The third quarter was a strong one for The Energy Strategist portfolios. And even after a sharp pullback for the sector at the beginning of the fourth quarter, the group is the best performing major sector in the S&P 500 this year.

My long-term outlook for the energy sector remains bright, and the recent correction will soon offer an outstanding buying opportunity. In the short run, however, some groups–most particularly the deepwater drillers and some services firms–could see more downside. Below I review the Wildcatters and Proven Reserves Portfolios, explaining my current positioning. I also update my advice on several names covered in How They Rate.

Ironically, some of the sub-sectors in the energy space that I’ve been most worried about for the past two quarters will likely outperform through the end of the fourth quarter. The list includes the North American-focused services firms and shallow-water drillers focused in the Gulf of Mexico. I’m reiterating my buy recommendation on Rowan (NYSE: RDC) and upgrading BJ Services (NYSE: BJS) to a buy in How They Rate. Both moves are tactical in nature rather than strategic–later this quarter I’ll look to re-enter the more internationally focused services names.

The most rewarding sectors this quarter are likely to be outside the oil and gas business. Nuclear plays have far more upside right now than most of the other sectors in The Energy Strategist’s coverage universe. And as the winter heating season approaches, coal stocks will shine. I recommend new money focus on these groups–Cameco (NYSE: CCJ), Penn-Virginia Resources (NYSE: PVR), Uranium Resources (NSDQ: URIX) and Natural Resource Partners (NYSE: NRP) are the best plays.

Finally, for a defensive play on energy and tax-advantaged income potential, our recommended Master Limited Partnerships (MLPs), including Teekay LNG Partners (NYSE: TGP) and Enterprise Products Partners (NYSE: EPD), are the top plays right now. Better still, a series of tax law changes will make the MLPs more attractive to institutional investors. This is one of my hottest income ideas right now; I plan to devote the next issue of The Energy Strategist to the sector.

Contract Drillers

The Energy Strategist portfolios no longer have any direct exposure to the contract drillers. Over the past six months, the drillers have been one of the best performing groups in the portfolio and the fundamental story remains attractive longer term. But there’s potential for more downside over the next few weeks–stand aside from the contract drillers for now. I’ll look to use a more significant correction to add a driller back to the portfolio tables.

As I outlined in the October 6 Flash Alert Energy Correction, we were stopped out of contract driller Global SantaFe (NYSE: GSF) for a 25 percent gain. I also recommended selling out of shallow-water driller Todco (NYSE: THE), a trade recommendation, on September 29 for an overall gain of more than 50 percent. Last, I recommended selling deepwater driller Noble Drilling (NYSE: NE) on August 29 for a 28 percent gain.

All three stocks will now be tracked in How They Rate; Noble is cut to a sell and Global SantaFe and Todco will be tracked as holds.

Given just how well the drillers in The Energy Strategist portfolios have been performing, the fact that we’ve now sold out of the sector is an important tactical move that requires further explanation.

Let’s review the long-term bullish case for the group as well as the short-term factors that I believe will bring more downside over the next few weeks.

The reason for the bull market in the drillers is simple: A global shortage of drilling rigs and an up-tick in drilling activity has pushed a steady rise in day-rates (the daily rate paid to the contract driller for leasing the rigs). Drillers do not actually explore for and produce oil and natural gas. Rather, these companies own drilling rigs that are leased out to energy exploration and production firms. Rig lease contracts can be signed for as little as a few months or as long as several years.

There are many different types of drilling rig (see TES, April 27, 2005, Offshore And Overseas) and different types earn vastly different day-rates. Some deepwater floater rigs can earn more than $300,000 per day, while a commodity shallow-water jackup rig can earn $50,000 to $60,000 in today’s market. But just about every type of rig has seen a rapid and sustained jump in day-rates over the past year-and-a-half. This is why the drillers have been showing such impressive growth in profitability.

Even more critical, unlike many prior cycles, the up-tick has not been localized in nature. To understand the importance of this point, one has only to examine the 2000-01 Gulf of Mexico drilling market.

