to 2008. Specifically, panic levels as measured by the VIX are running high, consistent with prior market lows. Meanwhile, although the TED spread currently indicates continued tightness in global credit markets, it’s likely that the passage of a bailout bill will help to instill confidence in the interbank lending market, at least short term. Finally, the fourth quarter is seasonally the strongest of the year.

Of course, the biggest reason of all to expect a rally in the energy patch this quarter is market fundamentals. As noted above, these bullish fundamentals have been obscured by the overall weakness in the equity and credit markets. As those headwinds dissipate, I believe investors will once again focus on underlying company and commodity market fundamentals.

As I highlighted at great length in the most recent issue of TES, What to Do in the Energy Sector Now, the primary fundamental factor weighing on crude oil prices in recent weeks has been downside risks to oil demand in the developed world.

Even if the “bailout” legislation is passed in close to its current form, it will not change the US economic picture overnight. US leading economic indicators continue to point to recession; legislation might ease the pain and mitigate the risk of an outright financial collapse but won’t abolish the business cycle. Based on the length of prior cycles, I suspect we could see stabilization in the US economy in the latter half of 2009.

That said, I believe the ultimate recovery from this downturn will be relatively flat as it will take some time for consumers to deleverage. Long term, however, a rising US savings rate and stronger consumer balance sheets are healthy for the economy.

This all means there’s continued downside risk to global oil demand near term until we begin to see that stabilization. For example, in the International Energy Agency’s (IEA) most recent oil market report, the agency lowered oil demand growth estimates for 2008 and 2009 by 100,000 barrels per day and 140,000 barrels per day, respectively. The demand revisions are almost entirely a function of a slump in US and developed world demand.

But there are some key offsets. First, non-OPEC (Organization of the Petroleum Exporting Countries) production continues to massively disappoint expectations. As I pointed out in the most recent issue of TEL, late in 2007 the IEA was looking for more than 1 million barrels per day of oil production growth from non-OPEC countries this year. The reality is that non-OPEC production will grow by roughly a quarter of that–just 275,000 barrels per day. In the most recent report, the IEA downgraded non-OPEC supply growth by a further 180,000 barrels per day in 2008 and 85,000 barrels per day in 2009. Taken together, those supply revisions more than offset the IEA’s revisions to developed world oil demand in the very same report.

Moreover, it’s amazing to me that so little is being said about the current US gasoline and oil inventory picture. It’s actually quite scary. Check out the charts below.

Source: Bloomberg

The first chart is US gasoline inventories. As you can see, inventories have recently plunged to levels unseen at any time over the past 18 years. In fact, based on longer-term data from the Energy Information Administration (EIA), US gasoline inventories are at the lowest levels since 1967. It should come as little surprise that there are actually shortages of gasoline in certain parts of the country; recent reports indicate these shortages could last through at least mid-October.

Although somewhat better supplied than gasoline, US oil inventories are now sitting in the lower half of their five-year average range. There’s hardly a glut of oil or refined products in the US.

The IEA also collects data on total oil and refined products inventories worldwide; the data is released with a significant time lag. But based on the most recent data from July, the IEA indicates that total inventories in developed world economies were at four-year seasonal lows. Since North America accounts for half of Organization for Economic Cooperation and Development (OECD) inventories, I can’t imagine this picture has loosened much since July.

My view on the oil market remains unchanged. A recession in the US is the only thing that saved the world from $200-per-barrel oil this summer. Oil prices could spike downward to the $70- to $80-per-barrel range if developed world oil demand figures continue to deteriorate in 2009. But supply-side risks will continue to act as a floor at those levels. And although the global economy is seeing some sort of slowdown at this time led by the US, it should start to ease toward the second half of 2009. When that happens, $200-per-barrel oil is right back in play.

As I noted in the last issue of TES, most energy stocks are already more than pricing in oil in the mid-$70-per-barrel range, trading at valuations as low as they’ve been since 2002. Therefore, I see little downside on a fundamental basis for oil-levered stocks.

