But energy-focused stocks have been performing well lately; the S&P 500 Energy Index was the second best-performing group in the S&P 500 in January despite falling commodity prices.

This suggests that most energy-related stocks have already priced in the worst news on the economy. Now is the time to buy top-notch energy stocks at bargain-basement prices.

In This Issue

Since late November, energy stocks have stopped underperforming the market. Although the ratio has only turned slightly higher, it’s impressive that energy stocks are holding up this well considering the fact that oil and natural gas pries have continued to slide since mid-October. See Stock Performance.

Oil consumption has fallen sharply across the developed world over the past year, and demand growth in developing countries has sharply decelerated. The key determinant of oil demand is, in turn, the state of the global economy. See Commodity Prices.

Refiners don’t make money by selling oil or natural gas. Rather, these firms buy oil as feedstock for their refineries; they then produce gasoline and other refined products for sale. A refiner’s profit comes from the spread between the cost of crude oil and the value of the refined products it sells. See Refining and Oil.

I still prefer gas over oil. However, demand trends in gas have deteriorated enough that I see prices remaining depressed in the near term before rebounding more sharply by the end of the year. In other words, I’m taking a slightly more bearish stance on natural gas in light of recent inventory reports. See Natural Gas.

My suggestion for playing the current energy market is to focus on four key themes: income-producing securities, integrated oils, high-quality, gas-focused exploration and production firms; and beaten down value names in the oil services space. See Playing the Trends.

Stock Performance

Oil and natural gas prices continue to languish, and the S&P 500 turned in its worst-ever January–yet there are some signs of life in energy-related stocks.

When the market as a whole is weak, it’s useful to examine sectors and stocks on a relative basis. In other words, determine which market groups are outperforming the S&P 500 and which are lagging.

A broader market decline tends to drag down most stocks and sectors, but those groups that outperform are often the leaders once the next bull market kicks off. In that light, the chart below is encouraging.

Source: Bloomberg

To calculate this chart I simply divided the price of the Philadelphia Oil Services Index by the price of the S&P 500. To make a long story short, when the line rises, services stocks are outperforming the broader S&P 500.

In this case, you can see that for most of 2007 and through the first half of 2008, energy stocks strongly outperformed the S&P 500. Then, as commodity prices began to slide last summer, that outperformance became a massive underperformance. In the vicious bear market that gripped the S&P 500 in the latter half of 2008, energy stocks fell faster than the broader market from July through October.

But since late November, energy stocks have stopped underperforming the market. Although the ratio has only turned slightly higher, it’s impressive that energy stocks are holding up this well considering the fact that oil and natural gas pries have continued to slide since mid-October.

And the Philadelphia Oil Services Index has been one of the worst-performing major energy indexes and among the most volatile. If we examine the S&P 500 Energy Index the picture is considerably more favorable.

To accurately gauge oil and natural gas prices, I prefer to examine the 12-month New York Mercantile Exchange (NYMEX) strip price, which is calculated by averaging the next 12 months’ worth of futures contracts. The advantage of this measure is that near-month futures contract prices are often distorted by short-term supply or demand issues; the strip offers a better measure of intermediate-term conditions.

Roughly speaking, if we look at the 12-month NYMEX strip prices, oil is down 35 percent from mid-October, and natural gas is off 25 percent.  Meanwhile, the S&P 500 is trading 7 percent off its Oct. 15 close. That would hardly seem an environment conducive for energy related stocks to outperform, but the S&P 500 Energy Index is actually up more than 12 percent over the same time frame.

This isn’t an isolated example: Many of the stocks in my coverage universe have seen significant upside over the past three months. Check out the table below for a closer look.

Source: Bloomberg, The Energy Strategist

This table shows the top and bottom performers within the S&P 500 Energy Index from Oct. 15 through Tuesday’s close. Among the top performers are a number of refining stocks and integrated oils as well as a handful of natural gas-focused producers. The bottom of the list includes several oil and gas services and contract drilling names. Returns have been impressive in light of the weak stock market and commodity backdrop.

It’s also worth highlighting a couple of additional pockets of notable outperformance that aren’t part of the S&P 500 Energy Index: master limited partnerships (MLP) and uranium stocks. I profiled the latter at some length in the January 21 TES, Uranium Revisited.

I’ll take a closer look at the MLPs later on in today’s report, but suffice to say that the Alerian MLP index rallied more than 15 percent in January, one of the strongest monthly performances for the index in its history.  And we’ve already seen several MLPs announce distribution increases, despite rock-bottom commodity prices and a still-troubled credit market.

The obvious question in light of this performance is why would energy stocks be outperforming amid this weak commodity price environment? I believe the answer is two-fold: extraordinarily cheap valuations on any historical basis and limited additional downside for commodity prices.

