The past six months have been among the most challenging in history for investors. Energy stocks have been among the most battered of all.

But oil and natural gas prices are at unreasonably depressed levels right now, and related stocks are pricing in an extremely pessimistic outlook for commodity prices. 

I’ll also outline new plays in my three core themes for playing the current market: high-income energy; major integrated oil companies; and stocks leveraged to natural gas.

The story of oil and gas prices is a long one. We’ll examine it from multiple angles. See The Oil Cycle.

Natural gas makes more investment sense than crude oil in the short term. See The Gas Equation.

I’m focusing on three key themes to capitalize on the current energy environment. See Playing the Trends.

Interested in boosting your returns via a simple options strategy? See Writing Calls.

Welcome to former subscribers of The Partnership. We’ve covered publicly traded partnerships in TES from the beginning, and now we’re absorbing a few Partnership recommendations into How They Rate coverage. See Welcoming the Partnership.

I’m often asked why we’ve seen so much volatility in prices this year and where crude oil prices are headed. To understand the factors at work, it’s useful to define the broader cycles we’re seeing in energy prices and to try to determine where we are within those cycles.

My basic thesis remains that energy prices and related stocks are locked in a long-term up-cycle that will last for at least another decade, perhaps far longer then that. But every bull market–no matter how powerful–is punctuated by pullbacks and corrections. Sometimes those corrections are brutal, as is certainly the case with oil prices in 2008. This is exactly what we’re seeing in the energy markets today: a cyclical decline within a longer-term uptrend.

As I’ve highlighted in recent issues, the current down-cycle is a function of oil demand. Supply will ultimately reemerge as a key issue, but for at least the next six months the path of crude oil prices will remain tightly tied to expectations for global economic growth.

Oil demand and global economic growth have historically been closely linked.

The chart above shows the annual growth in global per capita gross domestic product (GDP) and the annualized change in global oil demand; the chart doesn’t include data for 2008. As you can see, for most of the history covered by this chart, these two data points have been in lockstep.

The only exception has been the past three years. While global economic growth has hovered near three-decade highs, oil demand growth has been declining. Oil demand growth was at 4 percent in 2005, declining to less than 2 percent year-over-year in 2007.

This is explained by the rapid run-up in oil prices over the past few years. Rising energy costs have tempered demand growth, particularly in the developed world. In fact, most of the oil demand growth that did occur between 2005 and 2007 was in the developing world. In many cases this demand was supported by subsidized prices for fuel.

I see the nascent breakdown in the GDP/oil relationship over the past three years as a symptom of the supply shock the world has been experiencing. In past economic cycles, faster GDP growth powered higher oil demand and rising crude prices; higher oil, in turn, catalyzed increased drilling activity and growth in global oil supply. Those rising supplies helped keep a lid on crude oil prices.

In this cycle, however, supply growth was limited by geological factors; many of the world’s largest oilfields are mature and seeing declining production, while new fields are difficult, expensive and time-consuming to develop. Thus, even with oil prices sky-high and energy firms investing record sums in exploration and development, global oil supply rose only slightly between 2005 and 2007. Non-OPEC production growth has, in particular, serially come in under expectations. Long-term subscribers will recognize this as the “End of Easy Oil” thesis I’ve often discussed.

The bottom line: If supply can’t adjust to meet demand, the only economic factor left to move is price. With supply limited and demand rising due to a strong global economy, crude prices had to rise far enough to choke off excess demand. We touched this “demand destruction” price earlier this year.

These factors are behind the broader long-term up-cycle in energy prices. Although constrained supply is off investors’ radar screens right now, it won’t be for long.

The charts below illustrate the forces driving the current pullback within the longer-term cycle.

The first chart depicts the US Leading Economic Indicators (LEI), my favorite quick measure of economic health and future prospects. The LEI summarizes the performance of 10 key economic indicators; when the year-over-year change in LEI turns negative, it’s a good sign a recession is on its way. The indicator has once again proved its worth: LEI turned negative in late 2007, and the US economy slipped into recession in December 2007.

The LEI continued to deteriorate, falling to -3.7 percent as of the end of November. This is the lowest reading on LEI since the recession of the early 1980s.

The second chart shows the history of US economic growth and consensus estimates for the next few quarters. This data backs up what we’re seeing in LEI: US real GDP growth slowed to about 1.2 percent in 2008, down from 2 percent in 2007 and near 3 percent in 2005 and 2006.

Consensus estimates are for negative growth of about 1 percent in 2009. On a quarterly basis, the consensus believes that the economy shrunk by close to 4.5 percent in the fourth quarter and will continue to slump through the middle of next year, albeit at a slower pace. A tentative recovery is forecast to begin in the latter half of 2009.

There remains downside risk to these estimates. Although I agree we could well see the beginning of an economic recovery in the latter half of 2009, given recent economic data I’m looking for only a tepid bounceback by year-end 2009 followed by a slow recovery in 2010. As I’ve been predicting for several months now, this will be the worst recession in the US since the contractions of 1973-74 and 1981-82.

I suspect that continued growth in emerging markets will keep global GDP from turning outright negative in 2009. Massive fiscal and monetary stimulus both in the US and abroad should also begin to show up in economic data toward the end of next year. After all, China’s recent stimulus package is equivalent to 16 percent of its GDP and there are persistent rumors that the incoming administration in the US could push a stimulus package of as much as USD1 trillion early in 2009. This would be on top of the USD700 billion Troubled Asset Relief Program and a series of other bailouts the government has agreed to fund over the past year.

