Economic conditions continue to sour, crude oil prices remain depressed and the stock market continues to languish. But amid this troubled market there are myriad opportunities. Specifically, the energy market is already pricing in the worst possible news for the economy and commodity prices offering investors the best bargains of the past decade.

We’re following a simple strategy in The Energy Strategist: buying stocks in beaten-down energy subsectors with strong long-term prospects and buying defensive stocks and preferreds that offer high income potential.

Macroeconomics may seem an odd topic for an advisory focused on energy, but the condition of the global economy is far more important right now than any firm- or subsector-related issue. We’re still working through the aftermath of the post-September 15 credit crisis, and concerns about growth color much of the trading activity we’re seeing these days.

And to the surprise of few, the body officially charged with making such determinations announced this week that the US is in recession and has been since December 2007. For a little context, see The Economy.

Natural gas has handily outperformed crude oil since the end of September. For more on why I favor the former, see Natural Gas Over Oil.

Balance sheet strength and a history of profitability during commodity-price downturns make Super Oils a good way to insulate your portfolio. For the detailed case, see Think Big for Defense.

The depressed environment for commodity prices has overshadowed the income potential for the master limited partnerships in my coverage universe. For more on how these companies offer strong income and potential distribution growth, see Portfolio Updates.

It’s finally official: The US is in recession and has been since December 2007. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) officially announced the start date for the recession on Monday after weeks of hinting that such an announcement was imminent.

Although this declaration undoubtedly contributed to Monday’s severe market selloff, it should come as little surprise for investors as the evidence was clearly mounting. Longtime readers know I follow the year-over-year change in the Index of US Leading Economic Indicators (LEI) closely; whenever the year-over-year change falls below zero, there’s a good chance a recession will follow. No indicator is completely infallible, but the LEI has flagged all major US contractions since the 1960s.

The LEI first dropped below zero in late 2007. For most of this year I’ve been looking for NBER to announce a start date for the recession either in late 2007 or early 2008.

And the LEI continues to deteriorate; there’s absolutely no sign that an economic recovery is at hand. Federal Reserve Chairman Ben Bernanke stated in a speech this week that the US economy “downshifted” when the financial crisis began to really bite this fall. This fact is reflected in recent economic data and, of course, in the US stock market. The S&P 500 was in a nasty but orderly decline prior to September but accelerated to the downside quickly as credit conditions deteriorated.

It does appear that the credit crunch has eased notably over the past few weeks, and the interbank lending market continues to open up. As a gauge of credit market health, I continue to follow the TED Spread.

This spread shows the difference between the three-month London Interbank Offered Rate (LIBOR) and the three-month US Treasury bill. LIBOR is the interest rate banks charge one another on short-term loans; when LIBOR spikes relative to Treasuries, it means banks are reluctant to lend to one another. The big spike you see on the chart above occurred around the time of the Lehman Brothers bankruptcy, an event that clearly shook confidence.

Since late October, the TED Spread has continued to moderate steadily, recently falling back to levels unseen since before the Lehman filing. There have been a few blips to the upside; the latest occurred when Treasury Secretary Hank Paulson stated that he would leave the remainder of the $700 Troubled Asset Relief Program financial “bailout” money for the incoming Obama administration to spend. The market interpreted that as a sign the government wouldn’t continue pumping cash into credit markets. The subsequent decision to inject more capital into Citigroup (NYSE: C) quelled those fears.

The fact that credit markets remain so sensitive to this sort of day-to-day newsflow is proof positive that although conditions are improving global credit markets are far from normal. Credit markets generally should continue to function, and I don’t see another total credit freeze such as we saw in September happening again in coming months. However, it will take at least a year for sour loans to work through the financial system.

Some of the companies in my coverage universe are managing to take on new debt and open up new credit lines. For example, Proven Reserves bellwether Enterprise Products Partners (NYSE: EPD) recently took on a term loan and opened a new credit line totaling $593 million; both deals were accomplished at favorable rates. Others, such as oil giant Chevron (NYSE: CVX), have no need to access the credit markets due to significant cash reserves and no near-term debt to be refinanced.

