But there’s a bright side: There are signs that OPEC oil production cuts are beginning to filter through into US oil inventory data. In addition, there are growing signs that the Chinese economy is re-accelerating; the impact of the nation’s massive fiscal stimulus package is just beginning to filter through into economic data.

In the US, politics continues to be a concern. Selling in the broader markets picked up steam as President Obama announced his preliminary budget proposal. In this issue, we’ll take a look at the outlook for oil and gas prices, the potential impacts of the Obama budget proposal, and how to profit amid this extreme bout of stock market volatility.

In This Issue

The factors impacting energy stocks have more to do with broader economic issues than anything sector- or company-specific. We’ve yet to see convincing evidence that the US has reached the bottom of the current cycle. See It’s a Macro World.

The new administration has certainly been active of late, and the market has certainly taken notice. There are implications for energy investors stemming from all the initiatives emanating from Washington, DC. See Political Risks.

The goal of The Energy Strategist isn’t to analyze the political ramifications of certain legislative or executive choices. It’s to make money. See How to Play It.

We’ve focused on three major themes in recent months–high-income plays, Super Oils, and gas over oil–but there are other ways to maximize your profit potential as well. See Covered Calls.

It’s a Macro World

It’s official: the S&P 500 experienced its worst February since 1933, declining more than 10 percent. And March isn’t off to a better start; the S&P 500 plunged below key support on Monday and continues to trade below its 2002-03 lows by a significant margin.

The S&P 500 Energy Index fell just over 12 percent in February, while the Philadelphia Stock Exchange Oil Services Index (OSX) declined just under 6 percent. As a group energy stocks performed in line with the major averages, cold comfort in light of the broader market’s dismal showing.

At the risk of sounding like a broken record, the primary factors driving energy remain macroeconomic in nature rather than company-specific. It’s no accident that energy stocks are following the major averages; the stock market in general continues to be worried about ongoing evidence of economic weakness in the US. Probably the clearest manifestation of this was last week’s read on gross domestic product (GDP) for the fourth quarter of 2008.

Source: Bloomberg

US GDP shrunk at a 6.2 percent annualized pace, the fastest rate of decline since the recession of the early 1980s and a significant downward revision from January’s advance reading.

But none of this is a surprise. As I’ve explained on several occasions, this is undoubtedly the worst recession to hit the US since the contractions of the ’70s and early ’80s in both duration and severity.  As I wrote in the Feb. 20, 2009 Pay Me Weekly, It’s Still the Economy, there are no real signs that the US has hit the trough of this downturn yet.

Of the 10 indicators within the Conference Board’s Index of Leading Economic Indicators only two are showing any signs of life, money supply and interest rate spreads. These two indicators are most directly influenced by government policy.

But fast-growing money supply and a steep yield curve are not the firm foundation of a broad economic recovery. In fact, because of the lingering effects of the deflating credit bubble, monetary easing is likely to have a less significant impact on the economy than has been the case historically. I discussed this phenomenon as well as the concept of velocity of money in the Feb. 27, 2009 Pay Me Weekly, The Money Super-Accelerator.

The ongoing impact of a weak economy on energy demand will continue to keep a lid on rallies in the prices of oil and natural gas over the next few months. This is precisely why oil fell 10 percent on Monday, snapping a rally that began in the middle of last week.

At the same time, supply will continue to put a floor under energy prices. For crude, expectations are growing for further output cuts from OPEC countries to help match global oil demand with supply. And, as I pointed out in the last issue of TES, nearly a third of the planned production projects scheduled within OPEC for the next four years have been cancelled or severely delayed.

We may already be seeing the first evidence that ongoing OPEC output cuts coupled with continued declines in drilling activity outside OPEC are having an impact on US oil inventories.

Source: Bloomberg

This chart illustrates just how quickly oil inventories have been building in recent weeks. The purple bar represents analysts’ collective expectations for oil inventories each week at the time the weekly reports were released. The blue bar represents the actual crude oil inventory build (or decline) for each week. It’s clear that, with few exceptions, actual inventory builds have far exceeded analysts’ expectations.