Moreover, if I’m right about a broader market rally and a decline in the TED spread, I suspect we’ll see oil prices stabilize around current levels of $100-per-barrel through at least yearend. A more likely window for a spike down to $70- to $80-per-barrel will be early 2009 after the positive impetus of normalization in credit markets begins to wear off and the market refocuses on US economic weakness.

Perhaps even more puzzling than the action in crude is the extreme bearish sentiment surrounding the North American natural gas market. I’ve discussed natural gas to some extent in each of the past three issues of TES. The primary bearish factor hanging over natural gas prices remains the potential for a glut of gas due to strong production growth from US unconventional plays. I discussed this outlook in depth in the Aug. 20 and Sept. 3 issues of TES.

The EIA collects data on natural gas using several different surveys; the results of these differing surveys don’t always completely match up. However, it’s fair to say that we can see the impact of unconventional shale on US production.

Specifically, according to the EIA, US natural gas production is set to increase by nearly 8 percent in 2008 over 2007 levels. This increase is led almost entirely by US unconventional plays such as the Barnett Shale of Texas. Meanwhile, demand for natural gas is expected to rise just 3 percent in 2008; based on that data, you’d expect natural gas inventories to rise to glutted levels and prices to collapse.

But this market isn’t that simple. Some of the growth in US production has been offset by a collapse in liquefied natural gas (LNG) imports. With European Union (EU) natural gas prices still more than twice the US level, LNG imports are likely to remain subdued for the foreseeable future. In addition, Canadian gas production is likely to fall further over the next several quarters; that means less gas for export to the US.

More recently, an active US hurricane season continues to impact production of gas from the Gulf of Mexico. Here’s an updated chart showing US gas production shut-ins.

Although the media has long since moved onto other issues, there are still nearly 3.4 billion cubic feet (bcf) per day of natural gas production shut in as a result of Hurricanes Gustav and Ike. Total cumulative shut in since the disruptions began in late August now total 155 bcf. Before the disruptions are finally worked out of the system, these storms are likely to cost the US between 175 and 200 bcf of production.

I find it absolutely puzzling that the media seemed to gloss over both storms, categorizing them as largely non-events. Consider that in June of this year, the EIA released a report on hurricane outages listing the total production outage for each hurricane to affect the Gulf going back to 1995. According to this report, only Hurricanes Katrina and Rita had a larger impact on natural gas production.

At any rate, check out the chart of natural gas inventories below.

This is a standard chart of US natural gas inventories, illustrating the five-year average levels, the five-year maximum and five-year minimum. Despite the strongest production growth in decades, US gas inventories have actually normalized significantly this year.

At the beginning of 2008, inventories were still at or above the high end of the average range. We fell to below-average levels in midsummer and then saw a rise to as much as 102 bcf above average after a cooler-than-normal August. In light of recent hurricane disruptions, however, inventories are back down to just 32 bcf above average. When you consider that total US gas inventories are close to 3 trillion cubic feet (3,000 bcf), this is an insignificant deviation from average.

Last week’s inventory report was extremely bullish for gas, although it was ignored in light of the ongoing turmoil in credit markets. US inventories built by 51 bcf against expectations for around 65 bcf and an average of 77 bcf for this time of year. This is unlikely to be the last bullish report.

Up until now, some of the Gulf of Mexico gas production shut-in has been offset by milder-than-average weather and severe power outages caused by the very same storms in the Houston area. But moving forward, production shut-ins will continue to have an impact even as demand headwinds dissipate. And by mid-October, attention will turn from production to the outlook for the key winter heating season. As I’ve stated for some time, I’m looking for inventories to close out the season at–or just slightly above–the five-year average.

And don’t forget that there’s a huge difference between production growth on paper and actual gas coming out of the ground. What I mean is that producers seem to be gaining efficiency and experience in producing unconventional reserves, but it still takes years for the necessary pipelines, processing facilities and storage to be built to handle all that production. This is an extremely important point that I highlighted at some depth in the Aug. 20, 2008, issue, The Natural Gas Boom.