Shallow-water drilling activity in the Gulf of Mexico heated up during the 2000-01 natural gas-price spike as producers struggled to increase production and take advantage of higher prices. Most subscribers will remember that this spike coincided with the California energy crisis and widespread blackouts in that state. Check out the charts of rotary drilling rigs active in the Gulf from 1998 through 2005 and natural gas prices for a better idea of how the market in the Gulf played out.



Source: Baker Hughes



Source: Bloomberg

Back in 2000-01, natural gas prices spike to the $10 per million British thermal units (MMBTU) level. Higher prices prompted firms to step up exploration and development of natural gas reserves in the Gulf of Mexico–jackup rigs used in the shallow-water Gulf were suddenly in high demand and day-rates shot up.

But the stepped-up activity in the Gulf was not matched overseas—drilling activity in markets like the North Sea, Middle East and Africa didn’t accelerate as quickly as Gulf drilling activity. As you might expect, drillers actually moved rigs from elsewhere in the world back to the Gulf where day-rates were strongest.

The chart makes clear that rigs actively working in the US Gulf shot up from their 1999 average of about 105 to an average of 148 in 2001, a 41 percent increase in rig supply. For several months in 2000 and 2001, there were actually more than 150 rigs operating in the region.

Predictably, the increased supply of rigs eased the shortage of rigs in the region. That alone would have been enough to depress day-rates. Exacerbating the situation was the drop-off in gas prices, which lowered drilling demand still further. Day-rates in the region collapsed in 2001 and 2002.

The Long Cycle

The current cycle has been different. While gas prices have been steadily climbing since their late 2001 and 2002 lows, the rig count in the Gulf of Mexico has been falling. This has continued even since mid-2004, when gas prices began to rally to sustained levels between $7 and $10/MMBTU.

These sustained, almost historically high prices were not enough to prompt a rise in the Gulf rig count. And exploration and drilling activity has not been falling in the Gulf region–energy companies are desperately looking for new reserves.

The reason that more rigs haven’t been moved into the region as they were in 2000-01 is simple: Drilling activity is picking up globally. The North Sea has seen a tremendous pick up in drilling activity over the past year-and-a-half and offshore Africa is emerging as one of the hottest regions for new exploration activity. Just a week ago Chevron (NYSE: CVX) announced that it’s had to delay drilling plans for a North Sea field because there simply aren’t any rigs available right now to do the drilling. Various producers in all parts of the globe have issued similar statements.

Even secretive Saudi Arabia has announced plans to drastically step up its exploration and development activity–the Desert Kingdom plans to double its drilling fleet over the next two years and invest more than $20 billion in enhancing production capacity. That spells higher demand for drilling rigs and drilling services.

Bottom line: The supply of rigs in the Gulf has not increased because the rigs aren’t available. The rigs that could be used for drilling in the Gulf are already in use elsewhere. This is why the rise in day-rates has persisted and there has been little or no response in the form of increased supply of rigs. That reveals just how tight the global drilling market is right now.

And this is only the beginning of a multi-year exploration cycle. The big oil companies have very low reserve replacement ratios right now; they simply aren’t finding new reserves to replace their current production (see TES, August 10, 2005, The Great Wall Of Cash). Due to low energy commodity pricing in the 1990s, these companies simply haven’t spent much on exploration and development, but they’ll need to reverse all those years of underinvestment in the coming years. These spending plans are unlikely to change materially even if oil and gas prices moderate further in the short term. This suggests we’ll see a generally tight environment for rigs in the coming years.

In the short run, Hurricane Katrina and Hurricane Rita further crippled the Gulf of Mexico’s drilling market. It appears Rita alone took six jackup rigs that were operating in the Gulf out of commission; most won’t return for several months, if at all, representing about a 7 percent hit to supply in the region. And at least eight floater rigs have been damaged or have drifted away from their drilling locations. This is on top of significant damage from Katrina, and the long-planned planned repositioning of an additional seven Gulf jackup rigs to other parts of the world.