The yellow line cumulates these deviations. In other words, it’s a running total of how much oil inventories have exceeded expectations since mid-November 2008. As you can see, by mid-February, inventories had built up more than 20 million barrels a day faster than analysts’ models projected.

That trend shows some signs of reversing. Over the past two weeks inventories have come in well below expectations. Although it’s way too early to know for certain, this could be the first sign of the oil market balancing.

As I pointed out in the Feb. 25, 2009 issue of The Energy Letter, The Hunt for Catalysts, demand shows signs of stabilizing thanks to sharply lower prices. Meanwhile, OPEC production cuts and a severe decline in drilling globally are clearly impacting supplies.

And US refiners continue to exhibit remarkable discipline in the current environment.

Source: Energy Information Administration

This chart shows US refinery utilization–the percent of US refinery capacity that’s actually being used. The prominent downside spike you see in 2008 is due to the passage of hurricanes Gustav and Ike in August and September; these hurricanes resulted in the shut-in of several major refineries along the Gulf Coast.

Discounting that one-off spike, there is a clear trend: US refinery utilization has been steadily dropping in recent months. Refiners are cutting back their output of refined products because of low profit margins. This has helped to bring US gasoline inventories under control.

Source: Energy Information Administration

Gasoline inventories are falling sharply and are at the lower part of what would be considered average for this time of year. As a result gasoline prices have been outperforming oil prices since the end of 2008.

When the price of gasoline rises relative to crude oil, profit margins for the refiners tend to expand. For those unfamiliar with the refining industry, I offer a detailed primer in the March 21, 2007 TES, Looking Refined.  The classic measure of refiners’ profitability is the crack spread, which has steadily expanded this year. As long as gasoline prices and inventories remain relatively tight, this should also help to put a floor under oil prices.

The US isn’t the only game in town. Much of the growth in oil demand in recent years has come from the developing world, countries such as China and India in particular. As I noted in the last TES, only about USD185 billion of the USD787 billion US stimulus package is expected to enter the economy this fiscal year. Most economists are looking for a relatively small impact on 2009 economic growth, with more meaningful impacts to be felt in 2010.

But China’s stimulus is expected to have a greater impact on domestic GDP growth in 2009. In total, China’s stimulus could boost growth by more than 2 percent this year. China may well be the first major economy in the world to show a recovery from the global economic slowdown. A number of indicators suggest China’s economy may already be hitting bottom for this cycle.

Source: Bloomberg

This chart shows new loans being extended by Chinese banks. In many cases banks are making these loans to help fund the new infrastructure investments the government is making.

The current reading of 1.6 trillion renminbi is a record for this series and double the December total. It’s a positive sign to see loan growth in China; most developed-economy banks remain reluctant to extend credit, tightening lending standards after piling up bad debts on their balance sheets.

Another indicator many economists are pointing to is the Purchasing Managers Index. A reading above 50 indicates an expansion in activity, while a number below 50 indicates a contraction. The current reading of 49 remains weak, but the indicator has bounced sharply off its lows under 40 late last year.

Finally, the Baltic Dry Index continues to hold above 2,000, a sure sign that demand for dry bulk ships is on the rise. Dry bulk ships are typically used to carry commodities like steel and coal. One of the main sources of import demand for these commodities in recent years has been China; an uptick in rates off extreme lows last year indicates a resumption of demand from China.

Later this year, as the US economy stabilizes and begins to recover, oil demand in the US should stop falling and, to the extent that prices remain reasonable relative to last summer, could actually show growth into early 2010. When that happens, the market’s attention will shift back to supply; given the current pace of OPEC cuts and non-OPEC project cancellations supplies won’t be sufficient to meet demand with the global economy in a more normal state. That’s when we’ll see the next big run-up in oil prices and related stocks.