I don’t endorse all these fiscal stimuli; frankly, big government spending programs scare me. Nonetheless, it’s clear that this tidal wave of cash is coming, and it’s going to be financed by big deficits. We might as well recognize this fact and look for ways to take advantage. As investors we simply can’t afford to ignore the massive stimulus package Washington is likely to pass in the New Year.

For now, as the chart of GDP growth and oil demand suggests, the global economic slowdown has predictably resulted in an outright decline in global oil demand.

Source: Energy Information Administration

This chart summarizes the outlook for global oil demand over the coming year. The Energy Information Administration (EIA) once again revised downward estimates for 2008 and 2009 crude oil demand in its December Short-Term Energy Outlook. The world is now projected to see its first back-to-back declines in oil demand since the early 1980s recession.

There’s nothing particularly unusual about the demand cycle I’ve just outlined. What’s different this time around is the supply side of the equation. Supply explains to a great degree why we’ve seen such extreme volatility in crude prices this year.

As I noted earlier, the reason that oil demand growth was weaker in 2005-07 than would be expected given global GDP growth is that supply constraints pushed oil prices sky-high. With oil demand now plummeting, the world no longer faces those same supply constraints. Prices are adjusting not only to the cyclical decline in oil demand but also to the disappearance of the scarcity premium that drove the price spike earlier this year.

With the scarcity premium clearly out of the oil market, the only fundamental support for oil prices is cost. In other words, with demand falling and spare production capacity on the rise, the crude oil markets are now finding a level that will result in shrinking global oil supply. Just as oil prices rose to a level that choked off demand over the summer, they’re now adjusting to a level that will temper supplies.

There’s no way to pinpoint the exact price at which supplies will begin to shrink. However, commentary out of the producers suggests that an oil price of around USD70 to USD90 a barrel is needed to encourage the development of new fields and accelerate spending on exploration and development.

Meanwhile, at a price of around USD30 to USD40, many producers are unprofitable; at these prices oil supplies begin to fall off dramatically. What we’re currently seeing is the global oil markets testing the bottom of this range.

Just as I believe the economy is in for a rougher ride and shallower recovery than the consensus believes, I’m also looking for a sharper decline in oil supplies than current estimates suggest. As I noted in the Oct. 22, 2008 issue, we were already seeing clear evidence of project cancellations and big declines in capital spending on exploration and development even when oil prices were still above USD60.

With oil prices around $40 today, it’s likely that the trickle of project cancellations will soon seem a flood. Some estimate that with oil at USD30, as much as 20 percent of the world’s oil production is uneconomic–that’s more than 16 million barrels a day. Although only a small portion of that production would be shut in immediately, it’s clear that the longer oil prices stay at depressed levels, the more crude production will be shut in.

And investors continue to totally ignore recent OPEC supply cuts; one reason is that many believe OPEC members will “cheat” and fail to produce in line with their quotas.

The problem is that most OPEC members are seeing severe budget problems with oil below USD50. Some, including Venezuela, are truly scared right now because they face massive government deficits.

Venezuela has already fired up the printing presses to fund spending growth–inflation is running at over 30 percent annualized. Venezuela has already devalued its currency sharply against the US dollar, and black market exchange rates are far lower than the official rate. More devaluations are likely next year. In short, the Venezuelan economy is destabilizing.

I suspect other OPEC members are also feeling the pinch and are actively pushing to cut official quotas even further in an effort to put a floor under prices. This may actually mean that member countries become more cooperative than normal on production cuts.

Even if that’s not the case, what’s clearly likely is that production in countries like Venezuela will fall. With oil prices over USD100, the Chavez government wasn’t recycling enough of its oil revenues into energy-related infrastructure investments to maintain production. With oil at USD50, they simply don’t have any money to reinvest. The longer investment continues to dry up, the sharper the ensuing decline in output.

And don’t make the mistake of assuming it’s only high-cost OPEC member-states such as Venezuela and Iran that are scaling back production. Saudi Arabia is also already delaying or canceling planned projects. The country has delayed the 900,000 barrel a day (bbl/d) Manifa oilfield development and the planned USD1.2 billion project to restart production at the Dammam oilfield, one of Saudi Arabia’s oldest. In addition, the Desert Kingdom has delayed the construction of two major refineries with total throughput of close to 1 million bbl/d.

This chart shows the EIA estimates for non-OPEC production in 2009. The EIA has revised downward its outlook for 2009 non-OPEC production by more than 1.1 million bbl/d since July. The biggest declines in those estimates have come from downward revisions to output from Russia and Africa. These regions are clearly seeing a major slowdown in spending on exploration and development. The longer oil prices remain depressed, the sharper the downside revisions in non-OPEC production estimates are likely to be.

A few areas to watch include marginal US oil production, Brazil’s deepwater plays and Canada’s oil sands. Big oil sands projects and Brazil’s promising new deepwater plays probably require oil to be north of USD50 to generate a positive return. Although there are wide variations, I also suspect mature US wells require oil above USD40 to USD50 to be economic. Projects in all three areas are highly vulnerable at the current time.

The down-cycle in oil prices is likely to come to an end as oil reaches a price where the decline in supply balances the falloff in demand. This price is likely somewhere between USD30 and USD40 per barrel. The obvious question is when will the current down-cycle end and the longer-term bull market reassert itself.