Causes For Concern

Despite these positive factors, in the short run there’s considerable room for more downside. The market has a habit of focusing only on the good news when stocks are rallying and only on the bad news when they’re selling off. With that in mind, I see a few news items that are cause for concern. None were a problem when the sector was flying, but all could be roadblocks now that the first cracks are appearing and form the basis of my recommendation to step away from the group.

The most obvious risk for the drillers is severe profit taking. The S&P 500 energy sector was up over 17 percent in the third quarter and is up 32 percent this year. That compares to a 0.9 percent loss for the S&P 500. Suffice it to say that energy has handily outperformed the rest of the market for some time. This is true even with the recent, violent pullback in the group. The drillers performed much better, on average, than the energy sector at large.

There are two problems with that. First, outperformance of that magnitude tends to attract a good deal of “hot money.” We’re quite certain that momentum-oriented hedge funds and mutual funds piled into the sector in the third quarter, chasing strength in the group. And while The Energy Strategist was early to the party, highlighting how leveraged the drillers are to rising day-rates last spring, the bullish story is now well known.

There’s also the issue of demand destruction. This term, frequently used in the popular press, refers to the phenomenon that higher energy prices will lead to conservation and decreased consumption. The recent spikes in gasoline prices in the US market have prompted a decline in consumption, at least in the short run. There are also reports that larger sport-utility vehicles are not selling as well as they once were, utility companies are warning customers of coming rate increasing and some groups are running TV advertising campaigns encouraging conservation, all signs that consumers are beginning to respond to higher energy prices by consuming less. Demand destruction would, all things equal, lead to a decline in drilling activity and lower day-rates.

Of course, there’s a shorter-term effect that’s driving energy demand—we’re in a typical seasonal lull. As I outlined in the October 6 Flash Alert, peak periods of energy consumption in the US are the summer and winter months. The summer driving season begins to heat up in the late spring and the winter heating season picks up in the late autumn. As the market transitions from summer gasoline demand to winter heating demand, there is a seasonal period of a few weeks where there’s a notable lull in demand. While that’s nothing unusual, it could exacerbate fears that there is a prolonged and persistent decline in energy demand.

Finally, lately I’ve heard considerable talk of rig newbuilding, companies contracting with shipyards to build brand new rigs. At first, the announcements were centered on building new shallow-water jackup rigs. Early in 2005, the announcements of jackup newbuilding began to hit the market. Jackup rigs are much less expensive to build than are deepwater floating rigs such as semi-submersibles. Raising capital to build such rigs is considerably easier than for floaters, which can cost upwards of half a billion dollars.

But now, with day-rates for floaters so high, there are plans to build or reactivate as many as 50 new floater rigs. In fact, several speculative newbuilding companies have listed on the Oslo Stock Exchange. These companies are simply vehicles designed to raise capital to fund new rig construction.

Most of these rigs are not scheduled for delivery until after 2008. However, the fear of increased supply in the pipeline could well further temper expectations for day-rates in the short term. I would not be at all surprised to see more talk of rig upgrades, newbuilds and reactivations of rigs in storage in the coming weeks.

How To Play The Drillers

Over the long term, the world’s major oil companies will have to continue stepping up drilling and exploration activity to try and bulk up their reserves. But all of these factors taken together suggest a near-term cautious stance on the drillers.

The deepwater names have more downside in the short run. The reason is that earnings estimates for the deepwater-levered names have been rising very quickly as day-rates have shot higher. The pace of growth in earnings estimates will likely moderate over the next quarter or so as there’s no near-term catalyst for day-rates. But I’m a big believer in the long-term deepwater story and will look to re-establish positions in a few such names as they pull back further this autumn.

My favorite names right now are the Gulf-focused jackup drillers such as Rowan (NYSE: RDC)–the hurricanes in the Gulf have tightened the US shallow-water drilling market considerably, providing a short-term upside catalyst to day-rates.