As for natural gas, we continue to see producers scale back production and drilling activity at a record pace in response to weak US gas prices. Over the past two weeks countless producers of all sizes have announced significant cutbacks in their capital spending budgets for 2009. Many producers have stated that they’ll only spend within cash flow, opting for internally generated cash rather than borrowing money or issuing new shares.

Source: Bloomberg, Baker Hughes

This chart shows only rigs actively drilling for natural gas in the US. The rig count slid under 1,000 last week and is down 40 percent from its highs last August. That’s almost the same percentage decline as we saw back during the 2001 down-cycle, except the decline in rigs has happened in six rather than nine months.

We’re also seeing the decline in activity showing up in the Energy Information Administration’s (EIA) monthly natural gas production statistics. Excluding the impact of September’s hurricanes, US natural gas production has grown at an average annualized pace of 13.5 percent over the past year.

However, in the month of December, the last month for which the EIA is providing data, production growth dropped to zero. Production declines should begin to accelerate in coming months, helping offset ongoing declines in industrial demand.

For both crude oil and natural gas the tenuous balance of supply and demand will keep these markets range-bound for at least the next few months. But I am looking for demand to stabilize for both commodities by year’s end. When that happens, the focus will return to rapidly falling supplies; current depressed prices are sowing the seeds of the next up-cycle. Energy-related stocks will likely begin to move higher a few months before the commodities take off; historically, stocks lead fundamentals.

Back to In This Issue

Political Risks

In the last issue of The Energy Strategist, The Leviathan and Energy, I examined the USD787 billion American Recovery and Reinvestment Act of 2009, more commonly known as “the stimulus package.”

Washington, DC was once again the center of the stock market’s attention last week as President Obama released his preliminary budget proposal, entitled A New Era of Responsibility. It’s not my habit to make political commentary in this space. However, new government initiatives are impacting the market, and we simply can’t afford to ignore DC right now. In fact, it’s fair to say that the announcement of the budget acted as an additional downside catalyst for US equity markets last week.

That’s not to say there weren’t other factors behind the decline, but Mr. Obama’s budget hit some of the market’s strongest groups the hardest. Chief among those, the S&P 500 Health Care Index had outperformed the S&P 500 in 2009 until it dropped 11.4 percent last week while the broader market slipped 4.5 percent. Much of that weakness was focused on the Health Maintenance Organizations (HMO) such as Humana (NYSE: HUM); the S&P AmBest HMO index plummeted 22.6 percent last week.

Although it’s a bit beyond the scope of this particular energy-focused advisory, the main concern stemming from the president’s budget with respect to health care was the establishment of a USD634 billion “fund” for reform of the industry. Roughly half of this fund would be financed by tax increases, the other half by cutbacks in Medicare and Medicaid spending. Of the roughly USD316 slated to come from Medicare cutbacks, more than half (USD177 billion over 10 years) is supposed to come from a reform to the Medicare Advantage (MA) system.

Without getting into too much detail, under MA, Americans covered under Medicare can elect to be covered by private health insurers. In exchange the government pays the private insurers a fee for each Medicare recipient they cover. The Obama plan would essentially have the effect of lowering the amount these private insurers get, cutting into their profit margins. Many private insurers may decide the MA business is no longer lucrative enough to be viable; in one stroke of a pen, this eliminates what was one of the biggest profit centers for a company like Humana.

To be fair, Obama has spoken extensively about MA before, and this move wasn’t totally unexpected. However, many market participants were scared off by the speed at which the new Administration is proposing reforms and the ambitious extent of those moves. Senate Majority Leader Harry Reid has stated that he would like to pass new health care legislation by August; this looks highly unlikely, and even several Democrats have said the debate is likely to extend into 2010.

Some of the proposed tax increases are also quite controversial and may prompt some Democrats to revolt, necessitating changes. Alternatively, Obama may decide he wants more Republican support, particularly in the Senate. At any rate, the preliminary budget is just an opening draft, not the final act.