Mark Twain once said that history doesn’t repeat, but it does rhyme. It’s useful to look at prior demand-led dropoffs in energy prices for a clue as to when oil prices will bottom out and energy stocks mount a sustainable recovery.

There are a total of three down-cycles for global GDP growth and oil demand growth that are visible on this chart: 1990 through 1993; 1997 through 1998; and 2001 through 2002. In each case, energy stocks and prices got hit; the Philadelphia Oil Services Index (OSX) saw a decline of close to 70 percent from high to low in 1997-98 and 65 percent in 2001-02. This is very similar to the 73 percent decline we witnessed in the same index from its highs last spring to its early December lows.

Back in the 1990 through 1993 period, energy stocks simply marched in place in a volatile range. The start of the Iraq war contributed to volatility in prices in those years.

In each case, that initial sharp dropoff was followed by a period of consolidation–a trading range punctuated by sharp rallies and dramatic selloffs.

The important point to note is that this consolidation period starts before energy prices bottom out. For example, in the 1997-98 cycle, oil hit a low in December 1998, natural gas in early 1999. But the OSX hit its low in August 1998. Similarly, in 2001-02, oil prices hit a low on November 2001, gas in late October 2001. The OSX hit its low in September.

I suspect we’re now in the consolidation phase of this cycle. Oil prices may scrape bottom for a few more months in the USD30-to-USD40 per barrel range; we may even see a spike into the 20s on the downside or the 50s on the upside in reaction to short-term economic data. However, energy stocks are already pricing in weak commodity prices and aren’t reacting as negatively to falling oil and gas prices as was the case just a few months ago.

This chart shows a simple ratio, the S&P 500 Energy Index divided by the per barrel price of oil. A rising line suggests oil stocks are outperforming the commodity.

In recent weeks oil stocks have handily outperformed crude oil prices. Put another way, the S&P 500 Energy Index remains well off its annual lows, even as crude itself has broken to new cycle lows over the past couple weeks. When I see stocks outperforming the commodity, it suggests that these companies are already pricing in a weak commodity price environment–there’s limited downside to come.

Analysts, too, appear to be coming to grips with the slowdown. Over the past month and a half, consensus estimates for key energy stocks have fallen precipitously, more in line with the realities of USD40 a barrel oil.

For example, check out the chart below of 2009 earnings estimates for oil services giant Schlumberger (NYSE: SLB).

This chart shows consensus estimates for Schlumberger’s 2009 earnings per share (EPS). As recently as early October, analysts were still boosting their estimates for Schlumberger, as still-high oil prices weren’t expected to impact the large, international projects that have always been Schlumberger’s bread and butter.

But that outlook has totally changed. Estimates have nearly halved since that time. This is just another sign of the extremely pessimistic sentiment gripping the sector at this time, and yet another reason the energy sector has been outperforming oil prices. Much of the dropoff has already been factored into expectations.

It’s worth noting that I’ve used the Philadelphia Oil Services Index in my study of past cycles because it’s one of the most volatile subsectors in the energy space. It’s worth noting that in past cycles, certain subsectors of the energy space have produced solid gains, even as the OSX traded in a range. Chief among those are the integrated oil companies and the large exploration and production (E&P) firms; these groups tend to see buying interest before the group as a whole bottoms out.

Bottom line: My base case scenario is that we’ll see crude oil prices trade in a range between USD30 to USD40 through at least the first quarter of 2009. By mid-year, I suspect we’ll see prices recover to around USD50 as supplies begin to fall sharply and balance the market. Finally, I’m looking for oil prices to top USD70 by the end of 2009 as we begin to see more conclusive evidence of a recovery in oil demand.

As with all predictions, my outlook for oil is simply a projection based on historical norms and what I’m seeing in terms of supply and demand at this time. But it’s useful to play Devil’s Advocate, outlining the factors that could alter my outlook.

On the upside, crude oil prices could recover faster if we get more conclusive signs of stabilization in the US economy earlier than I expect. Alternatively, it’s possible we’ll see today’s cheap gasoline prices spur consumer demand and a stronger-than-normal summer driving season in 2009.

On the supply side, I’ll continue to watch OPEC. Additional cuts by the cartel, which I expect to see, and signs that OPEC member states are complying with their quotas could also put a floor under prices and push oil back over USD50 early in 2009.

On the downside, if the US economic recession deepens further into depression-like conditions, oil demand could fall even further than I expect. Even worse, if US weakness pushes Chinese economic growth under 5 percent instead of current expectations closer to 7 to 8 percent, that would further tamp down demand. This could result in a prolonged period of oil trading in the 20s.

The other side of this equation is supply. If producers go ahead with their projects despite ultra-low oil prices, we could see the world’s spare capacity to produce grow to more than 5 million bbl/d by the end of 2010. That would also put downward pressure on prices.

From my vantage point, the latter scenario is unlikely. We’re already seeing evidence of supply-side distress and project cancellations. Meanwhile, the pace of decline in US oil demand has moderated somewhat over the past month, suggesting lower prices may be filtering through into demand.

I also see the former (quick recovery in price) scenario as relatively unlikely. It would be unusual for an economy as badly battered as the US is today to mount a “V-shaped” recovery. It will also take time for the mountain of fiscal and monetary stimulus currently being pumped into the global economy to stimulate demand.

