Warren Buffett isn’t a market-timer, and he’s admitted on numerous occasions that he’s not great at predicting short-term events. Nonetheless, from a longer-term perspective, investors would do well to follow his basic contrarian discipline of buying stocks when others are fearful and selling when others are greedy.

As I’ve noted over the past few issues of The Energy Strategist, investors in the energy patch have clearly moved beyond fearful and into panic mode. Valuations for even the best-placed, most well-established companies in the space are sitting at levels unseen since the late 1990s when oil prices collapsed to around $10 per barrel.

In this issue, we’ll take a more detailed look at recent earnings releases from leading energy companies. It’s clear that there’s been some slowing in demand, and the credit crunch has had an impact on the fundamental business.

But the reaction in the stock market over the past three months goes well beyond even a worst-case scenario. Bottom line: Many energy-related stocks are pricing in a severe recession and a drop in earnings despite the fact that all fundamental signs still point to growth in 2009–albeit at a more modest pace.  

Recent action in the broader markets is reminiscent of sentiment characteristically seen near market lows. The short-term outlook for the energy patch is much better now than it was during the bear market in 1998 and 2002. See The Short Term.

I explore ongoing trends in the oil services business and, on a broader level, international oil and gas drilling activity. I also provide a rundown of my key conclusions gleaned from Schlumberger’s recent conference call. See Oil Services.

There’s one commodity that reigns supreme during even the most severe economic downturns because most people focus on generating power as cheaply as possible throughout such slumps. See The Recession Commodity.

In the current capital-constrained market, smaller players with little to no experience simply aren’t going to have a chance to compete in the land rig business against larger, more dynamic companies. I offer a peak into one of the most successful players in the business and explain how it continues to land contracts and capitalize on growing demand for rigs overseas. See Contract Drillers.

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

• Schlumberger (NYSE: SLB)
• Transocean (NYSE: RIG)
• Seadrill (Oslo: SDRL, OTC: SDRLF)
• Weatherford International (NYSE: WFT)
• Peabody Energy (NYSE: BTU)
• Norfolk Southern (NYSE: NSC)
• Nabors (NYSE: NBR)

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

• CGG Veritas (NYSE: CGV)
• ION (NYSE: IO)
• Rowan (NYSE: RDC)
• Ensco (NYSE: ESV)
• Pride International (NYSE: PDE)

In addition to the longer-term valuation arguments I’ll detail below, I’ve also been looking for a short-term turn in the energy patch followed by an impressive rally through yearend. In the Oct. 1 issue of TES and the Oct. 10 issue of The Energy Letter, I outlined the signals I’ve been looking for to identify a low.

I believe the low for most energy stocks is now behind us, and the end-of-year rally is underway. There’s been a normalization in the credit markets over the past few days that suggests interbank lending conditions are improving. Meanwhile, investors remain jittery and fear levels are high. This is just the sort of sentiment you typically see near market lows.

I’m looking for the Philadelphia Oil Services Index (OSX)–a good overall proxy for energy stocks–to follow a pattern similar to what happened in 1998 and again in 2002. Here are charts showing the action during those times.

As I’ll detail later on in today’s report, the fundamental outlook for energy remains far better today than it was in either 1998 or 2002. That said, on a pure price and a valuation basis, energy stocks have corrected just as sharply this time around as they did back then.

As you can see, after a correction of about 60 percent from the highs, the Oil Services Index saw a massive rally. Although there were some pullbacks and retests in both cases, both gave way to a new bull market in the group that was tremendously profitable for investors.

Here’s a closer look at the current action in the OSX.

This chart is remarkably similar to the 1998 and 2002 cases. I suspect we’ve seen the lows of the move and are now setting up for a broad general rally. To profit from the move, the key is to be selective; I highlighted a few of my favorite stocks and sectors in yesterday’s flash alert and in today’s issue below.

I’m also going to focus increasingly on energy stocks that are fundamentally unattractive. I suspect we’ll have opportunities to play the downside in some of these names next year. In addition, with the financial panic now easing, I’m looking for investors to once again become more selective about which stocks to buy; avoiding the losers will be just as important as picking winners.