Rowan was the driller hardest hit by Hurricane Rita; four of the six jackup rigs lost in the storm were Rowan’s. Nevertheless, the company maintains one of the top positions in the Gulf of Mexico drilling market, especially in premium more advanced jackup rigs. The shortage of rigs exacerbated by the hurricanes will bring about even higher day-rates in the region; Rowan is well positioned to benefit from that surge.

Better still, the Gulf of Mexico deep-shelf gas play is an emerging story that will benefit Rowan. Basically, there are some large, untapped pockets of natural gas located in the shallow-water Gulf of Mexico, on what’s known as the continental shelf. These pockets are located in shallow water, but deep under the seabed. This deep-shelf gas is a very hot resource right now, especially since these reserves are located so close to the mainland US; Rowan’s premium jackups are well placed to benefit. Rowan is a buy in How They Rate.

While Todco (NYSE: THE) is uniquely levered to strength in the Gulf, it’s now trading at a large valuation premium to Ensco (NYSE: ESV) and Rowan. On the technical front, that final run in September smacked of panic buying by momentum investors. Stand aside from Todco and wait for a more meaningful pullback.

Global SantaFe (NYSE: GSF) wins points for its balanced exposure to jack-up and floater rigs in some of the hottest markets globally. That said, it’s vulnerable to profit taking this autumn and doesn’t have as much exposure as the shallow-water drillers to a likely near-term bump in day-rates for the hurricane-ravaged Gulf of Mexico. The same is true of deepwater rig specialist Transocean (NYSE: RIG).

Global SantaFe and Transocean are both holds in How They Rate.

I slightly prefer Transocean to Noble (NYSE: NE) right now because it has more rigs uncommitted to contracts over the next two years than does Noble. That means that if day-rates continue to rise, Transocean should see marginally more benefit. Noble is a sell in How They Rate. This is by no means, however, a recommendation to short Noble.

Oil Services

Oil services plays have also been among the better performers in The Energy Strategist portfolios. As I detailed in the October 6 Flash Alert, we were stopped out of both Schlumberger (NYSE: SLB) and Weatherford (NYSE: WFT) for nice gains. Both will be tracked in How They Rate as holds.

As I previously covered some of the main functions of oil services companies (see TES, August 10, 2005, The Great Wall Of Cash) I won’t redefine the industry here. Suffice it to say that oilfield services is a rather broad term used to define all sorts of functions involved in just about every stage of the oil and gas exploration and production (E&P) process. For example, oil and gas explorers use seismic maps generated by service firms to evaluate the potential of unexplored reservoirs. And services firms also evaluate wells and use certain specialized techniques to rehabilitate older wells to improve the flow of oil and/or natural gas.

Because services firms are involved in just about every aspect of the E&P process, increased E&P budgets spell rising profitability for the group. Simply put, the more drilling and exploration that occurs worldwide, the more business there is for the world’s services firms.

When it comes to spending on oilfield services, it’s worth dividing the market into two main segments: North American services spending and international spending. The reason is that within the US and Canadian markets, smaller and intermediate-sized independent exploration and production companies conduct much of the drilling activity. Such smaller independent companies don’t have the capital or the need to develop huge, expensive deepwater projects. Instead, they’re willing to exploit smaller reserves of oil and gas or engage in brownfield developments–squeezing a bit more oil out of existing older wells.

Internationally, exploration projects are mainly (though certainly not exclusively) larger-scale and are conducted by the international integrated names, the national oil companies or larger independents. This includes large deepwater developments or the major expansion of drilling activity currently underway in some Middle Eastern markets such as Saudi Arabia.

The difference is that many large-scale international projects are planned out years in advance. As I mentioned above, the big integrated companies are facing a real crisis because their reserve replacement ratios are too low. Most have announced large budget increases for exploration and production and several have markedly exceeded those budgets over the past year.