There are two additional factors that can’t be ignored. First, the credit crunch has made it more difficult for E&P firms to produce oil profitably. It now costs considerably more for a company to borrow money to fund a drilling project than it did just a year ago; to cover those higher costs projects have to earn a higher return.

And second, there’s the question of inflation. Whether you agree with the government’s attempts to reflate the economy or despise all the bailouts, I suspect the flood of cash currently being pumped into the system will ultimately spell rising inflationary pressures and, quite likely, a weakening in the US dollar. That’s a positive scenario for oil and other commodities.

Back to In This Issue

In the Dec. 3 TES, I highlighted my reasons for being more bullish on natural gas than oil in the short term.

Many of you may have read alternative opinions on North American gas prices; some analysts are looking for a sustained trading range for gas between USD5 and USD6 per million British thermal units (MMBtu). Those bearish outlooks typically rest on three key assumptions: continued strong production growth from unconventional plays; rising imports of liquefied natural gas (LNG); and a big slump in North American gas demand.

US unconventional gas plays are among the most promising gas resources anywhere in the world. But producers won’t produce themselves into oblivion–as commodity prices have fallen, so has drilling activity.

It’s true that the majority of the dropoff in drilling activity has fallen to higher-cost conventional plays. But there’s also evidence of a slowdown in unconventional drilling activity.

The total US rig count has dropped from over 2,000 rigs last summer to 1,764. Most of those are simple vertical wells used to produce conventional gas fields.

However, you can definitely see a marked decline in the horizontal and directional rigs counts. These rigs are more likely to be used in developing unconventional plays. And several producers, including Chesapeake Energy (NYSE: CHK), have announced major reductions in capital spending plans for the next two years. Some of the decline in spending will fall on unconventional field development.

The more likely scenario is that we’ll see production follow a path broadly similar to what happened back in 2001-02, the last time the US rig count saw a precipitous fall.

Back then, the gas-directed rig count fell from a high of 1,060 rigs in July of 2001 to a low of 591 rigs the following April, a decline of about 45 percent over about nine months. Natural gas prices topped out in January 2001, months before the peak rig count, and bottomed out in late January 2002, about three months before the rig count hit its low.

This time around, the US rig count has fallen about 15 percent in just about three months. By next May, I expect to see the US rig count down by as much as 30 to 40 percent from its peak. I expect this to result in lower US gas production and a tightening in supplies, just as in 2002-02; I don’t see strong US gas production growth continuing despite the falling rig count and declining activity.

As for LNG, it’s true that a number of new export facilities are due for start-up in 2009, which should result in more LNG on the world market. Some of that gas will find its way to the US, particularly during the summer months, because the US has more storage and transport infrastructure than any other country in the world. But the idea that there will be a flood of LNG hitting US shores over the next three to six months strikes me as unlikely.

This chart shows the US price of natural gas divided by the UK-traded price and adjusted for currency. When the ratio is below 1, US gas prices are lower than in Europe.

Although this gap has narrowed since mid-summer, prices outside the US are still higher than in the US. That means LNG cargoes are likely to be directed to Europe and Asia rather than the US. The only thing I can see derailing that potential is an unusually warm winter in the EU and Asia or, alternatively, an unusually cold winter in the US that pushes US prices sharply higher. Bottom line: I’ll be watching LNG flows this spring but, at this time, I’m not looking for a flood of imports.

Finally there’s demand, and this is admittedly a wildcard. However, a cold start to the winter heating season is driving higher-than-normal demand across much of the US, offsetting some of the slump in demand from industrial gas consumers. A bit longer term, I see US gas demand underpinned by the fact that gas is the cleanest-burning fossil fuel–electricity generators will rely on gas-fired plants to meet any future carbon dioxide regulations.

There’s no appreciation yet for the potential for vast US gas supplies to be used as a transportation fuel, replacing crude oil demand. Alternatively, some producers have talked about the potential for a US LNG export terminal that could sell gas into the more supply-constrained European market.

Finally, many of the most bearish gas forecasts I’ve read pencil in no recovery in US gas demand until late 2010. I suspect we’ll see a recovery in the US economy beginning by the end of 2009 or early 2010. This will power a resurgence of gas demand.

While it helps to understand the risks to my forecast, for the reasons I’ve outlined I see natural gas on a stronger footing than oil. The market appears to agree with me for now as natural gas prices, though still drifting lower, continue to outperform crude oil. I’m looking for a recovery to around USD7 to USD8 per MMBtu by the end of heating season.

Back to In This Issue

In designing a strategy for tackling the current uncertain environment, I’ve taken into account my base-case outlook for oil and gas prices. However, we also must guard against the potential for the more bearish scenarios I explained above.

To that end, I continue to focus on three key investing themes for the current environment.

High Income Potential. In a choppy, sideways trading market, investors can still earn a solid return through dividends and interest payments.

This is particularly true in the current environment; liquidations by hedge funds and other institutional players have hit high-yielding groups hard over the past year. All that cash-motivated selling pressure is handing investors the opportunity of a lifetime to lock in yields of 8 to 15 percent or more with low risk of a cut to that payout.

When you consider that the 30-year Treasury bond yields just 2.6 percent and the yield on the three-month T-bill recently dipped into negative territory, those are impressive yields. Even if I’m wrong about oil and gas prices and we see more downside, these yields offer investors solid downside protection.

