The past three weeks marked the height of third-quarter earnings season for the energy patch. As expected, earnings for the group were strong and guidance for the year ahead was positive. Energy is the sector with the most visible earnings and revenue growth in the market. And this remains by far the most durable upturn in the oil and gas business since the 1970s.

In the long term I expect a prolonged upcycle for the industry, lasting at least another five to 10 years. Nevertheless, every great bull market has its corrections and it would be a mistake to think you can just buy any energy stock right now and see big gains over the next few months. As I’ve repeatedly indicated, crude oil prices could fall to the $50 to $55 per barrel (bbl) level short term while natural gas falls back to $8 per million Btu (MMBtu). Selectivity is paramount in such an environment.

Moreover, cost pressures are building in the group, a function of a shortage of workers and rising raw materials costs. This will clearly affect some sub-groups more than others.

Bottom line: it’s just as important to recognize the groups most vulnerable to further declines as it is to understand the biggest beneficiaries of the energy bull market.

Right now, I favor the oil services and infrastructure plays. The world’s energy producers are in the midst of a major crunch–demand for oil and gas is rising rapidly while the producers simply aren’t finding new reserves to replace current production. As I explained in The Great Wall Of Cash (TES, August 10, 2005), the global energy market is just now entering a new exploration cycle. Part of increased exploration activity is more aggressive drilling, and this plays right into the hands of the world’s oil services giants.

Furthermore, the major integrated oil companies, national oil companies and larger independents are unlikely to alter their exploration plans even if there’s a substantial short-term drop in energy prices. These companies are already investing billions in major, multi-year projects to develop new reserves; it’s unlikely those plans would be dropped even if crude oil prices slide back to the mid-50s per barrel and natural gas slips back to $8/MMbtu. That means well-placed services companies have plenty of earnings visibility for the next few quarters.

BJ Services and Dresser-Rand Group are already recommended in the Wildcatters portfolio, and I’m adding internationally leveraged oil services giant Weatherford.

I’ll also be profiling Core Laboratories, a promising-if-slightly-riskier play on the services boom. I’m adding the stock to How They Rate as a buy recommendation and will continue to follow the stock as a trade recommendation. Core Laboratories is suitable for more aggressive investors.

Investors should tread carefully in the exploration and production (E&P) space right now. Rising prices for oil field services and rising day-rates for hiring drilling rigs spell higher costs for producers. What’s more, there’s an acute shortage of workers in the oil field industry, a legacy of the long depression in the industry during the late 1980s and throughout the ‘90s. Attracting and retaining talent is a big problem that’s leading to wage inflation.

Worse still, it’s becoming harder and more expensive to find new reserves and extract oil from existing reserves. Companies with the ability to control costs and grow their production will do well over the next few years–lower cost producers can handle these higher costs. But a number of independent E&P companies have weak production growth and high production costs–such names should be avoided. I’m adding Pogo Producing as a short in the Wildcatters Portfolio. I’ll also highlight several other names that should be avoided in How They Rate. For those who prefer options to outright shorts, I’ll also offer a put alternative to the Frontier Oil short.

To summarize, I’m adding or reiterating my buy recommendations on the following stocks:

· Weatherford International (NYSE: WFT)
· Dresser-Rand Group (NYSE: DRC)
· BJ Services (NYSE: BJS)
· Core Laboratories (NYSE: CLB)
· Natural Resource Partners (NYSE: NRP)
· Burlington Northern SantaFe (NYSE: BNI)
· Penn-Virginia Resources (NYSE: PVR)

I’m recommending shorting or selling the following names:

· Pogo Producing (NYSE: PPP)
· EnCana (NYSE: ECA)
· Massey Energy (NYSE: MEE)
· Pioneer Natural Resources (NYSE: PXD)

But before we delve into the issue, take a moment to note that there are three tables located under the “Portfolios” tab on the left-hand margin of the Web site. The Proven Reserves Portfolio is designed to offer high income in the form of dividends or partnership distributions. I also tend to focus on less volatile stocks with an eye toward capital preservation. The Wildcatters Portfolio lists my favorite growth-oriented names that tend to carry higher risk.