These large-scale projects are unlikely to be delayed or stopped even if there’s a fairly significant drop in oil and natural gas prices; these companies have committed to an increase in their spending levels. Such projects require years of planning and can’t be easily abandoned and restarted simply because commodity prices fluctuate.

The North American market is more volatile. In the past, commodity prices have been a major driver of the level of drilling, exploration and development activity in this relatively mature market. Independents in the US market are generally exploiting either mature reserves using advanced techniques or are targeting smaller pockets of oil and gas. Some such projects require rather high commodity pricing to be economical; some of the smaller independents simply don’t have the cash to keep drilling if their cash flows decline due to lower energy prices. And such smaller-scale projects are more easily delayed or put off.

Generally speaking, then, the North American market is far more volatile and subject to commodity pricing volatility than the international market. That said, when the market heats up it can see particularly rapid growth and strong pricing–the services firms can see very extreme pricing power in the US. The strong activity in the US and Canada over the past two years has prompted just such a boom in North America. Check out the chart of the US rig count, the number of rigs actively drilling for oil and gas in the US both offshore and onshore (land rigs).



Source: Baker Hughes

It’s clear that the US rig count is up strongly over the past few years. More importantly, the rig count is up more than 15 percent since the beginning of the year, and more than 17 percent when compared to September 2004. This represents rig count growth more than twice the global average. This is testament to the drilling boom in the US this year.

Looking at the numbers from an even shorter-term perspective, it appears that the hurricane-related spikes in oil and gas prices are prompting yet another mini-boom in the US. With Gulf production idled but gas prices high, producers are looking to replace lost production in other parts of the country. This means aggressive drilling activity and even stronger growth for the services firms.

Through at least the end of 2005, the North American-focused firms should outperform the international players. In recent months, the bigger services companies in the US have been raising their prices for key services such as pressure pumping. Pressure pumping is a broad term used to describe various techniques–one of the most common is hydraulic fracturing.

Oil and gas do not exist underground in giant caverns or lakes. Instead, these hydrocarbons are trapped inside the pores of rocks such as sandstone. Geologists use two terms to describe reservoir rocks: porosity and permeability. Porosity refers to the number of pores in a given rock sample; the more porous a rock, the more oil and gas it can hold. In contrast, permeability refers to how well connected the pores in a rock are to one another; the more permeable a rock, the easier it is for hydrocarbons to flow out of their pores and into a well.

To improve permeability, services firms will perform hydraulic fracturing by pumping a gel-like substance into the reservoir rock itself under tremendous pressure. In fact, sometimes literally hundreds of pressure-pumping trucks are used for a single well. This fluid under pressure actually fractures and cracks the rock, creating channels through which oil and gas can flow.

The leader in North American pressure-pumping services is BJ Services (NYSE: BJS). Hurricane-related disruptions should keep the US services market tight for at least a few more quarters, allowing the company to continue pushing through price increases. That will continue pushing earnings estimates higher. BJ Services is now a buy in How They Rate.

Over the long term, the North American services business is less attractive than its international counterpart. Internationally, E&P spending will not only increase just as quickly as in North America, it will be less volatile. By far the two best names in international services are Weatherford (NYSE: WFT) and Schlumberger (NYSE: SLB)–they both have very broad exposure globally and offer a wide range of oilfield services.

Schlumberger is the largest oilfield services firm in the world. It’s also the technological leader in most areas, meaning that it’s the firm of choice when it comes to complex deepwater projects or advanced wells. International drilling projects are generally becoming more complex as easy-to-access land-based and shallow-water reserves are exploited. Schlumberger also wins points for its exposure in every imaginable corner of the world.

Weatherford is particularly skilled in services used to rehabilitate mature wells. With many of the world’s traditional reserves aging–the North Sea and Gulf of Mexico are two examples–demand for such services is likely to increase in the coming years. Further, Weatherford has been aggressively expanding its international presence particularly in regions like the Middle East and Africa. This is where the long-term growth in services spending will come from. Revenues from such regions will be connected to large projects run mainly by national oil companies such as Saudi Aramco; revenues should be dependable and insensitive to commodity pricing.