For those looking to commit new money to this investing theme, focus on Chesapeake Energy 6.375 Percent 06/15/15 Bonds (CUSIP: 165167BL0) and Chesapeake Energy 4.5 Percent Preferred Series D (NYSE: CHK D), yielding 13.9 and 9.0 percent, respectively.

Other favorite high-income plays are the master limited partnerships. My favorite high-yielding MLPs include Kinder Morgan Energy Partners (NYSE: KMP), Enterprise Products Partners (NYSE: EPD), Sunoco Logistics (NYSE: SXL) and, for more income with slightly more risk, Linn Energy (NSDQ: LINE).

And Rome-based Eni (NYSE: E) offers a yield of close to 8 percent at current levels. It’s also an outstanding play on the integrated Super Oils I highlight below.

Finally, in today’s issue I highlight a strategy–selling covered calls–that allows investors with a bit more risk tolerance to generate annualized yields of as much as 50 percent from stocks that pay only minimal dividends.

One more note: For those wishing to buy MLPs in a tax-advantaged account, I recommend purchasing Kinder Morgan Management (NYSE: KMR) rather than Kinder Morgan Energy Partners; the former pays distributions in stock rather than cash, avoiding the problem of unrelated business taxable income (UBTI). For broader exposure to the group within an IRA, consider closed-end MLP-focused fund Tortoise Energy Infrastructure Group (NYSE: TYG).

Gas Over Oil. Most E&P stocks have been hit hard by the recent market carnage and the pullback in gas prices and are now trading at levels unseen since the late 1990s.

If I’m right and gas prices see the USD7 to USD8 per MMBtu range by the end of this year’s winter heating season, these stocks could rally as much as 50 to 100 percent from current depressed levels.

If I’m wrong and gas remains mired in the USD5 to USD6 per MMBtu range as some pundits expect, my favorite plays can still produce positive returns. The reason is that I’m focusing on gas producers that have a highly attractive, low-cost reserve base. I’m also favoring companies that can live within their cash flows and don’t need to access the bond or credit markets to fund drilling programs.

These producers would also ultimately benefit from falling costs. Drilling and well completion costs have risen rapidly over the past few years because of tight labor and equipment markets in the energy industry. If gas is at USD5, drilling activity would continue to slow, and that likely means more spare supplies of people and equipment; the cost of drilling wells would decline, enhancing return prospects in the medium term.

My favorite gas-focused plays include EOG Resources (NYSE: EOG) and XTO Energy (NYSE: XTO).

Integrated Super Oils. There are four main reasons I like this group: low production costs; traditional defensive characteristics; low leverage; and acquisition opportunities.

First, the Super Oils are among the few firms that can actually make money with crude at USD30 to USD40 a barrel. In fact, these stocks actually performed well during the 1990s, an era of generally depressed energy prices. This dependable profitability is one reason the group tends to be a defensive haven for investors during market turmoil.

As of this writing, the S&P 500 is off 40 percent for 2008, and the Philadelphia Oil Services Index has fallen 63 percent; ExxonMobil (NYSE: XOM) is down just 17 percent and Chevron (NYSE: CVX) is off just 22 percent. Not bad when you consider how far oil has fallen this year.

Moreover, the Super Oils have historically been among the best groups to buy when the energy sector at large hits rock bottom. These are the first stocks investors dip their toes into when reallocating cash to the energy sector.

Finally, the Supers have generally clean balance sheets and, in many cases, huge reserves of cash. This means they’ll all have their pick of acquisition candidates in coming months; I’m looking for a boom in acquisitions to begin next year in the energy patch.

Consider that at the end of the second quarter, if you wanted to acquire Chesapeake Energy to get access to some of the finest shale plays in the US, you would have had to pay close to USD35 billion for the stock and assume some USD15 billion in debt. Most likely, given the strong oil and gas markets, you’d have been forced to pay at least a 25 to 35 percent premium for the equity; the total price tag would have been north of USD60 billion, and that’s a conservative estimate.

Right now, assuming a 35 percent premium for the stock, the same company would cost you less than USD30 billion in cash and assumed debts. This is just one example of the sort of discounts acquirers are facing given today’s weak commodity prices. In most cases, it would now be cheaper for a Super Oil to acquire reserves than explore for and develop their own plays. I see the majors taking advantage of this situation to beef up their reserve base.

My favorite majors include Chevron and Eni. I’m also adding two new integrated oils to the Portfolios, ExxonMobil to the Proven Reserves and Hess (NYSE: HES) to the Wildcatters.

ExxonMobil is perhaps the most defensive stock in the energy sector. With close to USD39 billion in cash and just USD10 billion in debt, Exxon has one of the cleanest balance sheets of any firm in the S&P 500. This also makes it a prime candidate as a consolidator; it has access to the cash and credit needed to make any acquisition it might care to.

Like most major integrated oil companies, Exxon’s business is primarily a combination of exploration and production and refining. Exxon’s upstream division (E&P) accounts for around two-thirds of total income, refining about 24 percent. The remaining 10 percent of the business consists of Exxon’s chemicals division.

One reason that I haven’t recommended Exxon over the past few years is that its upstream business–the unit with the highest potential returns–has lagged its peer group. Companies like Chevron have done a better job in terms of growing oil and natural gas production.

Source: Bloomberg, company reports

This chart shows Exxon’s oil and gas production in terms of thousands of barrels of oil equivalent per day. There’s a good deal of seasonality to its production results, but there’s also a clear pattern of lower highs and lower lows–Exxon’s production is falling.