Long-time TES readers know that I regard Schlumberger as a top-notch indicator of ongoing trends in the oil services business and, more broadly, international oil and gas drilling activity. Not only is the firm active in just about every imaginable market, but management has a history of hosting detailed conference calls. I always pay close attention to what Schlumberger has to say and, as usual, this quarter’s call was instructive.

Given the global credit crunch and the decline in oil and natural gas prices over the past few months, I went into the Schlumberger call looking to hear more about the potential impacts of these factors on the services business.  Particularly, I was looking to hear more about demand and growth potential outside of North America in light of ongoing financial and economic turmoil.  

As long-time readers are already aware, the North American services business is highly volatile and can turn on a proverbial dime. Producers in the region tend to be smaller, independent exploration and production (E&P) firms; the projects they’re pursuing are sensitive to commodity pricing.

To give you an idea of just how volatile this market can be, the environment was very weak for most of 2007 thanks to weak gas pricing. Early this year, the market turned as gas prices soared back into the teens. Since early July, the market has turned lower again as gas prices have once again receded to less than the roughly $7.50- to $8-per-million-British-thermal-units (MMBtu) range where many smaller producers become unprofitable. 

It should come as no surprise that there’s been an impact on North American drilling activity due to falling US gas prices. I highlighted at some length Chesapeake’s planned cutbacks in the most recent issue of TES, Energy Stocks Watch Washington. Since Chesapeake made that announcement, others have followed suit, including Petrohawk Energy. Given continued weakness in prices, more gas-focused drillers will undoubtedly follow, and I expect to hear more about this issue as earnings are released over the next few weeks.

Although North America is expected to be volatile, international activity has been much more dependable in recent years. This business carried the day back in 2006 and 2007, even when gas prices in North America slumped. This is why I was keen to hear what Schlumberger had to say specifically about international demand.

Bottom line: Schlumberger roughly met its earnings and revenue expectations, but its guidance and the general tenor of the call were cautious. That caution certainly applied to the North American market in a big way but also extended to some key international markets.

There’s been an impact on Schlumberger’s international growth outlook resulting from the recent downturn in energy prices and credit markets. Given the rapid deterioration in market and credit conditions since early September, management’s cautious comments are entirely unexpected.  

But, this caution doesn’t change my bullish outlook on Schlumberger for two simple reasons: The stock is already trading at valuations that more than discount a weakening growth outlook for 2009, and long-term growth dynamics remain intact. As I’ve written repeatedly over the past two months, Schlumberger’s valuation–like that of many other energy-related stocks–is stretched far to the downside.

Although there’s increased uncertainty about near-term growth prospects, most of the decline in the stock since the end of summer has been due to panic selling rather than fundamental deterioration. As Buffett alluded to in his op-ed, fear and loathing on Wall Street are good news for investors, offering an opportunity to buy the premier global services firm at a discounted price.

Here’s a rundown of my key conclusions gleaned from the Schlumberger call:

Schlumberger’s Cash and Credit Position is Second to None–In a market where investors are worried about any debt or counterparty risk whatsoever, a company like Schlumberger should trade at a premium. Management noted that the company had $4 billion in cash and investments at the end of the quarter and $2.1 billion in undrawn debt facility agreements. 

Total debt net of cash is $1.7 billion relative to a market capitalization of close to $65 billion. Meanwhile, Schlumberger met its capital spending plans, paid down debt and bought back stock in the quarter while still adding to cash. In a “normal” market I wouldn’t even bother to bring this up, but given the action of the past six weeks, this is a bullish point.

Based on management comments, it does sound like Schlumberger might slow its buyback plan and build cash given the current market environment. That cash could also be deployed on acquisitions, given the fact that Schlumberger said current valuations are yielding some opportunities.

Weak Economic Growth and the Credit Crunch Will Have an Effect–As I noted earlier, the impact in North America is fairly obvious and shouldn’t be a huge factor for Schlumberger because it has less exposure to North American gas markets than many in its peer group such as Halliburton.

The big change in language out of Schlumberger pertains to international markets. Check out this exchange during the company’s question and answer (Q&A) session:

Analyst: …just want to understand a little bit better your thoughts as they are today. Maybe six months ago you were looking at international as a 15 to 20 percent top line [revenue] growth market for you guys in 2009…are we at a single-digit growth now, [or] is it a few hundred basis points softer kind of ballpark?