Another clear indication of this ongoing problem is what’s known as natural gas basis differentials. Literally, basis differentials are a fancy way of saying that natural gas tends to trade at very different prices in different parts of the US. Here’s a current snapshot of natural gas prices in different parts of the US.

As you can see, gas trades at very different prices depending upon where it’s located. The official delivery point for US natural gas futures traded on the New York Mercantile Exchange (NYMEX) is the Henry Hub located in Louisiana. The Henry Hub price is the price you typically hear quoted on the news.

But this price isn’t anything close to the prices available in other parts of the US. Right now, for example, gas at the Opal Hub in Wyoming gas is trading at $3.33 per million British thermal units (MMBtu), less than half the current Henry Hub price. Meanwhile, New York gas trades at a premium to Henry Hub.

The reason has to do with infrastructure. Opal is located in the Rockies, and there’s extremely limited capacity to store gas in this region. In addition, there just aren’t enough pipelines in the area that can carry large quantities of gas east to markets like Henry Hub.

Therefore, gas tends to well up in the Rockies leading to a regional oversupply and falling prices. A simple measure of this problem can be seen in the chart below.

This chart shows the premium of Henry Hub gas prices over Opal. What you can see is that there have been several periods in which spreads have exploded to unusually large levels and other periods in which spreads have narrowed. 

For example, spreads collapsed in early 2008 after Kinder Morgan started to ramp up throughput on its Rockies Express (REX) pipeline. This huge pipe connects the Rockies with the Mid-Continent and, eventually, eastern markets. When the pipeline came online early this year, it offered another outlet for Rockies gas.

But the pipe is now basically running at capacity, so gas is once again welling up in the Rockies. To make matters worse, Kinder Morgan has temporarily shut off sections of REX to effect changes necessary to slightly boost capacity. This shutdown has caused gas to well up in several trading hubs across the US.

The spreads also tend to explode in summer. That’s because local heating demand in the Rockies offers one outlet for gas in the winter months; when heating demand falls in summer, all producers look to export their gas to other parts of the country. This is when the regional glut gets worse.

My point in all of this is to highlight the crucial importance of infrastructure. Just because a particular unconventional field is prolific and producers know how to drill wells doesn’t mean there’s pipeline and storage capacity sufficient to meet demand. This is one limitation on growth in shale production to which all-too-few pay attention.

Moreover, based on comments I hear from producers, services firms and contract drillers I believe the marginal cost of US gas is about $7 to $8 per MMBtu. Current prices on NYMEX are probably at or around that marginal cost; in other words, some higher-cost producers won’t be able to sustain drilling activity with gas prices this low.

And you can imagine the economics for producers in some of these glutted hubs. Not many producers can make money with gas at $3 or $4. My point is that I disagree with expectations from some analysts that gas prices will slip down into the $6 to $6.50per MMBtu region on NYMEX due to a surge in US production and a glut of gas.

My view remains that, even at current levels, the US rig count will fall and production growth will begin to moderate. Producers are unlikely to drill themselves into oblivion and a huge glut. Gas prices will need to remain in the $9- to $11-per-MMBtu range to sustain anything close to current production growth and drilling activity.

Chesapeake Announcement

I also believe that the market has largely misinterpreted an important business update and announcement from the largest E&P in the US, Chesapeake Energy.

The company has decided to take what amounts to two steps. The first is to shut in roughly 125 to 150 million cubic feet (MMcf) of gas production in Oklahoma. This gas production is being shut-in because wellhead prices are very low. The reason for this is exactly what I described above: This region is infrastructure constrained.

This really isn’t a totally new move for Chesapeake. The firm has shut-in production in the region temporarily before. It’s one of Chesapeake’s more marginal plays. And if gas prices rise back over the $10-per-MMBtu mark for some period of time, Chesapeake can always restart this production relatively quickly.

In addition, Chesapeake is cutting its capital spending plans by about 17 percent ($3.2 billion) between the second half of 2008 and the end of 2010. Of this total, $1.9 billion is a direct reduction in drilling activity; the remaining total is simply a reflection of recent deals Chesapeake has closed to sell off stakes in some of its plays and operate certain wells as joint ventures.