As for the first point, check out the chart below.

Source: Bloomberg

This chart shows the current trailing price-to-sales ratio for the Philadelphia Oil Services Index. I could have just as easily put up a chart showing price-to-earnings or price-to-book value for the same index–the trends are nearly identical. It’s clear that valuations for stocks in the energy industry haven’t been this low since at least 1998, when the per-barrel price of oil was in the teens. In many cases, stocks are actually trading below their 2008 valuations lows.

Investors should always be wary of charts showing long-term valuation trends in individual stocks and indexes. The reason is that a stock or industry group that looks cheap can continue getting cheaper; valuations are absolutely not a timing tool. Moreover, sometimes a stock or industry is “cheap” for a good reason, deteriorating fundamentals, for example.

In this case, however, the long-term fundamentals for energy stocks remain solid. The vicious correction in oil and gas prices in recent months is a temporary setback in the context of a longer-term uptrend. As I outline below, I continue to believe the key driver of the next energy bull market will be supply; the massive retrenchment in spending on exploration and development in recent months spells lower supplies. When demand does pick up again, there just won’t be enough supply to satisfy that demand at anything close to current prices.

Current depressed valuations of various energy indexes are absolutely meaningless over a one- or two-month time frame. However, depressed prices do represent an opportunity to pick up top-quality energy stocks at attractive levels; on a 12-month outlook, current prices represent a huge opportunity.

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Commodity Prices

The outlook for commodity prices is more complex. That said, I’m sticking with the price outlook I outlined in the January 7, 2009 TES, Good Riddance, 2008. I expect oil prices to remain range-bound between the low 30s and mid 50s over the next few months; as demand returns to the global market in the waning months of 2009, you’ll see crude once again mount a more significant uptrend. I suspect you’ll see oil back over USD100 a barrel again in 2010.

The key driver of the oil market remains demand. Oil consumption has fallen sharply across the developed world over the past year, and demand growth in developing countries has sharply decelerated. The key determinant of oil demand is, in turn, the state of the global economy.

As long-time readers are aware, my favorite measure of the state of the US economy is the Index of Leading Economic Indicators (LEI). The LEI is an index summarizing the performance of 10 important indicators of economic health. In the January 30, 2009 Pay Me Weekly, Follow the Economy’s Lead, I dig even deeper into the LEI, offering a lengthy and detailed look at every one of the 10 indicators that make up the index.

To summarize my report in PMW, the 10 leading indicators currently look weak and continue to deteriorate with the exception of two, money supply and interest rate spreads. US money supply has been growing sharply in recently months thanks to a long list of government bailouts and measures to boost liquidity. Check out the chart below for a closer look.

Source: Bloomberg

This is a measure of the total amount of inflation-adjusted money in the economy; M2 measures physical currency, checking and savings deposits as well other immediately available, on-demand forms of money.

When the inflation-adjusted money supply grows, that means monetary policy is easy and expansionary. This tends to be stimulatory for the economy. The quick spike in the index at the end of this chart is unprecedented. The chart above shows data going back to the early 1970s, and you won’t find a spike of similar magnitude anywhere else on it.

The world’s central banks are currently battling deflation, not inflation. The ongoing deleveraging of the global financial system is inherently deflationary, as is banks’ unwillingness to lend. However, I don’t see how the massive jump in M2 won’t eventually filter cause a sharp uptick in inflationary pressures and, quite likely, downward pressure on the US dollar. Rising inflation might not be great for the economy as a whole, but it does tend to support commodity prices–oil, natural gas and other physical assets tend to perform well when inflationary pressures are building.

The second component of LEI that’s been broadly supportive in recent weeks is interest rate spreads. As I explained in PMW, this measures the different between the yield on a 10-Year US Treasury bond and the current federal funds rate. This is essentially a measure of the steepness of the yield curve.

There are a few reasons why this might be important. First, when short-term interest rates are low (fed funds rate is low) relative to longer-term bonds–a steep yield curve–it’s an indication the US central bank has been easing monetary policy.

Also, when the yield curve is steep it tends to help the banks. The reason is that banks take in customer deposits and pay short-term interest rates on those deposits. As short-term rates have fallen, you’ve probably noticed the interest you’re paid on savings accounts and certificate of deposit accounts has also fallen.

The banks turn around and lend that cash out to consumers and businesses at longer-term interest rates. When the yield curve is steep, the spread banks earn between the cost of cash (deposit rates paid) and the interest rates they receive on loans grows, increasing profitability.

Granted, a weak lending environment and a lack of willingness to lend mean this isn’t as beneficial as it normally would be. That said, it’s generally a positive. Here’s the chart of the LEI measure of the yield curve.