CEO Andrew Gould: …I am sorry, I don’t know. We’re going to take this quarter by quarter, but today I have a little bit better visibility on North America because you know as well as I do what’s been happening every day. But on overseas, I just don’t have a good visibility to allow me to look at a number.

Source: Schlumberger Third Quarter Conference Call, Oct. 17, 2008

To put it simply, Schlumberger clearly sees that there will be an impact on growth in its international business, but it has little idea of how to quantify that impact.

Schlumberger does offer a bit more detail. Specifically, the company identifies North America as the biggest problem market. In addition to North America, Schlumberger notes that there are a large number of small-cap E&P firms operating in mature areas of the North Sea and in parts of Africa. Many are listed on London’s Alternative Investment Market (AIM) and need access to debt or equity markets to expand drilling plans. These firms are also vulnerable to the credit crunch.

But Schlumberger also said that Organization of the Petroleum Exporting Countries (OPEC) demand would likely hold up for at least a year after oil and gas prices began falling. And Schlumberger also noted that it’s currently looking for a slowdown in the rate of growth in spending for its customers, not an outright decline in spending.

Seismic Market Slowdown–One service market that received considerable attention during the call was seismic services, the use of sound and pressure waves to map underground reservoirs and rock formations. The basic tenet of the discussion was that seismic services are among the first areas to see a slowdown in growth when exploration spending slows.

Here’s a quote from CEO Andrew Gould that summarizes this concern aptly:

…I think the seismic business will undoubtedly be affected but there are two ways that it can be affected. The first way is that operators decide to slow programs in which case it will be moderately affected, not catastrophically. The catastrophic scenario is that they start going into M&A [merger and acquisition] activities. So if my customers start buying each other then they shut exploration down altogether for a year or so you know while they evaluate the portfolios and then re-decide what they’re going to exploit…

Source: Schlumberger Third Quarter Conference Call, Oct. 17, 2008

As I’ll explain in greater depth in a moment, the latter “catastrophic” scenario would likely end in an even bigger upturn in commodity prices than the moderate downturn scenario. However, looking only at seismic, it does appear fairly clear that there will be some sort of a downturn in 2009.

This isn’t a huge problem for Schlumberger. The company is conservative about investing in multi-client seismic surveys–databases of seismic shoots that can be sold to multiple clients–and typically only does such shoots when it has guaranteed revenue to back up the up-front investment needed. In addition, seismic is only one aspect of Schlumberger’s business, accounting for about 13 percent of revenues.

Long term, the outlook for seismic demand is rock solid. After all, operators in deepwater and other complex environments need seismic to pinpoint fields and place wells properly. Seismic is a core part of my long-held “end of easy oil” thesis described at length over the past few issues.

But short term, Schlumberger’s comments suggest potential downside pressure for pure-play seismic firms. I place France-based seismic giant CGG Veritas (NYSE: CGV), a company that I once recommended in TES, among that group; we were stopped out several weeks ago at much higher prices. Given Schlumberger’s comments, I’m changing my rating on CGG Veritas to a hold in my “How They Rate” coverage universe. The only reason I’m not rating the stock as a sell is its valuation and the potential for a massive fourth quarter rally in the general energy patch.

I also recommend avoiding ION (NYSE: IO). The company sells advanced equipment used to perform detailed onshore and offshore seismic shoots. Ultimately, ION owns some interesting technologies that offer real benefits and are likely to catch on among producers.

But if the seismic business does see even a modest slowdown, this won’t be good news for ION. I’m cutting the stock to a sell in How They Rate.

Credit Crunch and Startups–There are some beneficial effects stemming from the credit crunch for established firms such as Schlumberger. Chief among those is that some of the drilling rigs, seismic ships and equipment once scheduled to come to market over the next few years is now unlikely to enter the market.

The reason is simple: The construction of this equipment was financed by small startup firms that are, in turn, reliant on debt capital. Big companies with an established business can get access to credit at the current time; small startups can’t.

I highlighted this point in yesterday’s flash alert, Get Ready for an Energy Rally, with respect to drilling rigs. Specifically, Brazilian national oil company (NOC) Petrobras planned to use rigs from a handful of Brazilian and Norwegian startup firms to pursue its aggressive deepwater development plans.