In the era of easy credit, prior to the summer of 2007, companies took out large loans at attractive interest rates. Most investors paid relatively little attention to balance sheet risks. But the pendulum has swung: Leverage and credit quality have become among the most important determinants of a stock’s performance.

For example, I examined the 40 stocks in the S&P 500 Energy Index over the past three months. I divided the index into five groups ranked by total debt-to-equity ratios. The top group had the lowest debt-to-equity ratio, and group five had the highest. The following chart summarizes the performance of these groups since Sept. 1.

With the exception of group four, this chart shows a fairly consistent pattern. Energy stocks with lower debt burdens have broadly outperformed those with the highest leverage. The group four return appears to be an outlier in this data, due mainly to the outperformance of two natural gas producers that happened to land in this group, Range Resources (NYSE: RRC) and XTO Energy (NYSE: XTO). As I detail below, I continue to prefer holding exposure to gas-levered stocks over oil-levered stocks.

I believe there’s value to be found in select stocks that have been slammed due to their leverage. For example, as I outlined in the last TES, High Income With Upside, Chesapeake Energy (NYSE: CHK) has been hit hard in part because of concerns over its large debt burden.

But the company has managed to raise cash via several joint venture deals and can expect strong cash flows next year thanks to hedges the firm took on earlier this year that will lock in high prices for its production. As I explain in High Income with Upside, Chesapeake’s bonds and preferred shares look like an excellent way to play a recovery in the stock, providing an opportunity to earn a big yield while you wait.

Nonetheless, the chart above certainly argues for favoring companies that have no need to access the credit markets through the end of 2009 or that have undrawn credit lines they can tap if needed.

And don’t be tempted into thinking that just because there are tentative signs of improvement in credit markets the economic downturn is over. Some damage has already been done to the economy as a result of close to two months of complete lockdown in credit. This is evident from the chart below.

This chart shows annualized vehicle sales in the US. As you can see, total vehicle sales in the US have plummeted to levels unseen since the early ’90s.The main problem is that banks and automakers alike have become much stricter with lease and loan terms. That makes it tough for many consumers to borrow the money they need to purchase a new car or truck.

We can also see the aftershocks of the credit crunch in the Baltic Dry Index, a measure of rates charged by dry bulk tanker companies to transport goods such as iron ore, grain and coal.

The Baltic Dry Index has collapsed by close to 90 percent from its high this year. Ship owners simply can’t operate at a profit with rates where they are today.

The main problem in the dry bulk market is not that demand for commodities is slumping; Chinese demand has slowed, but this is mainly due to the fact that some companies there are running down excess inventories built up around the Olympics. Rather, goods shipped on dry bulk ships are typically secured by a letter of credit from a bank. Banks simply won’t issue those letters of credit, and those that will are demanding hefty fees.

The letter of credit issue is more important than any dropoff in demand, as is clear by looking at the following chart of the Baltic Dirty Index.

This chart shows the rates tanker firms charge to ship crude oil. The big shippers in the tanker market are companies such as ExxonMobil (NYSE: XOM), Chevron and some of the big national oil companies (NOC); these firms typically don’t use letters of credit in their operations.

As you can clearly see in the chart, tanker rates are down, but the decline is not even close to being as dramatic as for the dry bulkers.

Bottom line: My outlook remains that we’re headed for the deepest recession in the US since 1974. The European Union, Japan and other developed economies will also get hit by a nasty downturn; in fact, Japan and the EU are already in recession. Developing markets will see a slowdown, but growth won’t collapse completely.

The good news in all of this is that the US has already been in recession for 12 months. The longest contractions of the post-Depression era were the 16 month-long recessions in 1973-74 and 1981-82. Even if we assume this recession will endure a few months longer than that, it’s likely the US will start to see clear signs of a recovery by the latter half of 2009. And remember that the market is a forward-looking animal; it’s likely to find a low and rally before the economy troughs.

In addition, the relentless selling in stocks this year has thrown up bargains across many sectors and subsectors. In the case of energy, consider current relative valuations. On average from 1995 through 2006, the S&P 500 Energy Index traded with a price-to-earnings ratio that was higher than the S&P 500 as a whole.

