I’ve been to two investment conferences in the past month, one in Washington, DC, in early August and one in Las Vegas just last week. At both conferences, I was struck by just how many speakers were trying to call a top in energy stocks, and in oil and natural gas generally. It seems that despite the group’s giant relative outperformance over the past two years, few are ready to believe the move is for real.

Of course, calls for a top aren’t entirely misplaced; it just depends on your time frame. No sector or market moves in a straight line higher–even the Nasdaq Composite saw some pretty serious corrections between 1990 and 2000 on its way to an almost 800 percent gain. The simple fact is that every bull market in history had its corrections, and some of those shorter-term corrections can feel pretty severe when they occur. In the end, however, it’s the longer-term trends that generate the real wealth for investors.

The core thesis of The Energy Strategist is that there is a long-term bull market in energy. My goal is to find the stocks best placed to take advantage of that rally. I’ve outlined my basic thesis on the group on numerous occasions but suffice it to say that I see both a demand boom and a supply crunch in the energy patch right now.

Demand for oil, gas and electricity is rising rapidly in the developing world as emerging markets such as China and India experience rapid economic growth. Meanwhile, growth in global production of oil and gas is limited–traditional suppliers like Saudi Arabia look shaky and production from mature basins such as the Gulf of Mexico and the North Sea is most certainly in decline. As I outlined in “The Great Wall of Cash” (see TES, August 10, 2005), the big integrated energy players are having trouble finding new reserves to replace their production.

The Oil Services Index (OSX) has run up by nearly 100 percent since the beginning of 2004 and has been in an almost straight line higher this year (see chart).


Source: Bloomberg


The OSX is now at an all-time high (the index was initiated in 1997) and well above its 1997 and 2000 peaks. While I firmly believe in the group’s long-term prospects, it would be silly to say there’s no room for a correction on the order of 10 to 20 percent in the group. Such a move would do absolutely nothing to belay the bull market in the energy patch. This does not mean that such a pullback is imminent, just that it’s possible even if there’s no discernible shift in fundamentals for the group.

I’ve been asked on numerous occasions how investors should hedge their energy portfolios against such a retrenchment. More particularly, investors want to know how to protect the significant gains accrued over the past few months in energy holdings.

That is a fair question. In this issue, I’ll cover just such a hedging strategy. Specifically, I’ll detail a way to use the options market to lock in gains on some of The Energy Strategist’s best-performing picks without giving up all the upside if the energy patch just keeps on rallying. I’ll also examine our other strategies for playing defense in the event of a short-term pullback in the energy uptrend.

My goal is not to offer complicated investing strategies, but it’s necessary to give subscribers my very best ideas for protecting gains and making money in the energy markets. In this case it means considering the conservative use of the options market to hedge your gains; I detail this strategy below. I won’t account for this strategy when calculating returns for the portfolio, but I will track and report the results. It will enhance overall long-term returns.

In addition, Contributing Editor Yiannis Mostrous has updated our forecasts for oil and gas prices. Pursuant to this analysis, I’m adding XTO Energy (NYSE: XTO), an oil and gas exploration company, to How They Rate as a buy.

And finally, the last issue of The Energy Strategist (see TES, August 31, 2005, “King Coal”) took a detailed look at the coal business. In this issue I’ll examine a back-door way to play the coal business–I’m recommending a trade in Burlington Northern SantaFe (NYSE: BNI) that I’ll track in How They Rate and via periodic Flash Alerts to subscribers.

Before delving into these issues, I’d like to extend a final invitation to any readers in South Florida. Tomorrow evening, September 15, I’ll be appearing in Boca Raton with my colleague Wall Street Winners Editor Ivan Martchev. Ivan and I will each speak for about an hour at the Boca Raton Community Center for a local investment group. If you’re interested in attending, e-mail me at egue@kci-com.com and I’ll forward you the details for signing up. I’ve already received e-mails from several subscribers who’ll be attending and I look forward to meeting you there.