For those unfamiliar with Brazil’s deepwater market, the country has recently made a series of discoveries in what’s known as a “pre-salt” layer located under water about two miles deep. Although these fields promise to be among the largest discovered anywhere in the world over the past 20 years, they require the most advanced ultra-deepwater rigs to access.  

There’s an acute shortage of such rigs globally, and shipyards are so busy that there are few opportunities to add to the supply of ultra-deepwater rigs over the near term. This is why Petrobras signed contracts with startups to build and manage ultra-deepwater rigs for work after 2011; this is when the country had hoped to begin developing its massive deepwater reserves in earnest.  

But those rigs are now unlikely to get built until the shipyard spots–basically time on a construction calendar–can be reallocated to existing players with a more established business. The startups just can’t borrow the billions of dollars needed to fund a drilling rig construction project even though they have a signed contract with Petrobras effectively guaranteeing them revenue.

It isn’t just rigs. Schlumberger noted that it’s hearing from smaller services companies in the US looking to sell equipment such as pressure pumping units. This is equipment used to handle the hydraulic fracturing work I described in the Sept. 3, 2008, issue of TES, Unlocking Shale. Many of these small firms are startups dependant on debt financing; in the current environment, much of this equipment is likely to get purchased by established players at fire-sale prices.

Bottom line: The credit crunch does favor companies such as Schlumberger and established contract drillers such as Transocean and Seadrill; these firms will be around to grab the equipment and rig construction slots left open by distressed startups. To say the very least, I don’t see them paying top dollar.  

I continue to rate Transocean a buy in my How They Rate coverage universe for now, and I’m eyeing the stock for potential addition to the TES portfolios over the next few weeks. Seadrill is already recommended in my aggressive Gushers portfolio.

Continued Supply Issues–From a big picture standpoint, Schlumberger’s comments on long-term oil supply constraints represent the most interesting takeaway from the entire call.

The same basic point was reiterated in the CEO’s prepared remarks and a total of five separate occasions during the Q&A session. In fact, Schlumberger has made the very same point before in various conference calls. Simply put, if global oil producers cut back on exploration and development spending, the result will be a major impact on global oil supplies. This will mean that as soon as demand stabilizes and turns higher, there simply won’t be enough supply to meet all that demand. This will accelerate the price spike.

This is why, as I alluded to earlier, any drop off in spending on seismic exploration work would ultimately lead to a drop in production and an even more extended up-cycle.

Here’s one quote from Gould on this issue:

Gould: …I am now going to restate the caveat. And that is that the supply balance is extremely fragile. Nobody knows how deep the drop in demand is going to be but there is a limit to the drop in demand unless we have a sort of worldwide depression that’s going to last 10 years….if they [producers] shut down workover activity, non-OPEC production is going to start sliding even faster than it is at the moment. And to the extent that they shut down exploration now, they are going to increase the reserve replacement problem that the customers already have, And I am not just talking about IOCs [integrated oil companies], I am talking about everybody, So to the extent that they shut everything down, which they may well do, the recovery is going to be always stronger at the first sign demand is picking up again.

Analyst: If oil demand is flat for the next several years, how long do you think it will take until it’ll be back in balance?

Source: Schlumberger Third Quarter Conference Call, Oct. 17, 2008

In other words, if producers stop pushing production at mature fields, production will rapidly decline. As long-term readers know, global producers are already dealing with higher-than-expected decline rates in existing fields.

A classic example is Cantarell, Mexico’s giant field; the field produced more than 2 million barrels per day (bbl/d) in 2004 and now producers less than 1.5 million bbl/d. At that rate, production will plummet below a half million bbl/d by 2015–with devastating consequences for Mexico’s overall production and exports.

The second point is the time frame that Gould posits. The analyst asks how long it would take for the oil market to rebalance if demand is flat next year. Keep in mind that there’s no one currently looking for flat global demand growth in 2009. The International Energy Agency (IEA), for example, currently expects 440,000 bbl/d of growth in oil demand for 2009, and the US Energy Information Administration (EIA) expects 800,000 bbl/d. Therefore, flat demand is a bearish scenario.

But even under that bearish scenario, Schlumberger believes that a drop in exploration and development spending would quickly drag down supplies. This would have the effect of retightening the global oil market within a year-and-a-half from now.