Today, the energy sector is trading at 6.8 times earnings, a huge discount to the 18 times trailing earnings multiple for the S&P 500 as a whole. Thus, investors are pricing in a truly grim outlook for oil and natural gas prices, and any hint of bullish news is enough to send the group soaring. We may be in for a few months of bottom-scraping, but investors will ultimately look back on the end of 2008 as a stellar buying opportunity in the energy patch.

Finally, whether you love or hate the government’s response to the economic downturn, it’s fair to say recent actions will ultimately prove inflationary. The current fed funds rate is 1 percent, and it’s quite possible the Fed will cut rates to zero in an effort to reflate the economy.

But if you thought 0 percent interest rates is as low as the Fed can go, think again. Ben Bernanke has specifically outlined other steps for pursuing monetary stimulus. Chief among those is the possibility that the government would buy 10-year and other long-term US government bonds directly. This would have the effect of lowering the yield on longer-term government bonds. Because many mortgages and other loans are priced based on these bond yields (plus some sort of margin), this would also tend to bring down mortgage rates.

This is clearly an inflationary act. The Fed would essentially be printing money to purchase these long term-bonds and would then inject that cash into the economy. The Fed hasn’t purchased long-term bonds on this grand scale since the ’50s.

And it isn’t just the Fed. It’s clear to me that support is rising on both sides of the Congressional aisle for another round of fiscal stimulus. This could take the form of another tax rebate check. Alternatively, the Obama administration may decide to pursue a massive round of infrastructure spending; this would likely be financed in the short term by more borrowing rather than tax increases. Although Obama is likely to raise taxes eventually, I doubt he’ll do so in his first year or two in office given the weak economy.

The current financial crisis is essentially deflationary as companies around the world seek to reduce their leverage. This is why the dollar isn’t getting hit hard and inflation isn’t accelerating despite inflationary policies pursued by the federal government. Ultimately, however, these actions will result in a return of inflationary pressures. While that’s certainly not a positive for the US economy, it is a positive for commodity prices–including the price of oil and natural gas.

In addition to these macroeconomic forces, I’ve highlighted over the past few issues my expectation that oil supply will ultimately become a more important issue than demand. The longer oil remains below $70 a barrel, the more acute the pullback in drilling activity will be. The result will be lower oil supply and production, particularly from non-OPEC countries. Lower supplies will re-tighten the oil market; at the first sign of an uptick in demand, the world is likely to see yet another big spike in prices. The only thing that saved the world from $200 oil this year was a nasty US recession.

It might seem odd to spend so much time discussing the global economic environment in a newsletter dedicated to energy, but these macroeconomic issues are having a much larger effect on the price of energy-related stocks than any firm-specific news or events.

My strategy for dealing with the current market is simple: Hold a mix of defensive stocks (and bonds) that offer high current income potential and beaten-down names well-positioned to benefit from the coming recovery.

I continue to prefer exposure to natural gas-levered companies over those with a heavy weighting in crude oil. Although weakness in the broader market and in energy stocks continues to obfuscate the trend, natural gas has been handily outperforming crude since the end of September.

The chart above shows the current price of natural gas divided by the current price of oil. When the line is rising, that indicates that natural gas prices are performing better than oil and vice versa. You can clearly see a strong uptrend in this relative strength chart beginning in September.

Oil has been and will remain an economy-sensitive commodity for the foreseeable future. As I’ve noted before, crude oil prices have been following the path of the broader stock market for some time because the oil and stock markets are both concerned about the same thing – a global economic recession. While I believe that supply will ultimately be a far bigger issue, the oil markets are completely and totally focused on demand right now.

I suspect we’ll see a rally in the broader market that lasts into the first few weeks of 2009. As such, I wouldn’t be surprised to see oil work its way back above $60 a barrel in coming weeks. Nonetheless, we’ll definitely continue to experience economic weakness in 2009, and that will mean a choppy market for crude.

I’d be surprised to see oil drop far below current prices. A combination of OPEC supply cuts and continued disappointing non-OPEC production should form a floor for prices. But oil will remain highly volatile and sensitive to economic data until the market turns to the upside in anticipation of an economic recovery. As noted earlier, this isn’t likely until mid- to late 2009.