Source: Bloomberg

As you can see, the yield curve has steepened rapidly since early 2007 when it was inverted–back then short-term rates were higher than long-term rates. An inverted yield curve is typically an indication of tight monetary policy and a looming recession for reasons exactly opposite to the analysis I offered above.

This indicator is tending to be supportive of the LEI; however, in December it did pull back somewhat. I have no doubt the Federal Reserve will keep the yield curve relatively steep to support the economy.

But my key takeaway from delving into the LEI is that the only positive economic indicators are those that are more or less directly controlled by the US government. The government does appear to have been partially successful in unlocking the global credit markets. In January, for example, TES holdings Weatherford International (NYSE: WFT) and Nabors Industries (NYSE: NBR) were able to raise new capital by selling bonds.

Although the rates both firms are paying to borrow money are sharply higher than they were a year ago, it’s highly unlikely that either firm would have been able to raise new money just a few weeks ago.

That said, easy government money isn’t the foundation upon which sustainable and healthy economic rebounds are built. Before I have any confidence in a turn for the US economy, I need to see evidence that some of the other components of LEI, such as residential building permits or hours worked, have begun to stabilize. This will happen, and I suspect we’ll begin to see the light at the end of the proverbial tunnel late this year or early in 2010.

However, right now a weak US economy and weak US oil demand remain key headwinds for crude oil prices.

It’s also worth noting that I find very little encouragement in the recent read on fourth quarter US gross domestic product (GDP). US GDP fell by about 3.8 percent, its worst showing since the early ’80s recession; however, that was better than consensus expectations for a more than 5 percent decline and the whisper number of a 6 percent decline.

But before you get too excited, the main reason that US GDP was better than expected was due to a buildup in inventories of unsold goods. Rising inventories is hardly the sign of a healthy economy; on the contrary, this suggests US retailers and manufacturers are having a tough time selling their products. I find the LEI to be a more useful measure of economic prospects than the frequently revised GDP numbers.

Economic weakness isn’t confined to the US. The Organization for Economic Cooperation and Development (OECD) publishes LEI indexes for several key regions of the world. Check out the charts below.

Source: Bloomberg

Source: Bloomberg

The first chart shows the 12-month percent change in LEI for the Eurozone, the countries in the European Union that have signed on to use the common currency. The second chart is the 12-month change in Chinese LEI. Investors can interpret these indicators in much the same way as the US LEI year-over-year percent change.

As you can see, the picture for the EU looks every bit as negative, if not more so, than for the US. The 12-month change in LEI has rapidly deteriorated over the past year and now stands at the lowest level on record; this is consistent with a severe recession similar to the contractions witnessed in Europe in the ’70s and early ’80s.  This is not good news for European oil demand.

What’s even scarier is China’s LEI. China, India and other emerging markets have been the key drivers of global oil demand over the past five years. One could argue, in fact, that growth and development in the emerging markets has been the main driver of the energy bull market since the late ’90s.

Chinese LEI hasn’t turned negative year-over-year, but is it hovering around the lowest level since the OECD began publishing the index. We’ve already seen a deceleration in Chinese oil demand, and there are signs of some further economic distress there, such as rising unemployment, especially outside major urban areas.

Obviously, neither chart is a positive for global demand or for oil prices. I’ve written about LEI on several occasions over the past year in TES and will continue to offer updates. When we do begin to see stabilization in LEI and a turn to the upside, the oil and natural gas markets are likely to break to the upside.

I’m looking for the Eurozone to broadly follow the US out of recession. The reason is that both the Eurozone and the US are suffering from the same root problem: a sick financial system. While property markets in some key EU nations–Germany is a prime example–never got as bubbly as markets in the US or UK, banks across the Continent were key players in the very same toxic mortgage assets that plague the US banks. When this situation stabilizes, it will benefit both the US and EU economies greatly.

China is a more complex situation. The nation has historically been dependant on exports to the West for much of its growth. A synchronized downturn in the US and Eurozone economies is bad news for the export business. Increasingly, however, China has been developing a domestic demand stor–their internal market is growing rapidly as is trade with other developing Asian nations.

The Chinese government is seeking to support domestic demand in many ways including with a two-year, USD586 billion stimulus package and several measures designed to encourage the domestic property market. Growing domestic demand is sheltering China from the worst of the global downturn.

My long-time colleague and Asia expert Yiannis Mostrous believes that the Chinese economy is in for a rough ride in the first half of 2009 but will see a reacceleration of economic growth in the back half of the year. Some economists have been downgrading their expectations for Chinese growth in 2009 to the 5 to 6 percent range; Yiannis believes that growth will surprise to the upside this year.

Yiannis recently wrote in his excellent advisory Silk Road Investor:

China’s National Bureau of Statistics revised upward 2007 real GDP growth to 13 percent from 11.9 percent. The importance of the announcement is twofold.