Picking Your Sectors

There are several ways to hedge your energy portfolio against a short-term pullback in the energy sector. The most obvious is to simply sell the stocks most vulnerable to such a decline. It’s for this reason that I recommended selling Noble Corporation (NYSE: NE) a few weeks ago for a profit of nearly 30 percent. While the stock is at just about the same level as when I issued that sell recommendation, I am more confident than ever that this was a timely sell.

While the fundamentals have not deteriorated, there is increasing chatter about deepwater semisubmersible newbuilds–there are plans to build new deepwater drilling rigs over the next few years. More importantly, the Chinese shipyards are most likely going to enter this business, likely resulting in lower construction prices and an increase in rig supply.

I seriously doubt this will result in an oversupply of rigs. After all, the current shortage of deepwater rigs is very acute, and as energy companies engage in more exploration and development work in deepwater, demand for such rigs will soar. That said, it is a concern that could well weigh on sentiment in the short run.

I’m happy to stick with cheaper and more diversified Global SantaFe (NYSE: GSF). The driller has exposure to both deep and shallow water operations and is well placed in the hottest exploration markets globally such as the North Sea and offshore Africa. Earnings estimates are still way too low (though they’ve risen considerably over the past couple of months). As Global SantaFe rolls over some of its older drilling contracts at much higher day-rates, those estimates will likely rise, offering a fundamental boost to the stock.

What’s more, not all of the energy sector will follow the same path in a correction. Uranium plays like Wildcatters Cameco (NYSE: CCJ) and Denison (Toronto: DEN) are just breaking higher right now and haven’t seen the extreme moves that the oil- and refining-related stocks saw in the wake of Hurricane Katrina. These stocks have the potential to keep running even if there’s a significant pullback in oil and gas stocks.

The same is true of master limited partnership (MLP) recommendations Enterprise Products Partners (NYSE: EPD), Penn-Virginia Partners (NYSE: PVR) and Natural Resource Partners (NYSE: NRP). Enterprise has little commodity price risk–it simply charges a fee to ship gas through its pipelines and gas-processing facilities. And while the coal MLPs–Penn-Virginia and Natural Resource Partners–are sensitive to the price of coal, the relationship is less direct that for the coal-mining firms. Furthermore, as I’ll explain below, the price of coal has better near term support and catalysts than the price of oil.

Finally, the tanker shipping stocks are not sensitive to the price of oil, but to tanker shipping rates. The group appears to be putting in a normal seasonal low right now as I explain in depth here. I continue to recommend buying General Maritime and hedging that position with a short in OMI Corporation.

Hedging Your Bets

While careful stock picking can go a long way toward protecting your portfolio from a general decline in the energy sector, it’s not the whole story. I must also stress the importance of following my stop-loss advice in the portfolio tables.

Stop-loss orders are nothing more than standing orders you leave with your broker to sell you out of a stock once it touches a certain price. It costs nothing to set a stop; you only pay once the order is actually executed.

Whenever I initially add a stock to a portfolio, I’ll recommend a stop. That initial stop protects our downside. The beauty of such stops is that they force us to step aside and reevaluate our reasoning for entering a position. After all, if you’re stopped out of a stock for a loss, that means that, at least initially, the thesis on the stock is incorrect. And it’s a lot easier to be objective about a company if you’re out of the stock entirely.

I also trail my stops higher in profitable positions. As an example, I recommended entering Wildcatter Cameco at $37.76 back in May. I set the initial stop in the low 30s, but I’ve since recommended raising the stop to $41.50. Cameco is still likely to head higher from here and remains one of my favorite plays. However, if I’m completely wrong and the stock does pull back, you’d be stopped out above the recommended entry price for a decent profit. Hence, stops are also a means of protecting gains.

Be sure to check my latest stop recommendations in each issue. You’ll need to use a good-until-canceled stop order on all positions. These stops expire after one month and will need to be reauthorized. Stops are your first line of defense in any pullback.

Another way to protect your gains is a bit more complex and involves using the options market. I explain the basic strategy in a special report, The Options Hedge, which includes exact options contracts I’m recommending to hedge a few portfolio holdings.