In the very near term, both Weatherford and Schlumberger are vulnerable to further declines for some of the same reasons as the drillers. After a nice run, both names are due some additional profit taking. I’m maintaining a hold rating in How They Rate for both Schlumberger and Weatherford for now. My concerns are short-term in nature and I’m looking for a good opportunity to add both names back to the portfolio tables.

Infrastructure

In the last issue of The Energy Strategist (see Energy Infrastructure, September 29, 2005) I profiled the infrastructure industry in great depth and added Dresser-Rand (NYSE: DRC) to the Wildcatters Portfolio and picked up coverage of Cheniere Energy (AMEX: LNG) and Tidewater (NYSE: TDW) in How They Rate. My fundamental view on these companies is unchanged.

Dresser-Rand remains a relatively defensive pick in the event of a deeper pullback in energy prices. The company’s high-end advanced compressors are used for sophisticated applications such as hydrocracking units at refineries. If there’s one thing that the recent Gulf hurricanes have made abundantly clear it’s that America’s refining shortage can be far more damaging than any shortage or loss of oil production capacity. What’s more, refineries globally will have to upgrade their compressors to meet new environmental regulations even if demand for gasoline pulls back.

Cooper Cameron (NYSE: CAM) and FMC Technologies (NYE: FTI) can also be considered infrastructure plays. Both have held up better than the drillers and services names in the recent correction. Both should also benefit from the boom in E&P budgets.

For FMC, the most attractive part of the business is subsea equipment. This includes underwater production systems–known in the industry as Christmas trees–that are used on deepwater oil and gas wells. FMC is the market leader in subsea trees and is likely to maintain that lead thanks to its strategic long-term alliances with several larger integrated producers. Such contracts help to lock in long-term customers.

The best part about the subsea business is that most such deepwater projects involve extraordinarily long lead times. Better still, FMC holds the technological advantage; its subsea systems are more efficient than the competition and it’s installed the deepest systems to date. Because FMC has seen a steadily rising backlog of orders in recent quarters, we can be reasonably confident that their earnings growth is secure–there’s great visibility there.

Cooper Cameron operates in the subsea business like FMC but also makes other valves, compressors and regulators used in the oil and gas business. Cooper Cameron also benefits from earning s visibility resulting from the long lead times on many deepwater and offshore products. Cameron also has some stability resulting from its after-market business, replacing parts and systems on older wells and rigs.

Both Cooper Cameron and FMC remain buys within the Wildcatters Portfolio.

Nuclear And Coal

Utilities with extensive coal and/or nuclear capacity are seeing record profitability right now. The reason is simple: The hurricane-induced spike in natural gas prices sent the price of generating electricity from gas sky-high. Retail electricity prices are on the rise as prices tend to track the price of natural gas. But check out the chart of spark spreads below.



Souce: Bloomberg

Spark spreads measure the profitability of generating electricity from different fuels in different markets. The higher the spark spread, the higher the potential profits from generating power. As you can see, despite rapidly rising electricity prices, gas-fired generators aren’t seeing much benefit–spark spreads are very low.

But the cost of generating nuclear power hasn’t budged. The only fuel input into a nuclear plant is processed and enriched uranium. The price of this fuel makes up less than a quarter of the total cost of a kilowatt-hour of nuclear power. And much of that fuel cost stems from enriching the uranium, not the price of the uranium itself. Bottom line: Even though uranium prices have tripled over the past three years, there’s been little increase in the actual cost of producing nuclear power.

Coal-fired power generation is also shining. Coal prices have also risen a good deal in recent years but coal power remains extraordinarily cheap relative to natural gas. Gas would have to fall to under $3/MMBTU just to make gas-fired power competitive with coal. That’s a long fall from the near $14/MMBTU costs currently prevailing in the US.

While the coal and nuclear plays in The Energy Strategist portfolios have performed well on average, most have not seem the huge run-ups that the oil drilling and services stocks have, at least over the past three months. These stocks have attracted less hot money and have held up relatively well during the correction in the group that began last week.