First, it was higher growth in the service industries that provided the boost, indicating the steady transformation of the Chinese economy toward a domestic consumption-oriented economy, which will provide a more stable growth pattern.

Domestic consumption is now contributing close to 41 percent and rising, while manufacturing is coming down, currently at around 48 percent.

Second, it looks like China became the world’s third-largest economy in 2007. The top five economies in 2007 were the US (USD13,808 billion), Japan (USD4,380 billion), China (USD3,383 billion), Germany (USD3,321 billion) and the UK (USD2,807 billion).

I’m particularly encouraged by the rising domestic demand story in China. While the Chinese government’s attempts to stimulate growth may have little impact on demand for Chinese exports, they could well impact the domestic economy. And growth within China is of growing importance.

For now at least, the action in the Chinese stock market would appear to bear out this more optimistic view. Check out the chart below for a closer look.

Source: Bloomberg

This chart shows the performance of several key global equity markets including the US, UK, Japan and China. As you can see, China’s Shanghai A-share index is one of the only indexes in the world actually showing a positive performance so far this year, up more than 15 percent.

Although it’s still early, this positive stock market performance in the face of negative headlines about China’s economy is encouraging. It suggests that the Chinese market’s vicious correction in 2008 prices in the obvious economic slowdown. In addition, it also indicates growing optimism that China’s plans to stimulate growth will be at least partially successful in 2009.

Bottom line: The picture for oil demand is weak, particularly in the developed world. I continue to look for demand headwinds to abate after mid-year as continued normalization of credit markets in the developed world and a resumption of growth in emerging markets combine to stabilize the global economy.

It’s also worth mentioning the unprecedented distortions I’m currently seeing in the US oil markets. While some of these points are a bit technical, it’s extremely important to watch–I firmly believe that the oil prices you see quoted each day on CNBC are increasingly meaningless due to these distortions.

The easiest way to explain is through a series of charts. First, check out the chart of the futures curve for NYMEX crude oil.

Source: Bloomberg

This chart is simply a graphical representation of crude oil prices based on the NYMEX futures contract. For example, you can see that March 2009 crude oil futures are trading around USD40 to USD43 a barrel. Meanwhile, March 2010 futures are trading closer to USD58, a massive, USD15 spread.

This upward-sloping futures curve is known as contango; this is one of the most extreme examples of contango you’ll find in modern history. As I’ve explained before, there’s a good reason for this condition and it has to do with excessive inventories of oil in Cushing, Oklahoma.

Cushing is the official delivery point for US-traded crude oil futures. This massive pipeline and storage hub ranks among the largest of its kind in the world. But there’s a problem: Cushing’s oil storage is nearly full. This temporary glut of crude in Cushing is putting downward pressure on near-month crude oil futures. Looking out a year, most traders believe the storage situation at Cushing will have greatly eased; later-month oil futures more closely reflect intermediate- to long-term demand conditions.

Contango is also encouraging oil traders to hoard oil in storage; this is a major factor behind the build-up in crude oil inventories in recent months. The storage trade is simple. Traders buy oil on the spot market at depressed prices currently around USD41. The trader can then turn around and sell oil futures expiring six or 12 months in the future; for example, a trader could sell March 2010 crude futures for USD57. If that trader can store the oil for a year, it’s possible to realize a profit equal to the spread between spot and futures prices; in this case, that would be around USD16 a barrel over a one-year period.

But it’s not just severe contango in NYMEX futures that tell us something highly unusual is at work in the global oil markets. Check out the charts below for a closer look.

Source: Bloomberg

Source: Bloomberg

The first chart is the difference between West Texas Intermediate (WTI) and Brent oil prices. To calculate this spread I subtracted the price of Brent from the price of WTI and presented data going back to 1983.

On average, over this more than 25-year history, WTI has traded at an average USD1.30 premium to Brent. The main reason for this is that WTI is a slightly higher grade of oil than Brent; WTI is slightly lighter (easier to refine) and somewhat sweeter (contains less sulphur). As you can see, it’s highly unusual for Brent to trade at a premium to WTI.

But for the past several weeks, that’s exactly what’s happened. On some occasions since early December, Brent has traded at as much as an USD8 premium to WTI.

The second chart computes the same spread for WTI minus the price of Maya crude, a Mexican crude oil benchmark. I present data going back to the early ’90s; over this time period, the average spread between WTI and Maya has been for WTI to trade at around an USD8 premium. Because Maya is a heavy sour grade of crude, this spread simply reflects underlying crude oil quality.

But just as with the WTI/Brent spread, the spread to Maya isn’t behaving normally at the current time. Right now, WTI is only trading at a roughly USD2 premium to Maya, and earlier this year the two crudes traded at parity; this had never happened before.