The point is the budget introduced another layer of risk and uncertainty for the market as a whole. Although many observers expected some of these changes to come about eventually, there had been a growing expectation that Obama would hold off on more aggressive reform moves until the economy showed signs of stabilizing. Instead, the president has apparently decided he should try to push through as many initiatives as possible when his popularity is high.

Obama’s ambition sucked the wind out of the sails of one of the market’s few remaining leadership groups. The S&P 500 Health Care and Information Technology sectors are the most heavily weighted groups in the S&P 500; it’s undeniable that their recent wavering has contributed to the index’s overall weakness.

The market is also concerned by the sheer size of the proposed budget.

Source: A New Era of Responsibility, Office of Management and Budget

This chart shows total federal government outlays (spending) as a percent of US GDP going back to 1941. As you can see, spending has been steadily on the rise since 2001-02 after falling fairly steadily after 1982. Obama’s budget calls for outlays equal to nearly 28 percent of GDP for this fiscal year. That’s the largest spending since World War II, during which outlays equal to more than 40 percent of GDP were the norm.

These numbers are based on the administration’s estimates. They seem totally unrealistic to me. Specifically, the preliminary budget projects that US nominal GDP will grow at around 4.42 percent annualized between 2008 and 2019. That’s only slightly below the roughly 4.7 percent annualized growth in nominal GDP the US experienced in the 1990s.

The ’90s were among the best decades in US in history in terms of economic performance. To expect a repeat of that performance is naïve at best. More likely these are simply the sort of performance numbers that were needed to meet stated deficit targets; to be fair, this is a ploy that’s been used by presidents from both parties. Here’s a chart showing a more realistic projection of the US fiscal situation.

Source: A New Era of Responsibility, Office of Management and Budget; Bloomberg

To create this chart, I took the outlay figures from Obama’s budget proposal but tweaked the GDP numbers. I assumed the US economy shrinks 1 percent in 2009–a rather conservative estimate in my view and much more realistic than the small gain the budget projects. Then I simply compounded US GDP at a 2.5 percent annualized pace out through 2019.

As you can see, the picture here is even more alarming. The size of federal outlays expands to nearly 30 percent of GDP by the end of the period, the highest since 1945. And even under the Obama budget’s relatively rosy projections for federal tax receipts and growth, net debt held by the public would expand from about 41 percent of US GDP at the end of 2008 to more than 67 percent in 2019.

As far as the stock market is concerned, all this spending spells higher income taxes. Using Obama’s projections, total federal receipts rise from 17.7 percent of GDP in 2008 to a new high of 19.5 percent in 2019. Under my conservative/realistic assumptions for GDP growth, US government receipts would have to rise to 25 percent of GDP by 2019 to meet the preliminary budget’s deficit targets.

Source: A New Era of Responsibility, Office of Management and Budget; Bloomberg

As you can see, under my conservative assumptions tax revenues would have to hit record levels to fund all the planned spending under the preliminary budget and reduce the deficit as planned.

Rising public debt, income taxes and rising spending are hardly factors that tend to give cheer to the broader market averages. Whatever you might think about the merits of Obama’s plan, remember that the markets abhor uncertainty. Historic spending and the possibility of major tax increases to fund it all introduce a new level of political uncertainty.

For those interested, the personal income tax hikes proposed in the Obama budget amount to around USD636 billion over the next decade and generally don’t phase in until fiscal year (FY) 2011. There are three main provisions that the preliminary budget claims will impact individuals making over USD200,000 per year and couples making over USD250,000. Here’s a breakdown.

Source: A New Era of Responsibility, Office of Management and Budget; Bloomberg

The largest component of planned tax hikes is the reinstatement of the 36 and 39.6 percent marginal income tax rates. The second most important component is the elimination, or scale-back, of personal exemptions and itemized deductions for higher-income Americans. Finally, as promised on the campaign trail, Obama wants to raise to 20 percent the tax rate on dividends and capital gains for higher income earners.