Even more importantly, we are entering the winter heating season right now in the Northeast, a time that will undoubtedly bring nasty surprises to many consumers in the form of higher electricity and gas bills. That means the market’s focus will shift away from crude oil and gasoline prices and on to heating and electricity prices. I also believe this will shift the spotlight away from oil stocks and onto coal and nuclear power, two power sources that offer stable pricing. Katrina and Rita have already made the risks of relying too heavily on natural gas-fired power plants abundantly clear.

To make matters worse, some meteorologists have projected there’s a colder-than-normal winter in store for the Northeast and Mid-Atlantic States. This would be a stark contrast to last year’s relatively mild winter. If they’re correct and demand for electricity is particularly strong, coal and nuclear will get even more attention. There’s already talk of new nuclear plants in the US; expect those plans to gain traction the longer electricity prices remain high.

Not only are the prospects for nuclear and coal power undimmed but these markets should outperform the oil, oil services and drilling groups this winter. New money should focus considerable attention on the coal and nuclear plays within the portfolios.

Topping that list is Canada’s Cameco, the world’s top uranium miner. This stock is the obvious play on higher uranium prices and new nuclear plant construction because it’s one of the only miners in the world that can significantly increase production over the next five years. Cameco’s mines are the richest in the world and offer low mining costs.

Denison Mines (Toronto: DEN hasn’t performed as well as Cameco in recent months. The stock is very close to my raised stop recommendation, but I can see little fundamental reason for that underperformance. Though the stock doesn’t have the attractive reserve base that Cameco has, it has excellent high-grade reserves and some new exploration projects coming on-line that should bring increased production. Denison also has a solid relationship with Cogema, the uranium exploration and mining arm of the French government (France gets more than three-quarters of its power from nuclear). Denison remains a buy; I’ll reassess if the position is stopped out.

An even more direct play on uranium is Wildcatter Uranium Participation Corporation (Toronto: U), a company that’s actually managed by Denison. Uranium Participation owns physical uranium at approved warehouses. It’s similar to an exchange traded fund or closed-end fund that moves with uranium prices. I expect further price increases over the next 2 years as utilities run down their inventories of uranium and are forced to turn secure new supplies.

Both Dension and Uranium Participation are traded solely in Canada. (See the special report Trading Canadian Equities to learn more about how to buy Canadian stocks.)

I reviewed my two speculative trade recommendations on uranium–UEX Corporation (Toronto: UEX) and Uranium Resources (NSDQ: URIX)–in the October 6 Flash Alert.

On the coal front, my top recommendations are Penn-Virginia (NYSE: PVR) and Natural Resource Partners (NYSE: NRP).

Penn-Virginia owns coal properties and reserves in the Appalachia region of the US; the vast majority of these reserves are of low-sulphur coal. While production in the east is mature and will not grow quickly in the coming years, eastern coal is located very close to its end markets along the east coast, keeping transportation costs low. Penn-Virginia earns steady royalties by leasing out its properties and pays out a near 5 percent yield to unitholders.

Natural Resource Partners is a play on western coal regions. Western coal beds have not been as fully exploited as eastern reserves; production costs are lower and there’s more scope for production growth.

Both Natural Resource Partners and Penn-Virginia remain buys in the Proven Rserves Portfolio.

The Tankers

The normal seasonal up-tick in tankers rates is underway. The process has been accelerated by the Gulf Coast hurricanes; refiners desperately tried to restock their crude supplies post-hurricane, pushing tanker rates sharply higher in September. Check out the chart of the Baltic Dirty Index below.



Source: Bloomberg

The Baltic Dirty Index includes roughly a dozen tanker routes around the world. Long haul VLCC (very large crude carrier) routes as well as Suezmax and Aframax routes are included in the index.