The effect of this reduction in capital spending will be two-fold. First, Chesapeake is laying off rigs; in other words, the company will reduce the total number of rigs it uses in drilling operations. And second, Chesapeake is cutting its production growth guidance from an annualized 19 percent to a still-impressive 16 percent. This reduction in spending coupled with still-strong production growth will generate significant excess cash flows. Chesapeake plans to redirect this cash to debt reduction. Debt should fall by at least $2 billion over the next two years.

Chesapeake’s stated rationale for the move was that current gas prices are too low to sustain production at current levels. Chesapeake makes money with gas trading near the current quote, and the company has hedges covering roughly 70 percent of its projected 2009 production and close to half of its 2010 production. These hedges lock in prices above $9 per MMBtu for Chesapeake in those years. As CEO Aubrey McClendon put it, Chesapeake makes a lot of money with gas at $9 to $11 per MMBtu.

Chesapeake went on to state that it believes that natural gas production growth could outpace demand growth over the next two years as producers “cracked the code” on  producing unconventional plays. It will take at least that long for new sources of gas demand to emerge. It appears that the two leading candidates for new demand sources in Chesapeake’s view are compressed natural gas (CNG) and LNG export capacity.

CNG is just natural gas that’s used to power vehicles as replacement for conventional gasoline. At current prices, CNG would trade at about half the price of conventional gasoline. It produces more than 80 percent lower emissions of pollutants like sulphur dioxide, nitrous oxides and particulate matter. CNG also looks like a viable alternative in light of carbon dioxide (CO₂) regulations being imposed around the world; CNG emits about half the carbon of conventional gasoline.

Despite these advantages, I seriously doubt you’ll see widespread use of CNG in passenger cars for at least five years. Building out the stations and infrastructure needed to support passenger cars running on CNG is a daunting task. However, CNG proponents such as T. Boone Pickens really aren’t focusing their attention on the passenger car market near term but on long-haul trucks (18-wheelers) and fleet vehicles such as buses and taxis. Building out infrastructure to support these commercial markets would be far easier. This would also be a huge source of additional demand for gas produced in the US.

Another leading possibility is an LNG export terminal. Such a facility would allow US gas to be converted into a liquid form and shipped overseas to take advantage of much higher prices abroad. EU countries are currently extremely dependant on imported gas that’s primarily sourced from Russia. Although Russia will remain a key supplier, some nations are building out LNG import capacity in an effort to diversify supply sources; US LNG shipments would prove an attractive option.

The US has only one LNG liquefaction terminal, which is located in Alaska. Ironically, the country has a large number of LNG import terminals; up until about two years ago, the US was expected to face an increasingly large shortage of gas, not a glut.

Building an export terminal is expensive, and permitting such a facility would face issues especially from the normal Not in My Backyard (NIMBY) crowd. However, Chesapeake pointed out there are already plans to build a liquefaction plant in Canada; US gas exports could be handled through that facility. In addition, permitting a plant just across the border in Mexico might be easier.

Chesapeake suggested that it’s pursuing this option seriously. It’s hard to handicap the odds of an LNG export terminal in the US, but the longer overseas prices remain elevated, the more likely such a deal will be announced. This, too, would be a key source of demand for US producers.

The bottom line: Until CNG and LNG exports start to generate faster demand growth after 2010, Chesapeake sees the potential for prices to drop below marginal cost levels periodically amid fears of overproduction and oversupply.

Some viewed Chesapeake’s announcement as bearish and an indication that a big gas glut is coming as unconventional gas production ramps up faster than new demand. Some analysts continue to suggest gas prices are set to collapse to the $6-per-MMBtu region; based on current valuations, many gas-levered companies are already trading as if gas were priced in that range. I take a different view on this altogether.

Specifically, Chesapeake’s move is a clear indication that US producers aren’t going to drill themselves into oblivion. Chesapeake has one of the most attractive and lowest-cost acreage positions of any producer in North America and hedges covering production at much higher prices; however, Chesapeake is cutting back on production to head off the chances that there will be a glut. This is remarkably disciplined behavior for the largest producer in the US.  