The president’s budget also contains several provisions that directly impact the energy industry. The two most obvious are a provision that would establish a carbon dioxide (CO₂) cap-and-trade system and the elimination of certain tax credits that apply to US oil and natural gas producers. As to the cap-and-trade provisions, check out the chart below.

Source: A New Era of Responsibility, Office of Management and Budget

As you can see, the president’s budget assumes no climate revenues whatsoever before FY2012. After that, the budget pencils in roughly USD80 billion per year through the end of the forecast period. The proposed plan is to auction off carbon emissions credits to companies releasing CO₂ and allowing companies to trade the credits as needed. The president’s goal is to reduce carbon emissions by 14 percent below 2005 levels by the year 2020 and 83 percent by 2050.

The idea is that the total number of carbon credits available for auction would be reduced each year in line with the desired targets. Reducing the available supply of credits would push the cost of those credits higher and, therefore, incentivize further cutbacks in emissions. The exact details of this plan aren’t entirely clear, although the budget does include USD19 billion in additional funding for the Environmental Protection Agency (EPA) to establish baseline levels for carbon emissions that would help to establish exactly how and how many credits would need to be auctioned.

The idea of a cap-and-trade system for carbon emissions reductions isn’t really new, nor does its inclusion in the budget come as a great surprise. For well over two years, I’ve been projecting that the US would eventually establish just such a system. This is simply the first time that anyone in power has actually put pen to paper on such a plan. Individual feelings about global warming vary widely; I see no reason to enter that fray in this forum. But, as is the case with politics generally, it would be totally irresponsible to ignore the effects of these policies on our investment dollars.

The first point to note is that the immediate effect of any policy is likely to be negligible–the budget assumes no revenues from cap-and-trade before 2012, leaving plenty of time to make changes to the proposed system and for lobbyists to work their magic on Capitol Hill. And even if the plan goes ahead as is the initial reductions required would likely be quite small.

Because the electric power industry is the No. 1 emitter of CO₂ in the US, it’s logical to start with this sector. The obvious loser in this regard would be coal, the most carbon-intensive fossil fuel and the No. 1 source of carbon emissions globally.

Last summer, I was asked to write an editorial piece for the official magazine of the Group of 8 Summit. I subsequently was invited to attend the G8 Summit in Hokkaido, Japan in July; I outlined my main conclusions from the Summit in the July 23, 2008 TES, Clean Coal and Energy Efficiency.

In that issue and in my piece for the G8 one of my major points was that any attempt to regulate carbon emissions without addressing coal is futile. Coal accounts for half of US and global power generation and around 80 percent of China’s power supply. The idea, espoused by some environmental groups, that we can phase-out coal is not only ludicrous but dangerous, as it reveals an underlying lack of understanding as to the scope of the globe’s growing energy needs.

While at first blush the preliminary budget seems to disadvantage coal, there are plenty of provisions in the bill that are favorable to the industry as well. Note the following passage from A New Era of Responsibility:

… to build five commercial scale coal-fired plants with carbon capture and storage technology through public-private partnerships. The Energy Department will also scale up its demonstration projects for geologic storage for carbon dioxide. Combined, this funding will set the foundation for significant efforts to mitigate greenhouse gas emissions from coal-fired power plants.

This language is almost identical to a provision included in the stimulus bill passed last month and discussed at some length in the last issue. Bottom line: I don’t see anything unexpected or new in this budget that would affect coal. This is borne out by the fact that coal stocks actually slightly outperformed most other energy-related names since the budget proposal was released last week.

As I explained last summer, clean coal will become a more important investment theme in coming years as the US Dept of Energy begins to set up its demonstration projects. The early read is that the big coal firms would be involved in any such deals; my favorite coal name is Peabody Energy (NYSE: BTU). Later on in today’s report, I’ll outline a covered call strategy for investing in Peabody that allows traders to generate a 14 percent return over the next three months even if Peabody trades sideways.