These unusual spreads also reflect bloated inventories of crude at the Cushing hub. Since NYMEX-traded futures are based on WTI and, therefore, are delivered at Cushing, prices have been depressed by these inflated inventories. In other words, WTI prices aren’t reflecting normal supply/demand conditions.

Naturally, most US news outlets quote WTI crude oil as the key benchmark. But right now it would appear that Brent is a better reflection of overall global supply and demand conditions–Brent is telling us that the global supply and demand balance for crude isn’t as bearish as WTI prices seem to suggest.

Longer term, supply remains the key issue to watch in the crude oil market. There’s increasing evidence that OPEC member states are complying with agreed production cuts. More importantly, depressed oil prices continue to force producers to scale back on exploration and development spending.

Long-time TES readers know that I watch oil service giant Schlumberger (NYSE: SLB) extremely carefully as a gauge of overall health in energy markets. The reason is simply that Schlumberger has its hands in just about every imaginable oil- or gas-producing market on the planet.

Schlumberger’s fourth quarter earnings release and conference call were far and away the most bearish from the company in at least five years. CEO Andrew Gould was notably downbeat, particularly during the analysts’ question and answer (Q&A) session. Predictably, earnings estimates have plummeted since that call.

Nonetheless, it’s encouraging that Schlumberger has actually traded higher since its earnings release, rallying close to 10 percent against a 6.5 percent rally in the Philadelphia Oil Services Index. This strongly suggests that the negative news was already priced into Schlumberger’s stock; no one really believed the earnings estimates published prior to the release.

And there’s a light at the end of the tunnel: The severe decline in global oil exploration and development spending spells falling oil supplies. In this regard, an exchange that took place during Schlumberger’s earnings call is notable:

Analyst: Andrew [Andrew Gould, Schlumberger CEO], I was wondering in your view how do you–how does this cycle compare to other cycles you’ve experienced in your career? Would you put this closely, more closely aligned with the 1997 to 1999 period or more like the ’80 to ’86 period?

Gould: I think the–actually, I think it’s a bit different from both because the precipitous drop in the oil price is combined with the contraction of the general economy. So actually, the biggest difference I see from both sort of the mid-80s and as well as 1997-’98 is the speed with which everybody is reacting. Our customers are reacting at a much faster pace than they probably did even in 1997-’98, which was a very sharp cycle. I mean, my general comment is, these cycles as I experienced them are getting much sharper in their amplitude and shorter in their duration. Now of course, that depends on the general economy. But I would say that the big difference I see so far is the speed with which everyone is reacting.

The analyst is simply asking for a better feel for how the current oil down-cycle compares with major contractions of past years. What’s interesting is that Gould believes that this cycle doesn’t compare directly with prior downturns. Specifically, it appears that companies are reacting faster to the decline than in prior cycles; in other words, rather than maintaining their E&P spending for a few quarters to see what path commodity prices take, producers are aggressively cutting their plans and budgets.

It could be that this is at least partly due to the global credit crunch. Because most smaller producers can’t borrow money at favorable rates (or quite possibly at all), they’re actually unable to spend more than their cash flow. Troubled credit markets are, in effect, forcing their hands sooner.

What this means is that the decline in activity is happening faster. This spells a sharp downturn for Schlumberger and its competitors in the short term. But looking out six or nine months into the future, this downturn in spending likely spells a massive decline in production.

These comments support my view that this down-cycle will take the shape of a V. We’re already seeing the left side of that V as exploration and production activity shuts down. But as demand begins to return in the latter half of 2009, supply will be falling rapidly–the current downturn is sowing the seeds for a quick recovery as soon as demand stabilizes.

Gould also hints that Russia and what he calls “new” hydrocarbon resources will see a bigger decline in spending. Gould stated that in Russia spending on big projects such as Sakhalin will likely see continued spending as planned under long-term contracts. But smaller Russian oil and gas producers are not likely to maintain spending. Gould sees total meters drilled–the total length of wells drilled in Russia–declining by at least 10 to 20 percent this year. Gould went on to state that the resulting production drop-off would be “very significant.”

In his prepared remarks Gould also stated that “at current prices most of the new categories of hydrocarbon resources are not economic to develop.” When asked to clarify, he noted that his definition of “new” hydrocarbon resources includes ultra-deep deepwater, advanced enhanced oil recovery, heavy oil, tar sands and coal and gas-to-liquids. The problem with this is that if the world is going to meet long-term oil demand growth, these key hydrocarbon resources must be developed. Since spending is falling in these areas, it will be extremely difficult to quickly ramp up supply when demand returns to the oil market.

While Schlumberger clearly faces some near-term headwinds, the stock’s positive reaction to a downbeat conference call suggests that “news” is already in the stock.  Longer term, Schlumberger is the technology leader in the oil services market and is well placed to benefit from the coming upturn.