Winter Gas

The pundits are focused on oil and gasoline right now due to Katrina-related disruptions and the high retail pump prices of gasoline. It seems that even local news broadcasts have become completely devoted to the latest moves in gasoline prices. Nonetheless, the big season for oil is now over; in the summer months, consumers tend to drive more and that pushes up demand for gasoline. This is “The Summer Driving Season.”

A more interesting market right now is natural gas. Just as we move out of oil’s peak demand season, the winter heating season starts to pick up, pushing up demand for electricity and gas-fired heat. The chart below is a seasonal depiction of natural gas storage over the past few years.


Source: Energy Information Administration


The chart clearly illustrates a normal seasonal cycle for gas inventories: inventories of natural gas start building in late March or early April and continue building through the summer months. Gas inventories then peak out by November/December before declining precipitously through the winter months.

While gas is in demand at power plants all year long, demand is still highest in the winter months, “The Winter Heating Season.” This is why utilities tend to draw down stocks of gas in winter.

It appears that Katrina has put at least a small crimp in this cycle. As you can see in the chart above, inventories of natural gas had been running above the average for the past few years in 2005. In other words, the inventory line in the chart for 2005 has been holding above those for 2004 and 2003–inventories of gas have tended to be higher this year.

That is until recently. Just over the past few weeks, with significant natural gas production from the Gulf of Mexico shut down, the normal seasonal build in gas stocks has slowed. Gas inventories are now actually below 2004 levels. Suffice it to say that this is bullish for natural gas (Contributing Editor Yiannis Mostrous explains the bullish outlook for gas in greater detail below).

The most leveraged play in the gas sector is XTO Energy (NYSE: XTO). The company’s strategy over the past 10 years has been to acquire mature onshore US-based fields and develop them efficiently.

Basically, XTO is not out to find major new reserves of natural gas. Instead, the company focuses on reserves that have already been explored and partly depleted. In most cases, these are properties previously owned by one of the major integrated or independent names. The geology of such properties tends to be already well known, so XTO doesn’t have to spend a great deal on exploration.

XTO simply invests in advanced technology and productive methods to squeeze more gas out of these mature fields. And XTO also looks for ways to lower the operating costs of recovering smaller pockets of gas from mature fields. Simply put, the company tries to recover the gas left behind by prior producers.

XTO’s work in East Texas is a prime example of this strategy in action. There are several major gas-producing regions, such the Barnett Shale, that have seen significant production growth in recent years. These regions have been explored for years, but low gas prices throughout the 1990s meant that a lot of gas in the ground was uneconomical to produce. The main problem with producing gas efficiently has been poor permeability.

Gas, like oil, does not exist underground in some giant lake or gas-filled cavern. The gas is actually trapped in the pores (small spaces) between rocks. This gas is under tremendous geologic pressure; when you drill into the reservoir that geologic pressure tends to force the gas up the well and to the surface.

Unfortunately, if these pores aren’t well connected–poor permeability–it can be very difficult for the gas to move through the formation and into a well. In East Texas, however, some shale and sandstone formations with poor permeability hold significant pockets of gas.

Companies like XTO use fracturing treatments to help stimulate well productivity. Essentially, this involves pumping a liquid into the reservoir to actually crack the reservoir rock. These cracks offer channels through which the gas can flow to the wellhead. So-called “frac” jobs are now common in Texas as well as in the Rocky Mountains’ low-permeability tight sands deposits.

Another popular method for lowering well costs in commingling. In a typical reservoir, there are multiple layers of rock at different depths. Several of these layers can hold hydrocarbons. Commingling is a technique for producing gas out of several different rock layers from a single well. Producing in this manner can actually lower overall production costs by eliminating the need to drill multiple wells.

By employing these techniques, among others, XTO is able to identify, drill and produce pockets of gas in the mature fields in a cost-effective manner. And XTO owns properties all over the country, not just in East Texas.

XTO’s exposure to the domestic US market is very attractive right now. At least until LNG imports can be successfully ramped up–something that’s still a few years away–onshore gas reserves that can be easily transported to key US consumption centers will be in high demand.

The company has consistently delivered low production costs, high margins, and very good cash flow growth. With one of the best reserve replacement rates and production growth in the industry, XTO is a good way to play the trend and should be a member of a well-diversified portfolio. XTO is a buy and I’ll track it in How They Rate.