Other potential beneficiaries are engineering and construction (E&C) companies, including Nuclear Field Bet denizen Shaw Group (NYSE: SGR) and Alstom (France: ALO, OTC: AOMFF), a France-based, buy-rated firm my How They Rate coverage universe.

I must emphasize that this theme is longer-term in nature. Clean coal policy alone isn’t a reason to invest in any of these stocks. Right now, just as with oil and natural gas, the market is worried about the effects of the global economic recession on coal demand. Because coal is the key baseload–power generating capacity used nearly continually–fuel for power plants, demand is less sensitive to economic conditions than demand for oil. In addition, as I explained at great length in the January 7, 2009 issue, Good Riddance, 2008, most of the big coal companies are protected by longer-term contracts that lock in prices and shelter profits from swings in spot coal prices.

Another factor to watch is a recovery in China, a key consumer of coal. If the nascent improvements in the local economy I noted above continue, this would be a positive for Peabody’s Australian coal export operations as well as for coal prices generally.

Another point worth noting is that in almost every country that’s implemented a scheme to control carbon emissions, the commodity that sees the biggest jump in demand is natural gas. The reason is simple: Gas emits less than half the CO₂ coal emits, and gas plants offer cheaper, more reliable power output than wind or solar plants. In addition, gas plants are faster to build than nuclear plants and tend to encounter far less political and environmental opposition than coal plants.

At current gas prices between USD4 and USD5 per million British thermal units gas-fired power plants look like an even cheaper option. I highlight this long-term bullish dynamic for natural gas in the April 23, 2008 TES, Electric Charge. Again, however, it’s important to note that carbon regulations are bullish for gas longer term; this isn’t a near-term catalyst.

The final obvious sector to address is alternative energy. The president’s budget, just like the stimulus package, spills considerable ink talking about green energy technologies such as solar and wind.

Many investors seem to have the idea that any carbon charges levied by the government would be reinvested into clean energy projects. However, the president’s budget makes it abundantly clear that’s just not the case. Ff the USD645.7 billion in projected carbon-related revenue collected over the 2012 to 2019 period, only USD120 billion is earmarked for clean energy technologies. The remainder, some USD525 billion, is destined to pay for the president’s “Making Work Pay” initiatives that I discussed two weeks ago.

At any rate, I see all the cash the government is flooding into alternative energy as an incremental positive for the group. In the near term, the sector will be range-bound because of macroeconomic concerns and the resulting difficulty financing new wind and solar projects in the midst of a credit crunch. Don’t make the mistake of assuming that this clean-energy-friendly budget will act as a near-term catalyst for the group.

The final issue is who pays for these carbon credits. The obvious answer is that they’ll be purchased at auction by carbon emitters such as electric utility companies. Ultimately, however, the utilities are likely to pass on the higher carbon bills in the form of higher rates for consumers; electricity prices are likely to rise as a result of the bill.

The second aspect of the Obama budget to have a direct impact on the energy industry are provisions to remove certain tax benefits for the oil and natural gas exploration and production (E&P) industry. These provisions would all take effect starting in FY2011 (October 2010 through September 2011), so the impact won’t be immediate.

Source: A New Era of Responsibility, Office of Management and Budget

The total tax increases on oil companies over the 2011-to-2019 period amount to around USD31.5 billion. Here’s a look at these provisions.

The repeal of the manufacturing tax deduction for oil and gas companies: This is a special tax deduction that applies to domestic manufacturing income. While many don’t consider oil and gas to be a manufacturing industry, the group was allowed to claim this deduction, although the incentive was frozen under last year’s bailout bill. Obama is proposing the permanent repeal of this incentive.

Levy and excise tax on oil and gas producers in the Gulf of Mexico: In the late 1990s, while energy prices were languishing, the federal government signed deepwater leases with oil companies that gave them significant royalty relief. The intent was to encourage development in an environment where energy prices weren’t high enough to prompt producers to explore and produce in the region.