There are a couple of reasons for this. The impact of hurricanes Gustav and Ike certainly made Exxon’s third quarter 2008 results look worse than otherwise would have been the case. In addition, Exxon has signed many production sharing deals. Under production sharing contracts, Exxon shares production from wells with another company, typically the national oil company with which Exxon is partnering to develop the well.

These deals usually contain a clause that changes Exxon’s share of oil and gas produced depending on prevailing commodity price. Simply put, the higher oil and gas prices, the less Exxon receives in production volumes. Rising commodity prices in recent years pushed down Exxon’s share of total production.

However, the company does have a number of new projects scheduled for completion between now and the end of 2011 that should arrest, and perhaps reverse, the production slide.

Qatar North Field: The North field is the world’s largest non-associated (the gas isn’t mixed with oil) natural gas field. Total reserves in the North Field top 900 trillion cubic feet, and much of that gas is being developed for export in the form of LNG.

LNG is nothing more than a super-cooled version of natural gas. When cooled to minus 260 Fahrenheit (minus 162 degrees Celsius), natural gas turns into a liquid and can be loaded onto specialized tanker ships for transport anywhere in the world. Once it’s transported to its target market, the LNG is converted back into a gas (regasified) and injected into the pipeline grid.

Exxon has partnered with Qatar’s national oil company on several LNG liquefaction trains–facilities for converting gas into LNG–since the 1990s. The company has four trains due to come online between now and the end of 2009. These are some of the largest LNG facilities in the world, capable of producing some 7.8 million metric tons per annum of LNG. These projects also include the construction of LNG import terminals in key importing countries such as the UK and Italy.

Russia’s Sakhalin: Sakhalin is an island located off the east coast of Russia that’s rich in both oil and natural gas. The Sakhali-1 project includes three main oil and gas fields, all located offshore: Chayvo; Odoptu; and Arkutun Dagi.

Phase 1 of the Sakhalin project was to develop the Chavyo field. First production from this field occurred back in late 2005, and the project was fully completed in late 2006. This field has ramped up to full production of about 250,000 bbl/d and 115 million cubic feet of gas per day (MMcf/d) that’s being used locally in Russia. Over the next few years Exxon and its local partners plan to develop the remaining two Sakhalin fields.

Deepwater Angola: Exxon has several major deepwater projects underway in Angola. All are part of an offshore project known as Block 15.

The company has already started up production from its Kizomba A and Kizomba B projects in 2004 and 2005, respectively. It’s currently working on Kizomba C and has already hooked up some fields as part of this project. In total, production from block 15 should ramp up to about 700,000 bbl/d over the next year and a half.

Exxon’s refining and chemicals businesses aren’t as important to the bottom line as exploration and production. Nonetheless, Exxon has an outstanding lineup of complex refineries capable of refining even complex heavy sour types of crude oil.

Exxon also wins points for the broad geographic coverage of its operations. The company has 15 refineries in the Americas, 11 in Europe, Africa and the Middle East, and another 11 in Asia. Refining margins can vary wildly in different regions of the world; Exxon’s broad geographic base means it’s diversified.

Finally, Exxon has a chemicals operation that makes up about 10 percent of its profits. Demand for some chemicals, such as those used in consumer products, is cyclical and likely in a downdraft right now. However, Exxon also produces more complex specialty chemicals; growth and profit margins in these businesses tends to hold up well even when the economy weakens.

ExxonMobil is a huge, well diversified and well capitalized firm that’s perhaps the most defensive stock in my coverage universe. With several major growth projects in the hopper and enough cash to take advantage of attractive acquisition targets, new Proven Reserves Portfolio member ExxonMobil is a buy under 85 with a stop at 50.

Smaller and riskier than ExxonMobil, Hess has a number of major exploration and development projects underway that have huge potential. Because the firm generates around 90 percent of its profits from E&P, the exploration pipeline is key to Hess’ potential.

Brazil: Hess has a 40 percent interest in an offshore block located near Petrobras’ (NYSE: PBR) giant Tupi deepwater field. Tupi looks to be one of the largest oil discoveries of the past 20 years, so Hess’ interest in this block has the potential to be truly enormous and a real game-changer.

The company began drilling an exploration well on the block, known as BMS 22, in October. In its third quarter conference call, Hess stated that it expects to release the results of this well in the first quarter of 2009. Most are looking for an announcement in February.

Libya: In September, Hess completed a series of exploration wells on deepwater block 54 in Libya. The company announced the results of one of these exploration wells just last week. The A1-54/01 well was located in waters 2,807 feet deep and has a total length of 11,077 feet.

The company found oil and gas located in various sections of the well; in total, the well intersected 500 feet of oil- and gas-bearing rock. This looks to be a solid discovery that will be commercial, although Hess hasn’t announced its full schedule for developing the field.

Australia: Hess has a 100 percent interest in a permit known as WA-390-P, located in the prolific Northwest Shelf of Australia, one of the most promising natural gas-producing regions in the world. Hess drilled a series of four exploratory well, three of which turned out to be productive. The fourth well also contained gas but not in economic quantities.

Just like every other explorer in the world, Hess has and will continue to drill its fair share of dry holes–even with the most advanced technologies available today, oil and gas exploration still involves an element of luck. The trick is to pursue a fairly large and well diversified portfolio of projects; a few amazingly productive wells can make up for scores of the inevitable dry holes.