All investors should have exposure to this best-of-breed oil services name. I’m maintaining my buy recommendation on Schlumberger, a mainstay in the growth-oriented Wildcatters Portfolio.

I also continue to recommend smaller oil services firm Weatherford International (NYSE: WFT). This stock has been ravaged by the most rapid shift in the energy cycle in history. However, the stock is now as cheap as it’s ever been, and long-term trends remain positive.

I suspect that Weatherford will see the strongest relative growth of any major oil services firm in the world. The main reason: Weatherford’s exposure to so-called integrated project management (IPM) contracts and, in particular, its Chicontepec contract in Mexico. Weatherford had many vocal critics when it signed the Chicontepec deal, as it was, far and away, the low bidder on the project and many pundits felt the company wouldn’t be able to turn a decent profit.

But according to Weatherford’s recent conference call Chicontepec is going as planned, and it appears to be both operationally and financially a success. There could be more upside for Weatherford as part of this project as Mexico’s state-run oil company, PEMEX, may look to drill more wells around this project; Weatherford would be well-placed to win follow-up deals thanks to its experience in the region and existing infrastructure there.

There’s a strong possibility this will happen even if commodity prices remain depressed; Mexico is keen to stabilize the rate of its oil production decline, and Chicontepec is a big part of that effort.

And Chicontepec is one of a handful of IPM deals Weatherford has. The company is scheduled to start up several big IPM projects this year. This amounts to a backlog of business for Weatherford to work through; the backlog should help offset spending declines in the North American markets. Weatherford International remains a buy in the Wildcatters Portfolio.

To summarize, I see three key trends in the oil market today.

Demand headwinds remain a key obstacle to higher crude prices. I see no sign of this abating just yet. Continued demand concerns will keep oil prices below USD60 until at least summer.

The spending response to lower commodity prices has been rapid and sharp. This will bring down global oil production far faster than most expect, and the declines in supply will be deeper the longer oil remains sub-USD60. Supply should keep a floor under oil prices in the USD30 to USD35 area, roughly last year’s lows.

For the most part, energy stocks are already pricing in the weak demand environment. The sector will continue to see jagged volatility over the next few months but I suspect we won’t see significantly lower lows in the Philadelphia Oil Services Index or the S&P 500 Energy Index.

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Refining and Oil

In closing my discussion on oil markets, it’s worth commenting on the refiners, one of the best-performing sub-groups within energy sector over the past three months.

As long-time readers already know, refiners don’t make money by selling oil or natural gas. Rather, these firms buy oil as feedstock for their refineries; they then produce gasoline and other refined products for sale. A refiner’s profit comes from the spread between the cost of crude oil and the value of the refined products it sells.

This margin is often known as the crack spread; see the chart below.

Source: Bloomberg

This chart shows the current 3-2-1 crack spread. This is the theoretical profit margin a refiner receives by converting three barrels of crude oil into two barrels of gasoline and one of heating oil (diesel fuel).

As you can see, the crack spread has actually been rising in recent weeks. There are two reasons for that rise. First, crude prices have remained broadly depressed, especially WTI prices thanks to the glut of crude in Cushing. Because refiners buy crude to feed their refineries a low price for WTI means lower costs.

At the same time, gasoline and heating oil prices have been outperforming the price of crude. This means that the value of the products refiners sell–gasoline and heating oil–are rising. This explains their expanding margins.

These trends could persist for some time and even accelerate into the upcoming summer driving season. Although demand for gasoline will remain weak this summer, there will still likely be some pickup in gasoline demand between now and summer; lower gasoline prices may also encourage more consumption.

My play on the refining industry is Marathon Oil (NYSE: MRO), a company profiled at some depth in the January 7, 2009 TES, Good Riddance 2008. Marathon is an integrated oil company, not a pure-play refiner, but it does have the largest exposure to the refining industry of any integrated oil.

I also see Marathon revisiting plans to split off its refining and exploration and production businesses. This split would better highlight the valuation of both parts of the business and would be a positive catalyst for the stock. The company announced in its first quarter call on Feb. 3 that it would remain an integrated company for now; the rationale was that its financial strength and credit quality would be superior as a combined entity. If credit markets continue to improve, however, Marathon could revisit that decision.

Even with the prospects of a de-merger off the table for now, I recommend holding on to Marathon Oil as a play on the continued expansion of the crack spread as we head through the spring months.

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Natural Gas

TES readers know that I’ve generally preferred exposure to natural gas-levered firms rather than those levered to crude in recent weeks. The reason is that I saw demand for natural gas as more resilient to the weakening economy, and I felt that supplies would begin to fall off due to the rapid decline in US drilling activity levels.