As I’ve noted on a few occasions in TES, investors are currently focused solely on demand for oil. The reality is that supply will eventually be an even bigger issue. My base case is that the drop off in US oil demand begins to moderate next year amid lower prices and a stabilization of the economy in the latter half. Meanwhile, I suspect we’ll see continued growth in demand from developing nations; the offshoot will be slow but positive oil demand growth that begins to pick up with global growth toward the end of the year.

On the supply side, I do see a slowdown in spending growth that leads to disappointing supply growth, particularly outside OPEC. The end result: As demand stabilizes and the global economy recovers, $150-per-barrel oil is back in play by early 2010, if not sooner.

With respect to Schlumberger, my rationale for owning the stock remains the same. Spending on services is slowing, and the problem has spread from North America to a handful of other nations with significant production coming from smaller producers. As a result, Schlumberger has little visibility overseas.

But for the foreseeable future, markets such as the Middle East should remain relatively robust. The same can be said of deepwater developments; a series of new deepwater and offshore rigs are scheduled for delivery over the next 12 to 18 months.

Since these rigs are primarily owned by established contract drillers, I believe the rigs will actually hit the market unlike the rigs slated for delivery from Brazilian startups. Most are already contracted on long-term deals at high day-rates; producers will go ahead with those projects. Deepwater projects are service-intensive and that bodes well for Schlumberger’s high-tech product mix.

In North America, the rig count–total number of rigs actively drilling for oil and gas–will decline by 400 to 600 rigs by mid-2009. This is largely due to the scaled-back gas drilling plans by some producers such as Chesapeake. However, as I noted in the last issue of TES, reduced drilling spells less production and higher prices. I continue to like the North American gas market here. This could be a better-than-expected market for Schlumberger in 2009. 

Finally, it’s all about valuation. Schlumberger is trading at the cheapest valuation since the late ’90s, even though the global oil market looks to be on firmer footing today than it was back then. Although there are valid concerns about short-term demand growth, the supply outlook is far weaker than it was 10 years ago. It’s harder to increase oil production now than it was then. Buy Schlumberger.

Smaller oil services firm Weatherford reiterated a number of points that Schlumberger made in its call. In fact, management at Weatherford actually referred indirectly to Andrew Gould’s comments; I won’t rehash all those points.

However, here are a few key additional comments of interest from the Weatherford call:

Less Exploration Exposure–Weatherford and Schlumberger are technically in the same industry group and do overlap in some businesses. However, Schlumberger has considerably more leverage to exploration-related spending by global E&P firms.

Weatherford’s traditional business strengths involve squeezing more oil out of existing fields or carrying out drilling projects on mature fields. Simply put, Weatherford is more heavily focused on development spending than exploration spending. In fact, the company noted that its contracted business in 2009 has no material exposure to exploration work.

I suspect this distinction accounts for Weatherford’s more upbeat conference call earlier this week. As Weatherford noted, exploration spending is the first area to get cut back when companies are looking to cut capital spending and drilling activity; an example of that would be seismic services.

Low Exposure to Independents Internationally–As I noted for Schlumberger above, it’s the small independents operating in markets such as Africa and the North Sea that are most likely to cut their spending plans. Established integrated oil companies and state-owned national oil companies typically don’t change their spending plans on a dime; they’re less sensitive to commodity prices and have little or no need to access the credit markets.

Weatherford obviously has heavy exposure to independents in the US and Canada because these firms dominate the drilling scene. But internationally, management estimated that only about 20 percent of its business is with independents.

Russia Caution Near Term–Like Schlumberger, Weatherford did express a bit of near-term caution concerning Russia. CEO Bernard Duroc-Danner stated:

I was optimistic on Russia until the credit crisis started. I remain, like my larger peer, very constructive on Russia long term for the reasons that you know, which is there are very few countries that have the hydrocarbon potential they have, end of story, whether oil or gas. Now, that will never change.

Now, with respect to the very near term, given the level of taxation, royalties, in Russia, unless that changes, it’s clear that the cash flow of our clients is being squeezed in Russia. So the prognosis on Russia is not as strong in 2009 as it was, clearly. On the other hand, if the powers that be change the royalty system in Russia, which they are likely to, but it’s not my decision, then I think the cash flow of our clients will not be as pinched, and I think things are possible. All in all I remain very constructive on Russia long term, and you’d have to be in my business.