Natural gas prices aren’t as sensitive to the economy. While US crude oil demand has fallen by more than 1 million barrels a day this year and is likely to fall further next year, natural gas demand is still growing. Natural gas is growing as an electricity fuel; electricity demand isn’t particularly sensitive to economic growth.

And winter weather patterns are a huge determinant of natural gas demand. Current projections suggest that the winter of 2008-09 will be the coldest in many years across much of the US. This will drive higher demand for gas as a heating fuel.

Most important, however, the credit crunch is actually a huge positive for natural gas prices. The reason is simply that many US gas producers are relatively small companies that depend on debt financing to fund their drilling activity. With the credit markets drying up for smaller firms, they simply can’t obtain the money needed to drill new wells and are sharply reducing their activity levels. Producers across the board are being forced to live within their means, funding drilling solely via their existing cash flows.

Chesapeake Energy CEO Aubrey McClendon made the following comments during the company’s third quarter conference call:

[O]ver the past 60 days or so, we pulled down our Capex by $4 billion or so…We hit a high water mark of 158 rigs in August. We’re down to 145 no, headed to a low of 128 by the end of the year. We do have contingency plans to take that further down if we need to as we have stated before. We will not outspend our cash resources in 2009 and 2010. You know the exact number or rigs that goes away is really anybody’s guess but, from my perspective, it would seem that probably at least 300 and maybe as many as 4 or 500, are likely on their way down. And previously I guess I would have thought that it would take well into 2009 to achieve those levels but I think with the credit crunch now probably playing a bigger role even than lower gas prices, and affecting producers’ drilling plans I think you will start to see that melt away pretty quickly.

The only reason that I think it might be stickier than what anybody from the outside looking in would say is that companies do have oftentimes have multi well rig commitments or even multi month or multi year rig commitments. So that will keep things perhaps a little stickier and that’s why things haven’t dropped off as quickly as some people think. So with that, I suspect we will start to see much healthier supply and demand balances in the first part of 2009. Certainly by the summer of 2009, I think things will be back on the upswing and I think it almost guarantees a much better 2010 than I would have guessed just a few months ago…

McClendon clearly suggests that he feels the credit crunch is even more important than low gas prices in influencing drilling activity. While longer-term contracts for drilling rigs prevent drillers from reducing activity levels immediately, it’s quite clear that the crunch will eventually mean lower activity and production. In fact, McClendon suggests he felt this would actually accelerate the decline in the rig count.

McClendon made these comments at the end of October. His outlook proved remarkably prescient, as the chart below suggests.

Source: Bloomberg

This chart shows the total number of rigs actively drilling for oil and natural gas on land in the US. Because most US land rigs target gas rather than oil, the rig count is a useful measure of natural gas drilling activity levels.

Last week the US rig count dropped by a whopping 75 rigs, the largest-ever weekly drop in the Baker Hughes (NYSE: BHI) rig count. Earlier in November, the rig count saw a weekly drop of more than 40 rigs, the largest weekly drop since the early ’90s.US land rigs are definitely melting away quickly now, and the rig count could very well drop by more than 500 before next summer.

This removes the main headwind for US natural gas price: fears of excess supply. As I’ve noted before, the primary factor pushing natural gas prices lower this year is a fear that strong growth in production from US unconventional reserves would swamp demand. For those unfamiliar with unconventional gas, check out the September 3, 2008, issue of The Energy Strategist, Unlocking Shale, for a detailed explanation and a rundown of the most promising plays.

While the US has some of the most prolific natural gas fields in the world, they’re highly drilling intensive. Unconventional US gas wells have a high decline rate; production from these fields falls rapidly in the first year they’re in production. If producers aren’t drilling enough new wells to offset those declines, gas production falls rapidly.

The rapid dropoff in the US rig count will push production sharply lower in coming months. Lower supply and firm demand spells higher prices.

We are, in fact, already seeing the impact of lower drilling activity and the onset of winter eating season. Last week US natural gas inventories fell by a far larger-than-expected 66 billion cubic feet (bcf).

The chart above shows the current path of natural gas inventories compared to a “normal” range defined by the shaded area. As you can see, inventories are currently well within that average range.

The current total for gas in storage is 3,488 bcf, about 88 bcf higher than the five-year average of 3,334 bcf. But this is also about 109 bcf lower than last year at this time. If predictions for a colder winter pan out, gas in storage could quickly drop to below-average levels.