At any rate, Hess’s four-well program indicates that the field has large quantities of economically producible natural gas. The company is likely to do further drilling to delineate the field. In its fourth quarter call, Hess stated that it’s analyzing recent well data and a three-dimensional seismic survey it commissioned earlier in the year. Further drilling is projected to commence in the latter half of 2009.

US Gulf of Mexico: Hess already has several major deepwater fields in the Gulf of Mexico that are under production. A new one, the Shenzi field, is scheduled for start up early in 2009. Hess has plans to drill several more producing wells in 2009 to ramp up production from this find.

Ghana: Unfortunately, Hess recently announced that it drilled a dry hole in its Cape Three Points play in Ghana. Although that’s not good news, the company hasn’t totally abandoned the project; Hess plans to drill more wells in a different region of its acreage.

The company hasn’t announced a timetable for further Ghana wells, but it’s quite possible it will drill more wells in 2009.

Although Hess’ exploration pipeline is definitely exciting, don’t assume the company is just a high-risk play on future production potential. Hess produced 361,000 bbl/d of oil equivalent in the third quarter, up about 1 percent from the year-earlier period. And that figure would be close to 11,000 bbl/d higher if we exclude the impact of this year’s nasty Atlantic hurricane season.

The company is ramping up production in several key areas of the world. The list includes a promising position in the unconventional Bakken oilfield located in North Dakota.

In Africa, Hess is already a major player in several countries. Hess has production from two fields in Equatorial Guinea totaling close to 70,000 bbl/d. And in Hess also produces 22,000 bbl/d in Algeria, 23,000 in Libya and 12,000 in Gabon. As noted earlier, new exploration projects could soon add to that total.

And in Asia, Hess is already active in Indonesia, Thailand and Malaysia. In fact, the company recently announced that it plans to start production from its JDA Phase 2 field in the Gulf of Thailand early in 2009 and oil production from the Ujung Pangkah field in Indonesia should commence by midyear.

With USD1.4 billion in cash on the balance sheet and less than USD4 billion in debt, Hess has a clean balance sheet. The company should be able to fund exploration plans from a combination of internally generated cash flow and existing cash. Hess is a higher-risk play but has the potential to perform exceedingly well if exploratory well results to be released early next year are positive. Hess, a new member of the more aggressive Wildcatters Portfolio, is a buy under 60 with a stop at 31.

Both Hess and ExxonMobil are attractive plays, but they offer yields of only 2 percent and 0.8 percent, respectively.

For investors willing to pursue a more active strategy, there are ways to generate additional income from both Hess and Exxon. The highly volatile market environment is perfect for this strategy; it’s not unreasonable to assume that investors can generate short-term returns of 8 to 10 percent every 60 days from both of these stocks.

Long-time TES readers know I occasionally recommend the use of options–puts and calls–though not as a means of leveraging returns but as a way of reducing risk. (See the special report The ABCs of Options to Hedge Risk and the Feb. 26, 2008, Flash Alert Insurance with Collars.)

I’ve recommended these strategies sparingly. But on more than one occasion these defensive options strategies have paid off handsomely. For example, see the June 12, 2008, Flash Alert Unsteady as She Goes.

Investors who followed the options recommendations in this report locked in average gains of 35 to 90 percent in five big winners from the first half of 2008. These options strategies offset the vast majority of the damage incurred in the post-July energy selloff.

The strategy I outline below is known as the covered call or buy-write; it’s different than the strategies I highlight in the above-referenced report. A covered call is an options strategy that allows investors to generate income from stocks that pay only small dividends or, in fact, pay no dividends whatsoever.

Assume you purchase 200 shares of ExxonMobil at a current price of USD75 per share. The total cost of this transaction would be about USD15,000 plus commissions.

The current price of a February USD80 call option (Symbol: XOM BP) is about USD3.25. Options are traded in contracts covering 100 shares, so each contract costs roughly USD325 at this time. To write a covered call, you could sell two of these call contracts for total proceeds of USD650 on your USD15,000 position.

The February calls expire Feb. 20, 2009. Calls give the buyer the right (but not the obligation) to buy 100 shares of Exxon at USD80 per share–the strike price–at any time between now and expiration. Because you sold the call options, you’re selling this right.

Here are the three possible scenarios for the stock on that date.

Exxon trades up above 80 at expiration: In this scenario, the purchaser of the call options you sold would likely exercise those options. In this case, you’d be forced to sell your 200 shares of Exxon at a price of USD80 per share, for total proceeds of USD16,000.

In addition to those sales proceeds, you’d get to keep the entire USD650 you earned by selling the calls. Because you paid USD15,000 for the 200 shares and have received total proceeds of USD16,650, your total return on the transaction would be about 11 percent. But you’re generating this return over just a 58-day time frame; you could always buy back your Exxon stock and sell another call with a later expiration data and a higher strike price.

Exxon continues to trade under 80 per share but above 75: In this sideways market, the covered call strategy truly thrives. As long as ExxonMobil closes under USD80 in February, the calls you sold expire worthless. That means that you’ll get to keep your entire position in Exxon and the USD650 you sold the options for.

In this case your return would be USD650 on a 15,000 share position, about a 4.5 percent gain. Although that’s not a great deal, remember you can now sell a call with a higher strike price and generate more income on your position. And remember that if you can earn 4.5 percent every 60 days, you’ll generate a total annualized gain of more than 30 percent, not bad for a stock trading sideways.