For 2009, I’m cautious, and so what we’re planning for are things that we feel are very reliable, in terms of the need for the client to execute. We don’t plan on anything more than that.

Source: Weatherford Third Quarter Conference Call, Oct. 20, 2008

Just as with the North Sea and Africa, 2009 looks to be somewhat of a transition year for Russia. It appears that growth might slow and pause in 2009 under the current tax and royalty structure there.

That said, very much doubt the Russian government will allow a major retrenchment in their largest industry. There could well be some royalty and tax breaks in the pipeline in Russia that could help shore up or reaccelerate activity levels.

Locked-In Growth–During the prepared remarks, Weatherford didn’t temper its outlook for international growth in 2009. This is a major distinction to Schlumberger; as noted above, Gould essentially refused to predict international growth in 2009 due to the lack of visibility.

The first question Weatherford’s management fielded during the conference call was to explain why it didn’t see a need to get more cautious on 2009 international growth. The answer was simply that most of the company’s 2009 projects have already been negotiated and signed. The CEO estimates 80 to 100 percent growth.

There could certainly be some projects that will slip from 2009 into 2010, but this would appear to be a marginal problem at worst.

All told, my investment thesis for Weatherford remains similar to Schlumberger. There will absolutely be some slowdown in international growth in 2009, and North America faces some near-term headwinds. However, the issue appears to be more of a pause in growth rather than an outright collapse in spending. Spending from large national and integrated oil companies looks relatively solid.

Weatherford will benefit from its heavy exposure to development rather than exploration work. Meanwhile, Schlumberger will benefit from good leverage to highly-profitable deepwater projects scheduled to begin over the next 12 to 18 months.  

Meanwhile, Weatherford is trading at less than 7 times next year’s earnings estimates, the cheapest valuation in roughly a decade. This more than prices in any slowdown in demand for services overseas. Buy Weatherford at the current fire-sale prices.

When the economy is strong and the market is soaring, investors chat about new environmental policies and technology and the effect of these developments on various energy sectors. But when the economy is in a downturn, most people are simply focused on generating power as cheaply as possible. And there’s one commodity that reigns supreme in that regard: coal.

Mining giant Peabody Energy brought up an interesting point during its quarterly conference call last week. Specifically, Peabody noted that electricity is a staple and is less elastic to gross domestic product (GDP) that other commodities. In other words, consumers are far less likely to reduce their electricity consumption during an economic downturn than they are to cut back on oil use.

Peabody went on to quote a simple rule of thumb: A 1 percent decline in US GDP translated into roughly a 0.5 percent decline in total electricity demand assuming all other factors–such as weather conditions–are equal. And even that 0.5 percent decline in electricity demand overstates the impact on the coal markets. The reason is that coal plants are currently among the cheapest forms of baseload electricity generation available; these plants continue burning coal even as utilities shut down gas-fired plants and plants designed to meet peak power loads.

And consider what’s happening overseas. In China, the most bearish economic forecasts show the country’s economy growing at about 8 percent in 2009. This would translate into more than a 10 percent growth in electricity demand. Even though growth is slowing there, the country still needs to build plants at a record pace to keep up with demand; despite Herculean efforts, there are still blackouts periodically in parts of China when demand exceeds supply.

Peabody repeatedly called China “the world’s largest electricity market” during its call. That is an amazing statistic when you consider that the US has held that title for many decades, even if we account for the entire European Union as a single entity. China is overtaking the US now as the world’s largest electricity generator; analyzing trends there is more important than trying to forecast every twist and turn in the US economy.

Peabody highlighted the fact that the global coal markets remain solid. The company now estimates that US coal exports will top 85 million tons in 2008 and will be flat to slightly higher in 2009. This represents a somewhat more subdued outlook for 2009 than Peabody has previously projected; however, the US coal supply situation has worsened.

Several miners operating in the Appalachian region–the source of most US coal exports– have been unable to meet production goals because of difficult geological conditions, shortages of skilled labor and new government regulations that have increased their costs. Despite record-high coal prices in the first half of 2008, coal production from eastern mines rose less than 1 percent.