Scrolling down the Portfolio page you’ll find How They Rate. This is my “coverage universe,” stocks in the energy patch I follow regularly but do not currently count among my top recommendations. I offer buy, sell and hold advice in How They Rate with an eye toward guiding subscribers who may already hold these stocks in their portfolios.

I also send out periodic Flash Alerts via e-mail between issues or to recommend specific stocks for trading opportunities. These trades are more aggressive plays I recommend holding for six months or less. I keep track of these recommendations in How They Rate, via Flash Alerts and in regular issues of The Energy Strategist.

Services And Infrastructure

I’ve outlined my basic bullish case for the services industry in brief above and in greater depth in the August 10 TES, but there have been some more recent trends worthy of note.

Schlumberger is always an important company to watch when it comes to the services industry. Schlumberger is the world’s largest services company and has its hands in just about every oil and gas market globally. The company also has the widest breadth of services offering everything from seismic mapping services for finding and delineating reserves to services designed to enhance production from older wells. And the company counts all the major integrated firms and most of the larger independents as clients. Thus Schlumberger’s comments can offer a useful window into trends in the industry and are extremely closely watched by Wall Street analysts.

Overall, Schlumberger was very positive on the oil services business. Based on conversations with various companies in the industry, management expects spending on exploration and development will increase at a faster rate in 2006 compared to 2005. The company stated clearly that it believes we’re not even close to the end of this cycle.

More particularly, Schlumberger has seen increased demand for its “Q” class seismic ships. Seismic ships emit sound waves that bounce off rock formations deep under the ocean floor. These returning sound waves are collected by hydrophones–sensors towed behind the seismic vessel. But seismic data can vary greatly in the detail offered.

Years ago, most seismic data was two-dimensional, offering just a flat picture of what rock formations looked like. Later, three-dimensional technologies were developed to produce a more detailed, wider-angle picture of underground formations. And even more recently, four-dimensional technology has been widely used. This technology maps a reservoir over time to give producers a detailed picture of how effectively a formation is being exploited.

Schlumberger’s Q technology is among the most advanced technology available in the seismic business today. The technology uses very advanced software to eliminate noise caused by waves and other factors. And the company’s seismic ships are capable of analyzing data from a huge array of hydrophones. Thus the Q technology offers one of the most detailed pictures of an underwater reservoir available today.

In total, Schlumberger has five Q-ships, up from four at the beginning of 2005. In the third quarter they were 100 percent utilized–the ships were constantly being hired for new jobs. Several customers hired the Q-ships on multiple occasions last year; repeat business is a good sign of strong demand. Schlumberger is planning to add and sixth vessel in the second quarter of 2006 and a seventh is likely to follow later in 2006.

That sort of advanced high-resolution imaging is used for two basic purposes: developing new deepwater and offshore reserves and delineating existing reserves for what’s known as infield exploration. Infield exploration is simply the process of finding new exploitable reserves within existing fields. That customers seem willing to pay up for the more expensive Q seismic data is proof that the exploration cycle is underway.

Schlumberger also made a few geographic comments worth mentioning. One is that the Middle East, part of the so-called Eastern hemisphere market, has started to exhibit particularly strong growth in recent quarters. Saudi Arabia is, for example, now running an unusually large number of land seismic crews; more seismic activity than Saudi Aramco has undertaken in many years. This could be exploration for new fields but it’s far more likely that the Saudis are doing some infield exploration on their existing supergiant fields, trying to squeeze more production out of existing fields such as Ghawar.

And while Schlumberger was fairly skeptical on the US market earlier this year, recent comments have been more bullish. The company had cited concerns that there would be an oversupply of pressure pumping capacity in the US this year. Pressure pumping is a term used to describe a number of oilfield services.