That would boost natural gas prices. Unfortunately, even with higher gas prices, many smaller producers would be unable to accelerate their drilling plans due to the lack of debt financing. Such a scenario would be bullish for gas prices.

To make a long story short, the current supply/demand balance favors higher natural gas prices. I suspect we’ll see gas continue to outperform oil in coming months.

I already recommend several ways of playing the US natural gas market.

Among the producers, I continue to recommend EOG Resources (NYSE: EOG). This company has been among the strongest performers in the exploration and production (E&P) space this year, down just 15 percent since early September despite the broader market’s precipitous fall.

There are a couple of major reasons for that. First, EOG has one of the strongest cash and debt positions of any E&P I follow. The company has a total of $1.9 billion in debt and close to $900 million in cash; with a market cap of $20 billion, EOG has a clean balance sheet. EOG doesn’t need to access the credit markets to fund its planned drilling activity. Cash and a strong financing position are major positives in the current market environment.

Second, EOG’s market positioning in unconventional fields is favorable. As I outlined in the September 3 issue, EOG has a strong position in the Barnett Shale natural gas field as well as in the Bakken Shale oilfield in Montana and North Dakota. EOG will see growth in both its oil and gas production in coming years.

Looking a bit further into the future, EOG has a strong emerging gas prospect in Canada in the Muskwa Shale of British Columbia. Although it will take some time for pipeline capacity in the region to be sufficient, this unconventional gas play could rival US giants like the Barnett and Haynesville in terms of size; EOG estimates that its reserves in the region could top 6 trillion cubic feet.

EOG’s early drilling results are positive, and the company’s data on the play show that the gas-producing region in Muskwa is actually larger than in the Barnett, the largest unconventional gas field in the US today. Wildcatter Portfolio holding EOG Resources rates a buy under 100.

In the last TES, I added Chesapeake Energy 6.375 Percent Bonds of 06/15/15 (CUSIP: 165167BL0) to the Proven Reserves Portfolio and Chesapeake Energy 4.5 Percent Series D (NYSE: CHK D) convertible preferred shares to the Wildcatters Portfolio.

My thesis is that Chesapeake’s stock has been hit hard by a combination of cash-motivated selling and its large debt burden. But investors are overreacting to Chesapeake’s debt position as it’s taken several steps to free up billions in free cash flow over the next few years.

Specifically, Chesapeake has sold partial minority stakes in its Fayetteville, Haynesville and Marcellus shale plays in exchange for cash and funding toward its planned drilling programs. These purchases have been made by large international oil and gas companies; Britain’s BP (NYSE: BP) purchased the Fayetteville stake and StatOil Hydro (NYSE: STO) bought a stake in Chesapeake’s Marcellus acreage. These deals are proof that US unconventional gas plays are truly a world-class resource. I also like the fact that Chesapeake has either a No. 1 or No. 2 position in all of the most promising unconventional plays.

Recently, the stock got hit again after the company filed with the SEC to sell additional shares to the public. Obviously, a share offering would be a short-term negative for common stockholders as it dilutes their stake in the company. However, a share offering wouldn’t be a negative for bondholders; the additional cash should further quell any fears about the company’s credit position.

And longer term, the offering will also benefit common stockholders as some of that cash is likely to be used to pay down debt. Investors are highly sensitive to balance sheet risks in the current environment.

Finally, it’s worth noting that there are continued rumors about the possibility that Chesapeake could be acquired by BP or another big oil firm. Given the current slump in the stock, that sort of a deal would make a lot of economic sense. Chesapeake Energy 6.375 Percent Bonds of 06/15/15 and Chesapeake Energy 4.5 Percent Series D offer yields of roughly 13 percent and 8.5 percent, respectively, and remain buys at current prices.

To beef up our exposure to gas-levered E&Ps, I’m also adding XTO Energy (NYSE: XTO) to the Wildcatters Portfolio. XTO has been one of the most consistent performers among the gas-focused E&Ps and has an extremely low cost of production; XTO’s total finding and development costs are about $10 per barrel of oil equivalent (boe) compared to an industry average of closer to $14 per boe.