This chart reveals that the seasonal downdraft in tanker rates over the summer months is nothing unusual. Even in the summer of 2004, a year that turned out to be one of the best on record for the tanker industry, tanker rates declined precipitously. A seasonal drive higher in rates through at least the end of the fourth quarter and most likely into the first quarter of 2006 is also highly probable.

The chart reveals quite clearly that the normal seasonal drive higher in rates has already begun; rates bottomed in August this year, a bit earlier than is typical. Since that time, tanker rates have nearly doubled. Though rates aren’t quite as high as they were last year at this time, they’re considerably higher than the rates that prevailed in October of 2003.

The tanker companies in general, and Proven Reserves holding General Maritime (NYSE: GMR) in particular, have not been cutting their dividends in recent quarters. Because these firms simply pass along their earnings to shareholders, dividends will always be higher in the seasonally strong first and fourth quarters. Summer quarters are always weak.

Nordic American Tankers (NYSE: NAT), another operator of Suezmax tankers, recently reported earnings. As expected, tanker rates were lower this year than in 2004 so earnings fell. Nonetheless, the company’s profits were strong enough to generate a $0.60 quarterly payout in what’s likely to be the weakest quarter of the year. Management spoke of an up-tick in rates in September that’s likely to flow through into earnings this quarter.

I expect GenMar’s report to show the same trends; management will likely also talk up the surge in rates that’s already started in the fourth quarter. I’m looking for the improvement in tanker rates to flow to shareholders in the form of sharply higher dividends in the fourth quarter.

This is a good time to be investing in tanker stocks as the news flow will become increasingly positive through at least year’s end. I recommend hedging your position by shorting OMI Corporation (NYSE: OMM) and buying General Maritime in equal dollar amounts. This will allow you to capture GenMar’s huge dividends and partly protect yourself even if the tanker stocks fall.

Refiners And E&P

Refiners were some of the prime beneficiaries of the bull market in energy during the third quarter. Marathon(NYSE: MRO) was one of the best performing stocks in the portfolio; the stock was stopped out for a gain of 42 percent in early October. Marathon is now a hold in How They Rate.

The refiners did see a surge in margins after the hurricanes. But, like the drillers and services names, the group was due a correction; a great deal of momentum money was focused in this group.

What’s more, the refiners are actually losing money on marketing; basically that means gas stations. It appears that some firms have decided not to pass along all their cost increases to the consumer, most likely for fear of prevalent, yet ridiculous, claims of price gouging and the potential for a windfall tax on profits. These are not long-term concerns for the refiners. I’m looking to add Marathon back to the portfolio at an opportune time.

I’m also cutting XTO Energy (NYSE: XTO) to a hold in How They Rate. I still believe the fundamental story is intact, but it’s extremely leveraged to natural gas prices and is due a correction.

The Majors

By Yiannis Mostrous

Even the remaining few oil bears are becoming bulls now.

As these latecomers have raised their oil price projections for this year and next, we have become a bit more concerned. This newfangled optimism could lead the market to overshoot, a time-honored reality when the latecomers try to make a quick profit.

Without abandoning our long-term thesis (on the contrary, our view is as stable as ever), we’ll continue to make the appropriate adjustments to the portfolios.

Global and domestic economic developments indicate that some short of retracement should take place. A slight drop in US gasoline demand could accelerate–while high prices at the pump inspired some tapering of use, consumers have yet to experience the “excitement” of high natural gas prices and higher heating bills. In Asia, too, we are seeing a drop in demand as high prices are eating into governments’ (through subsidies) and consumers’ budgets.

If these trends gain traction, the newcomers will run for the exits, creating the short-term pullback we anticipate. Companies over-leveraged to the commodity and/or undisciplined in their capital methods will suffer the most.

Of the majors in the Proven Reserves Portfolio, ConocoPhillips (NYSE: COP) is the most leveraged to the price of oil–avoid it. The stock is now a hold and the stop-loss is being raised to $60.

All the other majors in the portfolio remain buys; stop-loss recommendations have been raised previously and are now quite close to the current trading prices.