Among the more common is hydraulic fracturing (see TES, August 10, 2005). In hydraulic fracturing, a gel-like liquid is actually pumped into a reservoir rock under tremendous pressure; the gel cracks the rock and improves the flow of oil and gas to the well. Specialized pump trucks produce the pressure, and the fleet of pump trucks has been expanding in recent quarters.

Pumping services have been among the more profitable businesses in North America this year; services companies have managed to push through a raft of price increases. Schlumberger indicated that despite those vastly higher prices, producers are waiting weeks–not days–for pressure pumping services to be performed on their wells. Demand obviously remains strong enough to absorb supply for now.

The chart “Baker Hughes US Land Rig Count” depicts land-based drilling rigs currently actively working in the US market.



Source: Baker Hughes

Schlumberger highlighted the growth in the North American rig count, saying there’s no theoretical limit on the number of land rigs working in the US. Already there are reports that a number of Chinese-made rigs are now working on drilling wells in the Rocky Mountain region. The Chinese have the manufacturing capacity to keep building land rigs as demand warrants.

Eventually, increased supply of land rigs could depress day-rates for rig operators (although that’s some time away). But the higher rig count is a major boon for the services group. More rigs spell more exploration activity, more pressure pumping and more services such as cementing and completion (see TES, August 10, 2005 for definitions of these functions).

Schlumberger (NYSE: SLB) is a great company that’s well placed to benefit from all this growth and I’m raising the stock to a buy in How They Rate.

However, a better play at this time is Weatherford International.

The key to Weatherford is that the company is uniquely positioned to benefit from the new exploration cycle, particularly in the eastern hemisphere. The company recently acquired Precision Energy Services (PES), an oil services business, from Canada-based Precision Drilling. PES is overwhelmingly a western hemisphere business with more than 85 percent of its revenues coming from the US and Canada. PES never expanded much overseas because Precision Drilling lacked the financial resources and global footprint to manage such an expansion.

But PES also has significant capabilities and technical know-how. The company is a market leader in wireline technologies and directional drilling. Wireline technologies involve lowering sophisticated electronic equipment into a well to test a reservoir. Wireline data is also often used in older wells to evaluate different strategies for enhancing production.

Directional drilling has become increasingly popular in recent years. In many cases, producers can increase their production from a well by drilling non-vertical wells. The goal with any well is to expose the surface area of the well to more oil or gas. Sometimes this is best accomplished with horizontal wells. This is particularly true in more mature markets where producers are targeting smaller deposits of oil.

PES wireline and directional technologies are world-class and would be in high demand in the international markets, particularly the Middle East. Because Weatherford already has huge international operations, and existing offices across the Middle East, the company can easily start selling PES services through its existing channels. This makes PES a much more valuable franchise under Weatherford’s control than it was on its own.

Weatherford is looking for the PES businesses to shift from only 15 percent eastern hemisphere today to closer to 50 percent eastern hemisphere over the next two to three years. Eventually, sales internationally will vastly exceed sales in the US and Canada. This sort of market-share gain clearly implies some solid growth for Weatherford.

I also like Weatherford’s position in underbalanced drilling. When a crew starts to drill a well, a liquid known as drilling mud is pumped down that well under pressure. Oil and gas reserves are under tremendous geologic pressure underground and would naturally tend to move into a well and shoot to the surface as the well is drilled, a dangerous situation called a blowout. In conventional drilling, wells are drilled overbalanced–the drilling mud is pumped down the well at a pressure that exceeds the geological pressure of the oil and gas. In overbalanced wells, the drilling mud actually prevents oil and gas from shooting out of the well.

But overbalanced drilling can damage older reservoirs. If a driller isn’t careful about pressures, it’s possible to actually pumping the drilling mud into the reservoir rock itself. As oil and gas are held in tiny pores in rock and travel through channels and cracks in that rock, drilling mud clogged in these pores can impede flows. Underblanced drilling involves pumping mud at a pressure that’s less than the natural geologic pressures of the reservoir.