Another Look At Coal

The other major fuel for power plants that’s in high demand during the winter months is coal.

Just as the winter heating season means a drawdown in gas inventories, it spells higher demand from utilities for coal to fire their power plants. With Hurricane Katrina disrupting gas supplies this season and sending gas-fired power costs sky-high, you can bet that America’s fleet of coal-fired plants will be working flat-out this winter to meet demand.

In the last issue of The Energy Strategist, I highlighted the extraordinarily low inventories of coal currently being held at the nation’s utilities (see chart below). This is a big problem, especially when you consider that we’re now entering a peak demand season. Utilities will be scrambling to secure coal supplies and restock their dwindling coal yards.



Source: Energy Information Administration


My favorite coal MLPs, Penn-Virginia (NYSE: PVR) and Natural Resource Partners (NYSE: NRP), are two great ways to play this supply crunch, as are coal-mining companies Peabody Energy (NYSE: BTU) and Arch Coal (NYSE: ACI). But there’s another back-door play on the coal market that’s getting less play in the press right now–the railroads.

It may seem strange to some to recommend transportation stocks in a service focused on energy, but the fact is that substantially all the coal consumed in US power plants is transported by rail. Due to high coal demand, the railroads have garnered considerable pricing power in recent years, jacking up prices for hauling coal from producing basins to power plants. This trend has reversed a nearly 20-year era of flat or softening hauling rates.

For most goods, there are two main modes of transport within the US: rails or roads. But for bulk commodities like coal and grain, the rails are a more common and efficient choice, especially for longer haul journeys.

The rail business is pretty simple. Railroads are responsible for maintaining their own tracks–that means replacing rails and ties as well as upgrading rails to handle more traffic where necessary. This is a relatively high fixed cost for the firms. The railroads are also responsible for fueling their own trains. In almost all cases nowadays trains are powered by diesel fuel.

On the revenue side, train operators charge a set rate for hauling cargo. As you might expect, rates vary by commodity and by hauling distance. Another factor is service quality–if railroads are late with shipments, their rates are negatively affected.

For many years, railroads suffered from consistently declining and depressed rates. This meant the group generated very low returns on capital because to keep operating they still had to shell out for track repairs and maintenance on railroad cars. But this is no longer the case. In recent years rising demand for electricity has spelled greater demand for coal; to haul that coal, railroads have been able to consistently boost their rates.

And it’s not just the energy sector that’s been strong–an increase in imports from abroad has spelled growing demand for rail shipping services to move those goods around the country. The same is true for US exports–growing demand for US exports of agricultural products requires moving ever more grain from the nation’s heartland to ports along the coasts.

While it’s also true that higher diesel fuel prices spell rising costs for the railroads, this isn’t a big problem. The better railroad companies have partly hedged their diesel needs over the next year or so at much lower prices. To cover the balance of these rising costs, the railroads have tacked on fuel surcharges to their rates.

These fuel surcharges are important for two reasons. First, the surcharges defray most, if not all, of the impact of rising energy costs. And second, it serves to illustrate that the railroads now have pricing power over their customers. The rails can now demand a higher fee just to compensate for their rising costs. Such high surcharges would have had little chance of surviving a few years ago.

With roughly one-quarter of its revenues coming from hauling coal, the railroad most leveraged to the coal story is Burlington Northern SantaFe (NYSE: BNI).

What’s more important is where Burlington’s coal exposure lies: its route network serves the heart of the Powder River Basin (PRB) in Wyoming and Montana. In fact, Burlington is the railroad most levered to this reserve–roughly 90 percent of the coal hauled over its lines is from the PRB.

Wyoming is the Saudi Arabia of coal. The PRB is the nation’s most promising coal-producing region long-term because coal from the PRB is cleaner-burning low-sulphur coal. Even better, the coal in the region is very easy and cost-effective to mine.

Already, some utilities, even along the East Coast, are switching from tradition sources like Appalachia to PRB coal. By making the switch, utilities are better able to meet environmental regulations for emissions. Chances are Burlington will be hauling the coal that these utilities need to keep their power plants running.