XTO is highly acquisitive and has amassed an impressive acreage position in the hottest unconventional natural gas plays in the US. The company has exposure in the Rockies, the Marcellus Shale, the Barnett Shale, the Fayetteville Shale and in the Haynesville. For a detailed rundown of these plays and XTO’s position in each, check out the September 3 TES. Roughly 80 percent of XTO’s production is gas, although the firm does have an acreage position in the Bakken oil play.

XTO has a history of making many small “bolt-on” acquisitions each year. This year, XTO has made several deals, including the acquisition of acreage in the Marcellus Shale from fellow Wildcatter Linn Energy (NSDQ: LINE). XTO most recently purchased a large tract of land from Hunt Petroleum.

As a result of these deals, XTO now has a huge inventory of acreage in well-understood gas-producing regions. This gives XTO plenty of drilling prospects for years even if the firm doesn’t do any more deals. In fact, the company recently announced it’s not likely to do any new deals next year; XTO instead plans to focus on maximizing cash flow.

XTO recently cut its 2009 drilling budget by about $800 million, but it still plans to spend nearly 30 percent more on drilling than it did in 2008. Overall, XTO should see its gas production grow by 20 percent next year, among the fastest production growth of any of the E&Ps I cover.

Better still, current low natural gas prices aren’t as big a problem for XTO as for other producers. The company has hedged 77 percent of its expected production in 2009 at an average price of $10.77 per million British thermal units (MMBtu). The company took advantage of higher natural gas prices earlier this year to lock in those hedges. In addition, thanks to its low production costs, XTO can make money at lower gas prices than many of its competitors.

Given its hedges and expected production goals, XTO won’t need to access the capital markets near term. Management estimates that XTO will generate more than $1.25 billion in free cash flow for 2009 even after funding its drilling and pipeline development projects.

The only knock against XTO is that its debt burden is relatively high. But in light of its strong free cash flow, investors have been willing to overlook that problem; the stock is among the best performers in the E&P group this year.

With a forward price-to-earnings ratio below 8, XTO is trading at close to the lowest valuation it ever has. Buy XTO Energy under 42 with a stop-loss at 21.

Another stock I’m considering for addition to the TES Portfolio is Devon Energy (NYSE: DVN). Devon has the strongest balance sheet of the US E&P stocks I follow; this fact made the stock a sort of safe haven for investors in recent months.

Devon is also the largest player in the Barnett Shale and has attractive positions in some other promising US unconventional plays, as I outlined in the September 3 issue. For now, I’m upgrading Devon Energy to a buy in How They Rate, but I may look to add it to the Portfolio in an upcoming issue.

Outside the E&P group, Gushers recommendation Nabors Industries (NYSE: NBR) and Wildcatters bellwether Weatherford International (NYSE: WFT) also have exposure to the US natural gas markets.

Nabors is a contract drilling firm that leases land rigs to operators for a fee known as a day-rate. The drop in the active rig count isn’t great news for land drillers; typically a falling rig count means a growing supply of idle rigs chasing a smaller number of drilling jobs.

But this cycle is shaping up differently than those of the past. Specifically, Nabors has a strong position in the market for more advanced built-for-purpose rigs. These rigs are needed to drill the attractive unconventional shale plays that have become America’s fastest-growing and most important source of gas production.

While we’re seeing producers lay off rigs and cut their capital spending plans, most are cutting activity in conventional gas fields and largely maintaining their drilling spend plans in the shale plays. That means that even as the rig count falls, demand for more advanced, high-specification rigs is holding up relatively well.

Trading at less than five times forward earnings, Nabors is pricing in an extremely gloomy outlook for natural gas drilling in the US; I suspect demand for its rigs will hold up far better than the market expects. Buy Nabors Industries under 17.

The focus of much of service giant Weatherford’s recent growth has been international contracts; however, the company retains a strong position in gas-related services in the US and Canada as well.

I also suspect that Weatherford’s growth overseas will hold up reasonably well. The reason is that many of Weatherford’s key service offerings relate to mature field development rather than new field exploration. For most producers, squeezing a bit more oil and gas from existing fields is cheaper than exploring for and developing new fields.