The advantage of this is that the mud won’t move into the reservoir rock. The disadvantage is, of course, that oil and gas will flow into the well, albeit at a reduced rate. Thus in underbalanced operations, producers must carefully control pressures so that the movement of oil and gas into the well proceeds at a controlled pace.

As noted above, much of the exploration in progress today is infield exploration. Many of the wells drilled during this process are drilled into more mature reservoirs that require underbalanced drilling. As you might imagine, underbalanced is a fast-growing business for Weatherford; profits growth is faster still because the company has pushed through some major price increases for the service.

Weatherford has stated it now has a number of expiring contracts in the Middle East and around the eastern hemisphere. Those contracts will be rolled into new two- to three-year contracts at significantly higher rates. This contract rollover coupled with the chance to sell PES services in the east makes Weatherford a highly attractive growth story. Weatherford (NYSE: WFT) is added to the Wildcatters Portfolio.

Long-time readers will recognize that we were stopped out of Weatherford for a significant profit during the October energy selloff. The company’s fundamentals haven’t changed; the selling was simply due to a lot of “hot” money leaving the sector and booking gains after a huge run in the first nine months of 2005. It is now time to re-enter the stock.

Schlumberger’s comments are also bullish for existing Wildcatters Dresser-Rand and BJ Services.

BJ Services is focused on North America and is particularly strong in pressure pumping services. Given just how tight the US pressure pumping market is now and how quickly the rig count is growing, this business will remain highly attractive over the next few quarters.

As explained in depth in Energy Infrastructure (TES, September 29, 2005), Dresser Rand is the dominant manufacturer of compressors used in a variety of oilfield applications. Compressors are, for example, used at refineries on drilling rigs and on floating production and storage facilities. The new exploration cycle will mean great demand for such products.

Finally, I’m adding Netherlands-based Core Laboratories to How They Rate as a buy and will track this stock as a trade recommendation.

Core Labs offers what’s known as reservoir description and optimization services.

Oil and gas don’t exist in giant underground lakes or cavers. Instead, hydrocarbons are held in the small pores of reservoir rocks. Analyzing the properties of the reservoir rock near a particular well is absolutely critical to deciding how to produce oil and gas. This analysis is what’s known as reservoir description.

Core Laboratories uses several techniques to accomplish that task. One of the most direct methods is called coring. This involves extracting an actual core sample of reservoir rock during the drilling process. Several such cores can then be analyzed to get a good idea of the characteristics of the reservoir. Core Laboratories also analyzes seismic surveys of a reservoir taken at various points in time to get an idea of the size of a reservoir and how best to produce it.

In addition, the company offers a series of production optimization services. The list includes hydraulic fracturing and water and/or carbon dioxide flooding. In flooding operations, water or a gas like carbon dioxide is pumped into a special purpose injection well under tremendous pressure. That water then moves through the reservoir, actually sweeping the oil out of the pores in the rock and pushing the hydrocarbons toward the wellbore. It’s a technology widely employed, particularly for older wells.

Keep in mind that as a ruled of thumb, oil companies produce roughly 30 to 50 percent of the original oil in place. For example, if the oil in a particular reservoir is estimated at 1 billion barrels–this is the original oil in place–a typical producer could expect to ultimately produce 400 to 500 million barrels from that field. Even if Core Labs can boost that figure by 5 to 10 percentage points, it can have a huge impact on the economic attractiveness of a particular field.

Core also wins points for its outstanding geographic diversification. Management typically moves operations geographically in search of the regions offering the best margins at any given time. Core has an excellent position in key growth markets in the eastern hemisphere including the Middle East and North Africa. Core Labs (NYSE: CLB) is a buy in How They Rate.

Exploration And Production

The services companies have seen massive cost increases in recent years. Obviously raw materials costs for steel and fuel have increased. But the most-often cited problem is labor.