However, in their infinite wisdom the feds “forgot” to include clauses in these contracts that terminated royalty relief when oil and gas prices exceed a certain limit. This provision would essentially correct that oversight, charging companies an excise tax to make up for lost royalties.

Repeal of expensing intangible drilling costs:  Under current law, E&P companies are allowed to expense certain costs associated with drilling wells, such as drilling mud, fuel and chemicals as soon as this money is invested. This has the effect of encouraging drilling because it reduces the after-tax cost of new wells.

Repeal percentage depletion for oil and gas: This one is best illustrated with an example. Consider a producer that spends USD1 million to drill a well in a particular field. The value of the oil and gas in that field is an asset, but it’s a finite asset; the producer will gradually produce the hydrocarbons over time. Under cost depletion a producer can recoup its USD1 million cost over a certain period of time tax free.

Under percentage depletion an oil and gas producer is able to deduct a percentage of the net income it receives from its well; in the US a producer is allowed to claim 15 percent of the total gross income from a well. The producer can continue to take this deduction even after its USD1 million investment is recouped.

The basic law has been in place since 1926 but has changed over time and includes myriad restrictions. For example, integrated oil companies don’t get this advantage. And the depletion allowances are only good for wells up to a daily production limit of 6,000 barrels of oil or 6 million cubic feet of gas. Obama’s plan calls for eliminating this advantage.

Finally, Obama’s budget includes several provisions that are considered revenue neutral in the context of the budget. These include the repeal of tax credits associated with enhanced oil recovery projects, marginal well production and tertiary injectants. Enhances oil recovery (EOR) involves injecting CO₂, nitrogen or other gases into an older oil well to help repressurize the field and boost oil production; the Permian basin of Texas is a particularly important region for EOR.

Mature (or “stripper”) wells are typically defined as wells producing less than 10 barrels a day (bbl/d) of crude oil. In many cases, such wells are only marginally profitable, particularly with oil prices at current levels. Tax credits helped make these wells more economic.

The knee-jerk reaction to these oil and gas tax measures is to sell E&P companies with exposure to the US market because the loss of these tax breaks will cut into their profitability. But the larger impact is that these measures will simply accelerate the eventual mega-spike higher in the price of oil and natural gas.

At the beginning of today’s report, I highlighted how the current focus on slumping demand will shift to rapidly falling supply as soon as the global economic picture stabilizes. The proposed tax measures would tend to impact supply. Consider the following charts.

Source: Energy Information Administration

Source: Energy Information Administration

These charts show total oil and natural gas production broken down by the size of the operator. As you can see, the top 10 natural gas producers in the US account for about 39 percent of US production, while the top 10 oil producers account for around 50 percent of the total. Note, however, that small producers–those ranked outside the top 100–account for around a quarter of US oil production and a fifth of gas production. There are more than 13,000 producers operating in the US.

Many of these smaller producers are targeting marginal stripper wells. In fact, it’s estimated that 1 million bbl/d of US production comes from stripper wells, and there are more than 400,000 such wells operating in the US. Although production from a particular well is negligible, the total is about a fifth of US oil supply.

Larger oil and gas producers such as Chesapeake Energy (NYSE: CHK) and EOG Resources (NYSE: EOG) have access to attractive reserves that benefit from favorable tax treatment but can still likely be produced economically under a less favorable tax regime. At least, this is true under an environment of more normal oil and natural gas prices.

But these smaller producers are a different story. In many cases these wells are producing because their operators want to take advantage of the favorable tax treatment, particularly the depreciation allowances. Once these breaks are phased out, those wells will go offline and/or drilling activity will be curtailed.

The result: lower domestic oil and gas supply. These proposed measures, scheduled to take effect in October 2010, will negatively impact US domestic energy supplies around the time that global energy demand will be accelerating. Some might say that the idea is to shift the US away from dependence on oil and gas, but the reality is that there’s no real alternative out there that’s viable on a large scale over the next 10 years, certainly not by 2011.