Gas prices have largely outperformed oil in recent weeks; however, gas has seen a severe pullback so far this year. Gas-levered exploration and production names have also outperformed those levered to oil prices this year; many of the big producers have continued to rally despite continued weakness in the commodity.

I still prefer gas over oil. However, demand trends in gas have deteriorated enough that I see prices remaining depressed in the near term before rebounding more sharply by the end of the year. In other words, I’m taking a slightly more bearish stance on natural gas in light of recent inventory reports.

The winter of 2008-09 is shaping up to be one of the coldest in recent memory across the US. I’m currently in Orlando, Florida for the World Money Show; the temperature here is projected to dip into the 20s Fahrenheit tonight. This is highly unusual for central Florida and has wreaked considerable damage on local crops and plants.

And this is just the latest in a series of cold Artic blasts for the US this year. According to the National Oceanographic and Atmospheric Association, this winter has so far been about 9 percent colder than last year for customers living in regions where natural gas heat is popular. This year is on track to be the coldest winter since 1978.

Given that backdrop, one would expect a major jump in natural gas demand–weather-related demand should be pushing some big gas drawdowns. Certainly that’s what analysts have been expecting to happen; see the chart below.

Source: Bloomberg

This chart compares actual gas drawdowns since Oct. 31, 2008 to consensus analysts’ expectations at the time the reports were released. Positive numbers on this chart indicate gas drawdowns that were smaller than expected.

As you can see, analysts have largely overestimated gas drawdowns this season. Since Oct. 31, gas drawdowns have come in a total of about 43 billion cubic feet (bcf) below expectations. That works out to around 3.6 bcf a week.

When you couple that with the extremely cold winter weather, it’s clear that something is amiss: Either production is stronger than analysts expect, or demand is falling faster than expected due to economic weakness. I suspect the answer is a combination of both.

As for production, check out the chart below.

Source: Energy Information Administration

This chart shows total US gas production going back several years. You can clearly see the boom in production that started in 2006–this marks the real ramp-up in US gas production from so-called unconventional fields.

I explained what’s meant by “unconventional” gas production back in the August 20, 2008 and September 3, 2008 issues, The Natural Gas Boom and Unlocking Shale, respectively. Suffice to say that these wells are highly productive, but producers had to learn how to produce them properly using modern fracturing and horizontal drilling techniques. You can see when US producers cracked the code on unconventional plays–the resulting surge in production was impressive.

The most recent data on gas production we have from the Energy Information Administration (EIA) is for November. It does appear that gas production has stalled somewhat lately, although this could easily be due primarily to hurricane-related disruptions late last year.

The fear among gas bears is that continued strong production growth from unconventional plays will swamp demand. There’s truth to this argument from a short-term perspective–even after gas prices topped out and began falling, it took time before prices fell enough to prompt companies to cut back on drilling and actually stop producing gas from higher-cost wells.

We began hearing of production cutbacks in late August and early September, roughly two months after gas prices topped out and began falling in earnest. But just because producers are shutting in wells and cutting back on exploration and development spending doesn’t mean gas production won’t continue to grow.

Producers likely had wells near completion in late August and decided to finish up wells they’d started. Other producers had contracted for drilling rigs; it typically makes sense to keep operating rigs you’ve already paid for, at least for a while.

This well and drilling backlog kept production moving higher even as producers began scaling back their efforts. The US rig count–the number of rigs actively drilling for oil and gas–topped out in August at more than 2,000 rigs and now stands at less than 1,500. This represents a far faster than expected decline in the US rig count; see the chart below for a closer look.

Source: Baker Hughes, Bloomberg

But in the last cycle for natural gas–in 2001 and 2002–it took roughly three months for the declining rig count to show up in production numbers. Since the most recent data we have from the EIA is for the month of November, it shouldn’t come as a huge surprise that lower drilling activity hasn’t yet shown up in EIA statistics in the form of falling production.

And the rig count really started to accelerate to the downside during the peak of the credit crunch in September through November; the effects of this decline in activity are likely only just beginning to be felt in terms of supply.

I have no doubt that falling drilling activity means falling gas supplies. The only real question is how much of a lag there will be. The last two weekly reports have seen drawdowns that exceeded analysts’ forecasts; it’s far too early to tell for sure, but this could represent the beginning of this supply effect hitting the gas market.

Some have said that most of the decline in drilling activity has been for vertical rigs drilling conventional wells, not more powerful rigs capable of drilling horizontal wells in prolific shale plays. This is true, to an extent. After all, producers naturally shut down operations in higher-cost conventional regions before clamping down on promising unconventional plays.

But the horizontal rig count is definitely dropping now; unconventional drilling activity levels are being curtailed. The horizontal rig count hit a high of 650 active rigs in late October and has now dropped to less than 550, a sizeable percentage decline.