Last year, only about 250 students graduated from US universities with degrees in petroleum engineering. This should come as little surprise as the 1980s and ‘90s were a tough time for the oil and gas business. With crude prices well under $20/bbl and gas at $2 or $3/MMbtu, energy companies weren’t exactly rolling in cash. Students were attracted to other industries with better-perceived growth prospects.

Of course, the industry boom of the ‘70s and early ‘80s attracted a great deal of talent to the industry. But many of those workers and managers either retired or left the industry during one of the waves of layoffs over the long oilfield depression of the ‘80s and ‘90s. Simply put, skilled labor and unskilled labor are in short supply worldwide. It will take some time before the upcycle in energy prices attracts more graduates.

Rising costs are a headache for services firms. But most of the major services companies have added cost escalation clauses to contracts of more than a year’s duration. These clauses help mitigate some of the cost increases. And by pushing through large price increases over the past year, most services firms have managed to retain their high profit margins despite an up-tick in costs.

Larger services firms, such as Weatherford and Schlumberger, are able to recruit their workforce from a variety of regions, in local markets around the world. And both firms have well-established partnering and recruiting arrangements with top universities. This doesn’t eliminate the cost inflation problem, though it certainly mitigates the effects.

Energy producers are even more brutally exposed to the same costs. The cost of leasing a standard shallow-water drilling rig in the Gulf of Mexico has more than doubled in the past year alone. Even commodity rigs in the region may see day-rates of more than $100,000 soon, up from less than $25,000 per day in 2002. Deepwater and land rigs have seen similar, or even larger, day-rate increases. Recall that energy E&P companies rarely own their own rigs–they are forced to hire out rigs at these rapidly rising day-rates just to continue their exploration and development activities.

And the higher prices that are benefiting the oil services business are bad news for producers. The cost of performing hydraulic fracturing is rising rapidly, as are costs for drilling advanced directional wells and for artificial lift equipment (various technologies that help increase the rate of production from older wells with lower reservoir pressures).

These cost increases are particularly acute in North America because a lot of the reserves currently being exploited are unconventional reserves, such as shale and tight sands (see The Energy Letter, May 20, 2005, The Gas Rush). Production projects in unconventional reserve basins are far more service intensive than conventional reserves–producers have to pay up for these expensive services.

And North America also has a number of mature fields. When producing a mature field, a common technique to boost production is simply to do some infill drilling. That means that if your wells were originally 10 miles apart you might come back and drill another right in the middle of the two original wells–you punch more holes in the ground. Obviously that strategy is more expensive when you’re hiring a land rig at sky-high day-rates.

Furthermore, the “E” in E&P is getting increasingly expensive. It’s becoming more difficult to find new reserves of oil and gas and, therefore, exploration costs are rising. Also, companies must perform detailed seismic reviews and reservoir evaluations before sending big money on new production projects–that, too, is extremely expensive.

Higher commodity prices allow producers to spend more on E&P and recoup these higher costs. This is exactly how the price mechanism should function: as commodity prices rise, producers have more cash to spend and deploy that cash. Eventually, higher exploration spending should yield an increase in reserves and oil supply. Because most energy firms saw meager profits in the ‘90s, they cut back on their exploration spending. The recent spike in commodity pricing is behind this new exploration wave.

But even with higher realized oil and gas prices, these higher costs are starting to pinch. And when commodity prices pull back, even temporarily, that can pinch the producers.

It’s important to note that not all oil producers will be affected by these trends equally. Large integrated oil companies, national oil companies and some larger independents can offer attractive compensation packages and usually hire the very best talent. What’s more, some such companies have low overall production costs because they have attractive reserves–reserves that are either easy to produce or relatively young. Our recommended major and independent oil companies such as BG Group (NYSE: BRG), ExxonMobil (NYSE: XOM) and Occidental Petroleum (NYSE: OXY) should be able to sustain growth despite the higher costs.