And the credit crunch is actually exacerbating the problem. According to Peabody, smaller miners in the east will be strapped for capital and just won’t have the cash needed to buy new equipment. For the small miners, expansions to take advantage of still attractive export prices are essentially out of the question.

Internationally, there are also supply issues. Peabody noted:

…Where new coal mines were planned to be built to respond to the growing [global] demand, we see that backing off quite a bit; we don’t see the availability of capital except for those with very strong balance sheets. So there’s a lot of projects put on hold and those are projects in Indonesia and Mozambique…

Source: Peabody Third Quarter Conference Call, Oct. 16, 2008

Peabody goes on to state that it doesn’t see China growing coal production fast enough to reestablish itself as a net exporter. The country will either be in deficit and forced to import large amounts of coal or will be close to a deficit and, therefore, unwilling to export.

The other sector to watch when gauging the state of the coal markets is railroads; companies such as TES recommendation Norfolk Southern (NYSE: NSC) move most of the country’s coal and offer the best window into ongoing trends in the business.

Both Norfolk Southern and CSX Corporation reported strength in their coal business; in fact, for both firms coal was the most impressive part of their business. Both firms highlighted continued strength in demand for hauling coal to export terminals; this backs up Peabody’s view of continued strength in the export market.

On the domestic front, CSX commented that utility coal stockpiles are currently running below year-ago levels, and the big utes are looking to add to their coal reserves ahead of the winter heating season. This also bodes well for robust demand domestically.

Of course, I’d be remiss if I failed to note that coal prices have declined since midsummer alongside the prices of all sorts of commodities. Here’s a chart of Big Sandy Barge Coal.

As you can see, the spot price of coal has declined sharply, though it remains well above year-ago levels and continues to trade around levels reached as recently as March. Some international coal benchmarks have declined even more sharply.

But the key point to note is that producers don’t really sell much coal in the spot market; it’s a contract business. Moreover, spot and futures market coal prices don’t always reflect the actual prices producers are able to get for their coal. Consider that Peabody stated:

…Generally you would expect the physical coal markets, the financial coal markets and, of course, the equities to be closely aligned. However, in recent months this relationship has become extremely disconnected. The easing in the physical markets has been magnified in the paper coal markets as banks and hedge funds have unwound their positions to preserve cash and fund redemptions, creating a large selling overhang unrelated to coal fundamentals.

Source: Peabody Third Quarter Conference Call, Oct. 16, 2008.

This is a fairly bullish statement in my view. Investors are clearly concerned about falling coal prices, but the reality appears to be that this is mainly a financial crisis issue rather than a glutted international or domestic coal market. Granted, coal markets have softened somewhat from ultra-tight levels early this year, but the decline in prices is hardly enough to warrant the massive selloff in stocks such as Peabody over the past few months.

Peabody is currently trading at less than 11 times projected 2008 earnings estimates. (It raised estimates at its conference call last week.) This represents the lowest price-to-earnings ratio for Peabody since going public earlier this decade.

This just doesn’t reflect fundamental performance. Peabody beat earnings and revenue expectations when it most
recently reported earnings and actually raised guidance for the full-year 2008. The company noted that it’s been signing contracts for its premium Powder River Basin (PRB) coal at a 50 percent premium to what it averaged in 2007. And Illinois Basin coal is faring even better, with realizations up 70 percent year-over-year. Peabody’s contracting activity in the US certainly doesn’t appear to be reflecting the weakness seen in coal futures and spot markets. The company has already committed a great deal of its expected US production for 2009, and pricing is better than 2008 levels.

Australian operations turned in an even more impressive result. Recent pricing activity out of this market has been running above April benchmark contract levels; coal prices in Asia are set in April. The company is clearly seeing some success in debottlenecking its coal export capacity from Australia.

Even better, Peabody is also rolling over 6 million to 7 million tons worth of legacy Australian coal contracts in 2009, far more than the 2.5 million tons rolled this year. These legacy contracts were priced years ago at depressed coal prices. As these are reset, pricing will improve.

Bottom line: It’s time to jump back into Peabody; I’m adding the stock to the Wildcatters Portfolio. Buy Peabody below 42 with a stop at 22.

Also note that strength in its coal-hauling business was one of the main positive factors behind railroad Norfolk Southern’s better-than-expected report released last night. Norfolk Southern remains a buy under 60 in the Wildcatters Portfolio with a stop at 41.