Counterbalancing that fall-off in the rig count is demand. As I’ve written here before, demand for electricity and home heating are relatively resistant to recession; in fact, we haven’t seen much effect on electricity demand, while heating demand is up this year thanks to the blistering cold.

However, industrial demand, including the use of natural gas as a chemical feedstock, is declining rapidly. Since this makes up around third of US gas, the weak economy is filtering through into demand statistics. Given the trend in LEI I highlighted earlier, this situation will persist as long as the economy remains weak.

Bottom line: I still see current gas prices representing a floor for the commodity. If anything, sub-USD5 gas will prompt producers to cut back even further on their production activities. In addition, I don’t believe we will see a widening glut of gas in the US this year. While demand trends will remain negative, current gas in storage is barely above the five-year average right now, and we may be seeing the first signs of a falling rig count’s effect on supplies.

But gas prices will likely remain in the sub-USD7 per million British thermal units neighborhood until we begin to see signs of economic stabilization. As the economy recovers and demand returns, consumers will find supplies dropping; just as with oil this could spell a rapid run-up in prices again as early as late 2009 or 2010.

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Playing the Trends

My suggestion for playing the current energy market is to focus on four key themes: income-producing securities, integrated oils, high-quality, gas-focused exploration and production firms; and beaten down value names in the oil services space.

Income-producing stocks such as master limited pPartnerships (MLP) currently offer some mouth-watering yields. Most MLPs were hit hard in 2008 thanks primarily to concerns that the credit crunch would kill their access to capital. While the group has seen a strong start to the New Year, the average yield for an Alerian MLP Index component exceeds 10 percent.

I highlighted my favorites in the November 5, 2008 and November 19, 2008 issues, Time for Income and High Income With Upside, respectively. I won’t belabor those points again here. Suffice to say that we’ve already seen several of my recommended MLPs announce distribution increases for the fourth quarter.

Duncan Energy Partners (NYSE: DEP), Natural Resource Partners (NYSE: NRP), Enterprise Products Partners (NYSE: EPD), Sunoco Logistics (NYSE: SXL) and Kinder Morgan Energy Partners (NYSE: KMP) have all announced significant increases in their quarterly distributions–hardly a sign of a sector in trouble.

One key fundamental risk to the group remains the gathering and processing (G&P) business, a risk I first highlighted in the December 3, 2008 issue, Crisis Equals Opportunity. In that issue I flagged three TES-recommended MLPs as potentially negatively impacted by weakening G&P businesses: Eagle Rock Energy Partners (NSDQ: EROC), Williams LP (NYSE: WPZ) and Hiland GP (NSDQ: HPGP).

My conclusion in that issue was that the first two in the series were insulated enough that the G&P business wasn’t a big problem; I maintained my buy ratings on both. Subsequently, both have seen nice rallies.

I did cut Hiland GP to a hold and suggested that a distribution cut would be likely if trends persisted. Hiland did cut its distribution from USD0.3175 per quarter to USD0.10. This came as little surprise and, in fact, appears to have already been priced into the stock–Hiland shares hardly budged on the news.

But Hiland GP remains a troubled company due to the rapid decline in profitability for its G&P business. It represents a call option on a return to health of the underlying business. This is the only reason I’m not recommending you sell the stock outright at this time. It’s also the only one of the TES-recommended MLPs that’s seen a major fundamental problem with its base business.

To thicken the plot, the chairman of Hiland, Harold Hamm, has offered to take both Hiland GP and Hiland Holdings (NSDQ: HLND) private at USD3.20 and USD9.50, respectively. Because Hamm controls the majority of outstanding Hiland GP stock, taking that firm private would be relatively easy.

However, Hamm only controls a little over a third of Hiland’s outstanding units, and I doubt he’d want Hiland GP without Hiland itself. The outcome of this proposed deal is far from certain at this time. For now, continue to hold Hiland GP but, as I noted in early December, new investors should steer clear of the stock and focus on my other MLP recommendations outlined in the above-referenced issues.

In addition to the MLP, I continue to recommend Chesapeake preferred stock and bonds as income plays. Those plays were outlined in the November 19, 2008 issue, High Income with Upside.

My rationale for investing in integrated oils and super majors is that these firms can be profitable even at current depressed prices. In addition, most have clean balance sheets and now have the opportunity to make attractive acquisitions at fire-sale prices.

My favorites in this group are ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), and Eni (NYSE: E). A bit riskier but also attractive are Hess Corp (NYSE: HES) and Marathon Oil (NYSE: MRO).

Finally, my favorite two natural gas focused producers are EOG Resources (NYSE: EOG) and XTO Energy (NYSE: XTO). Both firms benefit from stellar positions in key US shale plays as well as low production costs.

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