The losers will be some of the smaller independents with high production costs. A number of these names are based in North America where service prices and wage increases have been most dramatic over the past year-and-a-half. These stocks stand to lose most if crude pulls back to $55/bbl in the near term, as I expect. Such a drop, coupled with high costs would crimp profitability.

Avoid companies with poor reserves and little potential for growth in production. When we get the next leg higher in the oils, companies that can increase their production will be the big winners because they’ll be boosting production into a rising market. Those with stagnant growth prospects will underperform.

To play this downside I’m adding Pogo Producing (NYSE: PPP) as a short in the Wildcatters Portfolio. Pogo has been undergoing some major changes and restructuring in recent years and is now relying almost entirely on North American E&P to fuel production growth.

Pogo sold off much of its international operations in 2005 (the main reserves it held were in the Gulf of Thailand and Hungary) and also drastically cut back its drilling and exploration programs in the first half of 2005, citing rapidly rising exploration costs. In fact, Pogo announced it would delay drilling all of its 200-plus planned development wells until 2006.

In mid-year, Pogo rapidly reversed course, boosting its drilling exploration spending by more than 50 percent. And management followed up that announcement with the purchase of Canada’s Northrock Resources from Unocal in September for more than $1.7 billion. This added roughly 40 percent to the company’s proven reserves.

Pogo hasn’t been successful in boosting production for some time now and has consistently missed expectations on the exploration front, finding fewer new reserves than Wall Street expected. To put the company’s production into perspective, total daily production in barrels or oil equivalent was about 115 in 2003, 106 in 2004 and will likely fall to less than 80 this year. This is hardly a growth profile.

As for the major Northrock acquisition, it’s no clear whether Pogo overpaid for this company, but its purchase price was certainly at the top end of the range for recent deals. What’s more, Pogo has no experience in Canada and cost overruns from the Canadian exploration program are likely–a flurry of drilling activity in this region has pushed up services and drilling costs.

Pogo has retained some operations in the Gulf of Mexico. While some of the recent 8 percent quarterly production drop-off was due to the Gulf Coast hurricanes, Pogo can’t just blame the storms. Exploration programs in the region certainly haven’t panned out as well as expected and costs are rising rapidly.

Pogo is exposed to rapidly rising North American drilling costs and is relying on an uncertain exploration program to drive production growth.

Pogo Producing is a short recommendation in the Wildcatters Portfolio.

If you’re uncomfortable with short positions, consider buying the January 2007 $50 put options on Pogo Producing (OLL MJ). I prefer the short position to the puts. But if you decide to buy the puts, be sure to use a relatively small position size–they offer plenty of leverage to downside in the stock.

I’m also adding Pioneer Natural Resources (NYSE: PXD) and EnCana (NYSE: ECA) to How They Rate as sells. I’m not currently recommending either stock as a short, but both are vulnerable here and there are much better plays in E&P.

Coal

I was struck by the wide divergence in performance among coal companies in the third quarter. It seems that some miners in Appalachia are having trouble meeting their production targets. There’s a simple reason for this: Mines in this region are mature and it’s becoming increasingly difficult and expensive to maintain production.

A perfect example is Massey Energy, the largest coal miner in central Appalachia. Massey reported a host of cost problems in its third quarter report. Underground mines failed to achieve expected productivity, a key signal that the reserve base is rapidly maturing at the company’s key mines. Management has admitted as much, stating that it’s getting increasingly difficult to meet production goals.

An even worse situation is wage cost inflation. The company is pouring money into training programs but it remains extremely difficult to attract unskilled labor to the mines. And once Massey trains miners, retention is a big problem. Despite significant efforts to ameliorate the labor issues, management once again admitted its retention rate is lagging expectations.

Laborers for underground mines are the hardest to find and take the longest to train. Since underground mining is a key part of Massey’s business, that spells rising production costs. I’m downgrading Massey (NYSE: MEE) to a sell in How They Rate.