And consider that hauling coal from Appalachia to the East Coast is a much shorter trip than from Wyoming. That means the distances involved in the coal trade are getting larger–long-haul journeys earn the railroads better profit margins.

I did point out last issue that railroad maintenance work has been a major headache for users of PRB coal. Burlington, among others, has been putting some serious investment into their tracks in the region. Some of that work is basic maintenance, while some constitutes upgrades that will ultimately allow more coal to be hauled from the region.

The good news is that Burlington is nearly finished with its maintenance work. Management has said substantially all of the required work will be completed this year. In fact, run rates along the rail lines in the region are already improving this quarter from second quarter levels. And further improvement is expected in the fourth quarter.

Factoring in significant price hikes for hauling PRB coal and increases in shipping volumes, Burlington is looking at mid- to upper single-digit increases in profitability from its coal-hauling activity. In the near-term I see the utilities’ desperate need to restock their inventories as a catalyst for the stock. In addition, the increased volumes that will come as maintenance work is completed will also act as a fundamental driver for Burlington through year-end.

Finally, outside the coal business, railroads are benefiting from the trucking industry’s woes. Trucking firms such as Yellow Corporation (NSDQ: YELL) have been hit by a shortage of drivers as well as rising fuel costs. This is one reason that rail stocks have been rallying while the truckers sell off sharply (see charts of Burlington and Yellow below).

Burlington Northern Santa Fe (NYSE: BNI)


Source: Bloomberg

Yellow Corporation (NSDQ: YELL)


Source: Bloomberg


Because skilled drivers are in such short supply, the truckers have had to jack up wages, cutting into profit margins. The shortage has also caused a general degradation in service levels. As the logical alternative for transporting goods, all that benefits the rails.

I’m adding Burlington to How They Rate as a trade recommendation. I’m looking for a move to the mid- to upper 60s over the next few months.

An alternative pick is Norfolk Southern (NYSE: NSC), which garners about 20 percent of revenues from coal; much of that coal comes from East Coast (Appalachia) reserves. Norfolk has seen solid returns from its coal business and has a solid record of quality service. I’ll track Norfolk Southern, too, in How They Rate.

The Game Is Changing

By Yiannis G. Mostrous

In the May 26 issue of The Energy Strategist we urged investors to buy into oil stocks after the per barrel price approached our 2005 floor of $45. We went on to say:

And although prices could go a little lower in the near term, it seems that the risks are rather on the upside. Therefore, we are taking our oil price forecasts higher and now expect the price of oil to stay closer to $50 than $40 this year and closer to $55 in 2006. In addition, over the longer term–until the end of the decade–we expect that oil will be moving between $45 and $55, with the possibility that it can break above $55 and approach $60.

Today, and given the reality of Hurricane Katrina and our tight supply and demand outlook for the winter, we are raising our 2005 oil price to the upper 50s. Expect the price of oil to stay closer to $60 than $50 this year.

As said here before, low energy prices are a thing of the past. Although corrections will take place, they should be viewed as breathers in the context of a new secular bull market.

That said, the biggest surprise this year will come from the gas market. Very few people realize that US gas prices are no longer driven by inventories. On the contrary the most important aspects are the rising costs in supply and demand. The impact of Katrina on the Gulf of Mexico, which accounts for 17 percent of US gas production, clearly demonstrates how the supply side of the equation can be chaotically altered. Needless to say, we expect the price of gas to stabilize closer to $10 per thousand cubic feet.

Many investors have pointed out that liquefied natural gas (LNG) could fill the gap. We don’t agree. The main problem is that the US lacks the regasification capacity to offset the loss of production the country is currently experiencing. Regasification capacity utilization has remained at around 60 percent because of price competition between the US, Europe and Japan. But even so, the US gas market is more than 60 billion cubic feet per day, and even the most optimistic market observers do not expect LNG to bring in more than 2 billion cubic feet per day this winter.

Of course LNG plays will benefit from the inevitable rise in LNG traffic in the US. Our favorite is Wildcatters Portfolio holding BG Group (NYSE: BRG), because of its big presence in the Atlantic, particularly its Trinidad installations.