Based on Chesapeake’s comments, it also appears that other producers are remaining disciplined. The company noted during a lengthy conference call after the announcement that it wouldn’t be surprised to see the US gas rig count fall by 200 to 400 rigs before yearend. In addition, there’s already evidence in August drilling permit data that producers are cutting back. Chesapeake is the first big producer to announce a drilling activity cut, but it’s unlikely to be the last.

Because just a handful of producers control the most attractive unconventional plays, drilling and capital spending decisions by these firms can have a large and real impact on natural gas supply. Based on Chesapeake’ comments, it’s clear to me that these producers will scale back their plans when prices fall much below $8 per MMBtu in order to head off the potential for a glut. I just don’t see evidence that these big companies would keep producing at maximum rates even as gas falls below marginal cost levels.

Don’t misunderstand me. I’m not looking for $20-per-MMBtu gas next year. But I do expect a rational pricing environment in which natural gas prices average in the $9- to $11-per-MMBtu range.

Moves to the mid- to upper half of that range would prompt producers to drill more aggressively and hedge their production; this will keep a lid on price rallies. But moves into or below that magic $7- to $8-per-MMBtu marginal cost zone will very quickly result in announcements such as we saw from Chesapeake last week. In my view, many on Wall Street are simply too focused on the shale production glut argument, and much of this fear is already priced into stocks such as Chesapeake and TES portfolio holding EOG Resources. This leaves room for a sizeable upside surprise.

After 2010, the environment could change meaningfully. The key will be how much new demand we see come on-stream as a result of CNG and LNG projects.

Over the past several issues of TES, I’ve highlighted several important long-term trends for the oil, natural gas and other energy markets. I’ve also examined a number of well-placed stocks to play each of these trends. I see little real fundamental change in prospects for most of these firms despite sometimes sharp price declines resulting from recent financial market turmoil.

However, in light of the still-volatile market, I continue to recommend focusing on a handful of the best-placed, highest-confidence stocks. I continue to look for an opportunity to get more aggressive; I’m monitoring the technical factors and indicators that I explained earlier in today’s issue.

Once again, here’s my current table of Fresh Money Buys, explained in the last issue of TES.

The first seven recommendations are my top plays on some of the most exciting long-term trends in the energy markets. The final three picks are designed to perform well if oil prices drop a bit further near term or are stable through yearend.

I explained my rationale on each in the last issue of TES. Here’s a brief update on two that have been in the news.

Nabors Industries (NYSE: NBR)–Nabors is a contract land driller, meaning that the company leases land drilling rigs to producers in exchange for a daily fee known as a day-rate. The stock has, like most energy names, been hit by the unstable broader market action. However, it’s fair to say that Nabors reacted negatively to Chesapeake’s recent decision to reduce its capital spending plans.

The reason for that negative reaction has some logic. The US onshore rig count is currently hovering around 2,000 rigs. If Chesapeake is correct about 200 to 400 rigs being laid off–taken off active duty–in the next three months, it would be a 10 to 20 percent reduction in the US rig count. That spells more idle rigs competing for fewer jobs. Day-rates could be expected to fall.

I would bring up two counterarguments, however. First, not all land rigs are created equal; many of the hottest unconventional shale plays in the US require the use of more powerful, more capable rigs. These rigs offer more than 1,000 horsepower and are needed for deeper drilling operations.

In Chesapeake’s conference call, the company was careful to note that it’s continuing its aggressive drilling plans in the Haynesville and Fayetteville Shales as well as in the Marcellus Shale. See the Sept. 3, 2008, issue, Unlocking Shale, if you’re unfamiliar with these plays.

The rigs Chesapeake is laying off seem to be coming mainly from higher cost conventional fields, not the hot shale plays. In addition, Chesapeake appears to be starting the process of winding down its activity in the Barnett Shale in recognition of the end of rapid production growth in this play, which I discussed in the Aug. 20, 2008, issue, The Natural Gas Boom.