Painting an entirely different picture was the world’s largest miner, Peabody Energy. I’ve outlined Peabody’s prospects in The Energy Letter (see TEL, November 4, 2005, Not Always The Obvious Play) and the stark contrast between Peabody’s prospects and those of Massey are worth noting.

Peabody has reserves spread more evenly across the US. Most attractive, however, are its reserves in the Powder River Basin (PRB) in the Western US–Peabody has the highest exposure to the region.

The PRB is attractive for several reasons. First and foremost, most of the mining in the PRB is surface mining and not the more expensive underground methods used in eastern mines. These are young, relatively new mines and it’s much easier to consistently boost production in the PRB than in maturing mines in central Appalachia.

Peabody has improved cost containment by using draglines on some of its major operations. To get an idea just what a dragline is, check out the picture below.



Source: coaleducationresources.org

This is an older model, but it certainly gives an idea of the scale involved, especially if you note the rather large car parked in the foreground. The dragline is essentially a giant weighted bucket or scoop attached to a long cable. That bucket is dragged along the ground to strip away the overburden, the rocks and vegetation that covers the coal.

Coal in the PRB is not buried very deeply. Thus, the stripping ratio–the amount of overburden that must be removed–is rather low compared to other regions. These giant draglines cut down on the need to use trucks and shovels to strip overburden. They’re less labor intensive and more cost effective–Peabody claims a 50 percent cost reduction from using draglines in the PRB.

PRB coal is also more attractive because it’s low in sulphur. Sulphur pollution regulations are becoming increasingly stringent and a number of Eastern utilities have started using PRB coal to meet pollution regulations. It should come as little surprise that PRB coal prices have increased more than 150 percent over the past year. Peabody’s vast low- and ultra-low sulphur reserves are truly a crown jewel. Peabody remains a bit extended, but it’s my favorite play among the coal miners and all subscribers should consider taking at least a small position in the stock. I’m maintaining my buy recommendation on Peabody Energy (NYSE: BTU) in How They Rate.

I’m also recommending three other plays on coal. In the Proven Reserves Portfolio, I’ve been recommending two master limited partnerships (MLPS) that are direct plays on coal.

The MLPs don’t actually mine coal, so they’re not exposed to all the cost increases that plague the miners. Instead, these companies just own coal-producing properties and accept royalty payments on the coal produced. In the last issue, (see TES, October 26, 2005, The Next Big Income Investment) I outlined the case for buying MLPs in great depth and specifically addressed my two favorite plays, Natural Resource Partners and Penn-Virginia Resources.

Natural Resource Partners hit our recommended stop loss last week, generating a loss of about 12 percent (including distributions). Whenever one of my stocks hits a stop, I take time to step aside and reassess the case for owning the name. In this case, I see no changes to the fundamentals of Natural Resource Partners and regard the dip as an opportunity to jump back in. I will account for the stop-out when calculating the yearend performance of the portfolio.

The dip was likely caused by the mandatory conversion of subordinated units. These subordinated units were trading separately but will now be converted into Natural Resource units. The transition should be completed this month. In the short term, the transition causes some minor dilution–the company will now have more units outstanding. But that effect is minor and should now be priced into the stock.

On the fundamental front, Natural Resource Partners has once again upped its distribution to reflect higher royalty revenues. Natural Resource Partners (NYSE: NRP) is re-added to the Proven Reserves Portfolio as a buy.

Finally, as I pointed out in The Energy Letter (see TEL, November 4, 2005, Not Always The Obvious Play), railroads are another stealth beneficiary of the bull market in PRB coal. Rail is the only feasible means of transporting coal out of the region and the rails are charging very high rates to move coal.

My favorite play is the company with the largest rail network in the PRB, Burlington Northern SantaFe (NYSE: BNI). I’ll continue to follow this stock as a trade recommendation in How They Rate.