I highlighted my outlook for deepwater-focused drillers Seadrill and Transocean in my analysis of Schlumberger’s report above.

The bottom line: Weak credit markets have actually eliminated some competition for the established deepwater drilling contractors. Meanwhile, we have plenty of visibility into their earnings prospects, as most deepwater rigs are contracted years in advance and have been securing contracts at highly attractive day-rates.

As for land rigs, the main concern remains North America. Specifically, most North American onshore drilling activity targets natural gas and weak natural gas prices are prompting producers to scale back on their drilling plans. As I noted earlier in this issue and in the last issue of TES, I’m looking for roughly 400 to 500 rigs to come out of the North American rig count as a result of weak gas prices and drilling scale backs.

You might expect this would hurt a company like Nabors (NYSE: NBR), which leases land rigs in exchange for a daily fee or day-rate; after all, if demand for rigs is falling and the supply of idle rigs rises, you’d expect day-rates to fall as well.

But that’s a vast oversimplification of reality; Nabors has a differentiated business model. It’s true that when rig supply rises, day-rates fall. But that assumes all rigs are the same, which absolutely isn’t the case.

Although producers are cutting their drilling plans in conventional reservoirs, most of the big independent E&Ps continue to invest in promising shale plays such as the Haynesville Shale in Louisiana and the Fayetteville Shale in Arkansas; I described these promising plays in the Sept. 3, 2008, issue of TES, Unlocking Shale. The problem is that drilling efficiently in these shale plays requires the most advanced, most capable rigs on the market today.

So even as the market for less-capable rigs drops off, the supply of very powerful rigs remains tight. Better still, these rigs are often “built for purpose rigs,” designed for use by a particular producer on a particular play. They’re often secured under long-term contracts rather than priced on prevailing supply and demand conditions.

In Nabors’ quarterly report, the company noted that it’s received contracts for 36 of these fit-for-purpose rigs so far in 2008. Interestingly, 11 of those commitments came in the third quarter, even as gas prices plummeted.

Nabors believes that it will ultimately take 40 to 50 rigs out of active service because of the decline in drilling activity. That’s not a great deal when you consider that Nabors is among the largest land drillers in the US, and the US rig count is likely to contract by 10 times that number.

Even better, the rigs Nabors is taking out of service are older, less-capable rigs that tend to receive lower day-rates. Nabors can simply retire these rigs and cannibalize them for spare parts; alternatively, it’s possible some might find contracts overseas at solid prices. Bottom line: Nabors’ profit margins might actually improve as these low-margin rigs are scrapped and new contracts are signed.

In addition, I see the same basic positive dynamic working for Nabors as is the case for the offshore drillers. Basically, there have been a few companies trying to enter the land rig business. These undercapitalized players with no experience simply aren’t going to have a chance to compete with Nabors in the current capital-constrained market.

Finally, overseas demand for rigs appears to be solid. As I noted earlier, there’s some slowdown in markets in which Nabors participates, such as Russia. However, the weakness is likely to remain concentrated in exploration-related work, and that’s not really Nabors’ business. At any rate, in the call, Nabors stated that Russia’s outlook continues to look bright. Buy Nabors below 17 with a stop at $9.90. I can see this stock more than doubling in short order if I’m right about a fourth quarter rally.

The one area of the contract drilling market in which I do see the potential for considerable weakness is in international shallow-water jackup rigs. Day-rates for international jackup rigs have been solid in recent years, and contract drillers with exposure to the space have been able to contract rigs under attractive longer-term deals.

Not only is the supply of these rigs rising, but many are contracted by the smaller E&P firms in markets such as Africa and the North Sea. As I’ve explained, these are areas that will see the brunt of any decline in spending and activity for 2009. In fact, based on recent fleet status reports, we’re already seeing day-rates on international jackups turn lower.

The weakness may well expand to mess-capable floating rigs that handle work in waters too deep for jackups but are too shallow to require ultra-deepwater rigs. These rigs are often called mid-water rigs. 

As a result, I’m cutting firms in my coverage universe with exposure to these markets. The list includes Rowan (NYSE: RDC), Ensco (NYSE: ESV) and Pride International (NYSE: PDE). All three of these stocks are now rated as sells in “How They Rate.”

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 me and 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.