That means that when oil and gas prices drop and producers start looking to cut costs, the first areas to see reductions in spending are those related to exploration. Meanwhile, those same producers will look to continue developing their existing fields.

Weatherford’s focus on development rather than exploration work means that it should see relatively robust growth, even with oil trading at current depressed prices. Buy Weatherford International under 15.

Super Oil companies such as Chevron and ExxonMobil are typically involved in two main business lines, exploration and production (E&P) and refining. Thus they’re exposed to the same problems as other energy producers right now: depressed oil and natural gas prices.

Yet the majors have been among the best performers in the energy patch this year. In fact, ExxonMobil is the only stock in the S&P 500 Energy Index that’s actually trading higher than it was three months ago.

There are a couple of fundamental reasons for the group’s defensive characteristics. First, most of the super majors have pristine balance sheets and huge cash positions; for example, Exxon holds $38 billion in cash on its balance sheet, while Chevron holds $11 billion. And cash is king in this market.

Second, the Super Oils have a long history of showing profitability even in low commodity price environments. Both Chevron and Exxon remained profitable during the vicious bear market in energy prices back in 1998. Chevron and Exxon provided investors with average annualized returns of 14 and 16 percent, respectively, in what was generally not a great decade for energy-related firms.

My favorite Super Oil is Chevron. The reason is that of the Supers, Chevron has the best prospects to actually generate real growth in production in coming years. The company has a long list of attractive organic growth projects due for completion over the next few years.

The list includes Chevron’s Agbami project offshore Nigeria and the Tengiz expansion project in Kazakhstan. The company also announced it’s seeing its first production from the deepwater Blind Faith project in the Gulf of Mexico.

Chevron estimates its costs per barrel of oil produced at less than $20, among the lowest of any of the majors. And Chevron also tops the list in terms of reserve replacement–it’s one of the only oil majors actually booking enough new reserves to replace the oil and gas it produces.

I also like Chevron’s aggressive expansion into the global liquefied natural gas (LNG) market. LNG is nothing more than a super-cooled version of natural gas that can be loaded onto a tanker and shipped anywhere in the world. While LNG imports into the US are weak thanks to strong domestic production, this isn’t true elsewhere around the world.

Both the EU and Asia are major, fast-growing gas importers. Chevron’s huge Gorgon LNG project in Australia is well placed to serve the latter market. Chevron is added to the Proven Reserves Portfolio as a buy under 85.

In the November 5 issue, Time for Income, I outlined my case for buying master limited partnership (MLP) stocks. These companies offer strong income and the potential for dividend growth even in the current depressed environment for commodity prices. Most have little or no exposure to commodity prices whatsoever and have been beaten down due to artificial selling pressure caused by cash-motivated institutional sellers.

In Time for Income I offered detailed updates on five of my recommended MLPs and promised more updates on the remaining MLPs recommended in the Portfolio as they reported earnings.

The safest MLPs I recommend are Kinder Morgan Energy Partners (NYSE: KMP) and Enterprise Products Partners (NYSE: EPD); investors looking for income and stability should buy those two first. While the others have seen unprecedented volatility, they remain largely insulated from commodity price volatility. The one exception to this is a business line known as gathering and processing (G&P).

Gathering lines are small-diameter pipelines that collect oil and natural gas from individual wells. Before it’s suitable for injection into the nation’s pipeline network, gas requires processing. Processors remove impurities from the gas and separate natural gas liquids (NGL) from the gas stream. NGLs include valuable saleable hydrocarbons such as propane.

Not all companies involved in G&P have real exposure to commodity prices; it depends entirely on the types of contracts they’ve signed and their service territories.

Gathering can provide some sensitivity to oil and gas prices because gatherers get paid based on the volumes of gas they collect from wells; when gas prices fall, companies cut back on drilling, and that spells lower volumes.

That said, the prices firms pay for gathering services isn’t directly related to commodity prices, and the dropoff in volumes of gas produced has been far less than the fall in the price of gas–gathering has only modest exposure to commodity prices. Further, gatherers operating in promising regions near unconventional gas plays are unlikely to see a significant falloff in volumes.

Processing is a different story. Some processors chart a simple fee for processing gas that’s based largely on the volumes processed–these are stable, commodity-insensitive deals.