ExxonMobil falls to 65: In this scenario you’d have lost money on your position in Exxon, but the calls you sold would still expire worthless. That means that you’d get to keep the entire USD650 in income you received from selling the Exxon calls.

Although that’s not enough to offset your loss in the stock entirely, it would certainly soften the blow. And, because you still own the stock, you could always look to sell more calls with a later expiration data to generate more income.

As with all options trades, here are a few ground rules:

• If you don’t feel comfortable with this strategy, don’t execute the trade or consider only using it to cover one of your stocks.
• If you aren’t comfortable with the concept or idea of options, consider starting out small or just avoid the idea entirely.
• Don’t sell the calls unless you are long the stock.

For investors willing to pursue a covered call strategy to generate a bit of additional income, I’ll track the following two covered call trades in my aggressive Gushers Portfolio.

Buy ExxonMobil (NYSE: XOM) and sell 1 February 2009 USD80 Call Option (Symbol: XOM BP) for USD3 or better. The payouts from this strategy are outlined above.

Buy Hess (NYSE: HES) and sell 1 May 2009 USD55 Call for each 100 shares purchased for USD7 or better. For every call contract sold, you will generate about USD750 in income; based on the current price of USD48.82, that’s equivalent to about a 15 percent gain if Hess simply trades sideways for the next 142 days. (May expiration is May 15, 2009.)

If Hess trades above USD55 at expiration, you’ll make a total gain of about 33 percent. And finally, the options give you about USD7.50 per share in downside protection. Shares in Hess would have to fall below about USD41 before you’d begin losing money on the stock; that’s not far above the 52-week low of USD35.50.

If you’re wondering why I’m recommending this strategy at the current time, it’s simple: the best time to sell options is when the market is volatile. The reason is that market volatility pushes up the price of options and therefore the income you can generate by selling calls. The chart below illustrates current options volatility.

This chart depicts the S&P Volatility Index, commonly known as VIX. VIX measures how much volatility is priced into the S&P options market; when the VIX is high, it’s a good time to consider doing a few covered call trades. The VIX is at historically high levels right now.

Back to In This Issue

Welcoming the Partnership

My publisher, KCI Communications, has decided to cease publication of The Partnership, a newsletter that offered dedicated coverage of MLPs and other publicly traded partnership (PTP) stocks. Subscribers to The Partnership are now receiving a subscription to The Energy Strategist as an alternative.

I’d like to take this opportunity to welcome former Partnership subscribers to the newsletter; I sincerely hope you enjoy TES. We’ve been covering MLPs and PTPs within TES for the past three and a half years and will continue to do so.

I’ve also taken a closer look at The Partnership recommendations and will be adding several to the TES How They Rate coverage universe. Several Partnership picks are already in the TES Portfolios as buy recommendations; these are my favorite plays in the group.

What follows is a quick rundown on the remaining Partnership picks. None of these are being added to the TES Portfolios; this advice is simply a guide as to my current outlook. Ongoing coverage can be found in How They Rate.

WP Carey (NYSE: WPC) is in the commercial real estate business and is therefore a bit beyond the TES coverage universe. WP Carey is, however, a hold in my Personal Finance Growth Portfolio.

WP Carey’s basic business looks healthy; in fact, the firm boosted its quarterly distribution for the 28th consecutive time just last week–that’s an impressive track record. And don’t be put off by the term “real estate” as it applies to WP Carey.

One of the company’s main businesses is sale-leaseback transactions. Under such deals, WP Carey buys properties from companies and then immediately leases those buildings back to the seller under a long-term lease deal. This is essentially a means for companies to raise capital; the seller realizes immediate cash value from selling their properties. WP Carey gets a long-term stream of rent income that it can pass through to stockholders in the form of distribution payments.

The weak economy and credit crunch might actually help WP Carey because more companies are looking to use sale-leaseback transactions as a way of raising capital.

Energy Transfer Partners (NYSE: ETP) is a buy in How They Rate.

Energy Transfer’s joint venture projects with TES Portfolio holding Kinder Morgan look like attractive deals. In particular, I like the company’s exposure to the MidContinent Express Pipeline that will serve many of America’s fastest growing shale plays.

Energy Transfer’s large size makes it easier to raise capital. And its solid distribution coverage means a dividend cut is highly unlikely regardless of the path of commodity prices.

Plains All-American Pipeline (NYSE: PAA) owns pipelines used to transport crude oil and refined products and owns a series of related storage facilities.

I really like the economics for crude oil and refined product storage right now. The reason is that current crude oil prices are extremely weak; there’s a glut of crude around the key Cushing Oklahoma terminal. However, crude oil futures pries for delivery in a year’s time are significantly higher, more than USD13 a barrel higher. This creates an incentive for producers to store crude oil and sell it in the futures market at a significant premium price.

I’m adding Plains All-American to the How They Rate coverage universe as a buy.

TEPPCO Partners (NYSE: TPP) is controlled by Dan Duncan, the oil billionaire behind Portfolio recommendations Duncan Energy Partners (NYSE: DEP) and Enterprise Products Partners (NYSE: EPD).

TEPPCO’s assets are solid, and I like its joint venture deals with Enterprise. However, TEPPCO’s growth potential is less than either Enterprise or Duncan; holding exposure to all three stocks would be overkill. I’ll track TEPPCO Partners as a hold in How They Rate.

Capital Product Partners (NSDQ: CP