My point is that, although Chesapeake wouldn’t identify the rigs it’s letting go, it’s logical to suppose that they’re mainly less-capable, lower-horsepower rigs–not rigs that would be used to drill in Haynesville.

Nabors, like all drillers, owns a mixture of rigs, and Chesapeake’s announcement suggests that these rigs might see day-rate pressure. But Nabors is heavily weighted toward newer, more capable rigs including so-called “fit for purpose” rigs that it builds specifically for a certain play. Demand for these rigs should remain strong as producers idle conventional production and focus on shale.

Second, remember that close to one-half of Nabors earnings will soon come from international land drilling operations. These rigs typically target oil and are contracted under long-term deals at attractive day-rates. Nabors may well have the ability to move any high-horsepower US rigs that are laid off to overseas markets.

Bottom line: Nabors overreacted to Chesapeake’s announcement. Unless the company reveals a major disappointment when it reports earnings next month, the stock has upside to the mid- to upper $40s in the context of a fourth quarter rally. Buy Nabors Industries.

For the record, I’d be more worried about Patterson Utility Energy (NSDQ: PTEN) in light of Chesapeake’s announcement, a land driller with a less attractive base of rigs than Nabors and less exposure abroad.

A second firm to keep an eye on is Enterprise Products Partners (NYSE: EPD), a master limited partnership (MLP) that owns a wide variety of natural gas infrastructure assets. Like all MLPs, Enterprise does carry significant debt–close to $8 billion relative to a market cap of $11.2 billion. This is why MLPs such as Enterprise have been hard hit and remain volatile during the credit panic over the past two days.

I did a quick study of the Alerian MLP Index, an index that covers all of the leading MLPs in the US. I did a statistical regression to identify the correlation between this index and the TED spread I discussed above. What I found was fairly amazing: The two are negatively correlated with a statistical significance of 99.1 percent, based on data from July 1, 2007, through the present.

In plain English, that means that when the TED spread rises, MLPs tend to get hit. The correlation is evident in the data to enough of an extent that it’s unlikely to be due to random luck.

If I’m correct about the bailout bill helping to stabilize credit markets and the TED spread, this should be a big positive for Enterprise and other MLPs. If not, Enterprise remains a safe haven in the sector with one of the lowest debt burdens of any MLP.

Meanwhile, much of the company’s debt isn’t due to mature for years. There’s no cash crunch on the horizon. The current environment offers a great opportunity to buy Enterprise Products Partners at a deep discount and collect the 8.1 percent tax-advantaged yield.

If the markets stabilize and look ready to embark on a fourth quarter rally, two major groups will top my list of go-to stocks.

First, the action in coal stocks continues to surprise me. This group has been slaughtered in recent weeks despite ongoing bullish fundamentals I explained in the last issue of TES.

Even better, several East Coast coal producers have recently announced production shortfalls. These firms just aren’t able to produce as much coal as they would like. Keep in mind that these producers are trying. Coal export prices remain highly attractive at the current time.

However, shortages of skilled labor, a host of new government regulations and thinning coal seams are all impacting production growth. This will tend to keep the US coal market tight and prices elevated. Peabody Coal (NYSE: BTU) remains my favorite in this group. I’m looking to add this stock back to the portfolio after we were stopped out for a profit last month.

Second, I’m looking for more US natural gas exposure. I highlighted my outlook for gas prices above. It’s also worth noting that, in recoveries from panic selloffs in the past, the energy patch has tended to outperform the broader S&P 500. Within the energy patch, gas-levered names have tended to see the fastest and largest upside. Petrohawk Energy (NYSE: HK), highlighted in the Aug. 20 issue, is among the top plays on my list.

Whether John McCain wins the White House and expands domestic oil exploration or Barack Obama becomes the first African-American president and spends billions to build a green future, energy will be the focal point of the next administration’s efforts.

I’ll be leading KCI Communications’ first-ever interactive energy summit Oct. 15, 2008, at 2 pm ET. Join me for my webinar, “Power Up Your Portfolio with Energy,” by registering at www.kci-com.com/webinar.

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 of 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.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Roger Conrad, Gregg Early and Neil George.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.