The problem comes from a contract type known as percent of proceeds (POP). Some POP contracts are written in such a way that the processor actually buys the natural gas at the wellhead from producers and then processes and sells the gas and NGLs. A prearranged percentage of the proceeds from those sales is then paid to the producers.

Obviously this business isn’t as sensitive to commodity prices as actual production. The reason is that when oil and gas prices fall, the processor earns less revenue from selling gas and NGLs; however, the cost of the gas it buys also falls, helping to offset some of that headwind.

The problem right now is that NGLs typically trade somewhat in line with crude. Natural gas prices have been outperforming crude over the couple of months; for companies with POP contracts, the cost of buying natural gas from producers has gone down by less than the value of the NGLs they sell. This depressed margins.

None of this was a concern whatsoever until October, when crude prices really began to fall sharply. There are three MLPs in the TES Portfolio with large enough exposure to G&P where this could be a potential concern: Hiland Holdings GP (NSDQ: HPGP), Williams Partners LP (NYSE: WPZ) and Eagle Rock Energy Partners (NSDQ: EROC). The only one of those three that really concerns me is Hiland.

The reason is simple. Williams has some POP contracts but has been building its exposure to fee-based contracts in recent years; its commodity exposure has been dropping. Based on its most recent presentation, it appears that roughly two-thirds of Williams’ revenues come from fee-based businesses and have little or no commodity exposure.

Second, Williams covers its current distributions 1.8 times, has strong cash and debt positions, and has hedged some of its commodity exposure for 2009. Bottom line: Williams isn’t likely to boost its distribution next year, but a distribution cut is unlikely unless oil and gas prices remain depressed going into 2010. Buy Williams Partners LP.

Eagle Rock has around $175 million in available credit facilities and recently reset a large number of its oil and gas hedged for 2009 at highly attractive prices; it reset some of its oil hedges to around $100 a barrel. These hedges cover a good bit of its 2009 commodity exposure.

Eagle also covered its third quarter distribution at 200 percent, one of the largest coverage ratios of any MLP I cover. This also gives it a large bit of breathing room.

The company set out the $60 level for oil as the basic break point for its G&P business. In quarters where oil is under $60, Eagle would have to borrow to meet its distribution payments. Above $60, it can continue to meet distribution payments using cash flows.

My sense from the third quarter call is that Eagle will maintain its distributions for at least the next two to three quarters. I suspect oil prices will be on the rise again within the next six months, so this headwind will begin to abate. My concern would grow only if oil remains under $60 by the middle of 2009. I’m retaining my buy rating on Eagle Rock Energy Partners.

Eagle and Williams both are involved in businesses other than G&P; that diversification is a big benefit. But Hiland’s main business is G&P and has heavy exposure to POP contracts.

Hiland also has fewer hedges covering 2009 commodity exposure than Eagle and Williams, so it’ll feel the pain of low energy prices more acutely than the others. While I continue to like Hiland’s long-term prospects, I suspect it might have to cut its distribution next year if we don’t see an improvement in oil prices over the next quarter or so.

The good news is that the stock has been mauled and is now trading at a level that more than prices in the potential for a distribution cut. I’m cutting my recommendation on Hiland Holdings GP to a hold but will retain it in the Portfolio. It’s the highest risk play among my MLP recommendations.

I also continue to recommend Linn Energy (NSDQ: LINE), an LP that’s actually involved in oil and gas production. Although this stock sometimes follows gas prices, the company has essentially no exposure to commodity prices.

Linn is close to 100 percent hedged on all its oil and gas production through the end of 2011. So whether oil’s at $60 or $160, it won’t really affect Linn’s cash flows. Further, the company has hedged its basis risk. Natural gas trades at different prices in different parts of the US, and those prices can be wildly divergent at times. Therefore, using the NYMEX contract based on prices at the Henry Hub in Louisiana may not represent a complete hedge for a producer like Linn–this is known as basis risk.

But Linn has actually taken on hedges to eliminate this risk. I don’t see Linn raising its distributions until the credit markets improve and it can start making more acquisitions. However, Linn’s distribution is unlikely to be cut even if prices remain depressed for far longer. Buy Linn Energy.