These measures will therefore tend to reduce domestic supply, increase the call on OPEC (and non-OPEC) imports and raise energy prices. The magnitude of these effects is tough to ascertain but something in the 500,000 bbl/d range for oil doesn’t seem overly aggressive to me. Judging from the quick, negative reaction out of the Independent Petroleum Association of America (IPAA) and the American Petroleum Institute (API), these measures are a huge concern for smaller producers.

Back to In This Issue

How to Play It

With the S&P 500 slipping to its lowest close since 1997, it’s hardly surprising that most energy stocks are trading lower in recent months. That said, even with the market in freefall, more than a third of the companies in my coverage universe are trading higher over the past three months–there are ports in the proverbial storm. In addition, energy is outperforming the S&P 500 near term. The S&P 500 Energy Index is outperforming the S&P 500 over the past three months by a margin of nearly 2-to-1 margin even though both indexes are trading lower.

During market downturns it’s always a useful exercise to examine which companies are outperforming. In fact, as a matter of course I look at the performance of all stocks in my coverage universe over trailing two-week and three- and six-month time frames. Some of the stocks that hold up relatively well during big selloffs often turn out to be the leaders of any subsequent advance.

A quick perusal of the most recent statistics for energy stocks reveals the following trends.

Uranium stocks are performing relatively well. Of the top 10 performers on a trailing three-month basis, four were uranium mining firms up an average of nearly 35 percent. Part of this is simply a rebound from extraordinarily depressed conditions at the end of last year. But I also see positive developments underway in the industry, which I outlined in the Jan. 21, 2009 issue, Uranium Revisited.

Master limited partnerships (MLP) are outperforming. Four of the top 10 performers in my coverage list are MLPs or limited liability corporations (LLC). As I noted in The Leviathan and Energy, MLPs continue to benefit from a normalization of credit markets.

There’s further good news in this regard: ONEOK Partners (NYSE: OKS), an MLP focused on natural gas pipelines and storage facilities, recently priced a USD500 million 10-year bond offering at a yield-to-maturity of about 8.625 percent, a smaller yield than MLP bond offerings made in January.

In addition, Proven Reserves bellwether Kinder Morgan Energy Partners (NYSE: KMP) was able to increase the size of a scheduled offering of new units (shares); these funds are slated to help finance some of Kinder’s impressive slate of organic growth projects. And a smaller MLP, Regency Energy Partners LP (NSDQ: RGNC), got financing for a pipeline that will serve the ultra-hot Haynesville Shale natural gas play in Louisiana. (Those readers unfamiliar with this massive deposit of gas should check out the Sept. 3, 2008 TES, Unlocking Shale.)

Finally, from a macroeconomic perspective, the US Federal Reserve has started its enlarged Term Asset-Backed Liquidity Facility (TALF) plan. This should, at least in the short term, boost liquidity and lower rates in several key asset-backed debt markets.

The only area of the MLP space that isn’t doing well is gathering and processing (G&P), a commodity-sensitive business I discussed Dec. 3. I briefly outlined my recommendations in the MLP space two weeks ago, and I’ll offer a more detailed look at the sector over the next few issues.

One more point is worth noting: One of the only outright positives I see in Obama’s budget plan is that the outline contained no plans or language suggesting any change in the tax status for MLPs. The budget does address the taxation of carried interest on some partnerships (mainly private equity firms), but this doesn’t apply to MLPs. In fact, MLPs’ tax status actually becomes more attractive once the qualified dividend tax rate rises to 20 percent.

Energy-related bonds and preferred shares holding up well. Bonds and preferred shares are benefiting from continued normalization in credit markets, the same basic trend that’s helping out the MLP space.

I recommend Chesapeake Energy 4.5 Percent Convertible Preferred of 12/31/49 (NYSE: CHK D, CUSIP: 165167842) and Chesapeake Energy 6.375 Percent Bonds of 06/15/15 (CUSIP: 165167BL0). I highlight both Chesapeake Energy issues in the Nov. 19, 2008 issue, High Income with Upside.

The bonds are performing particularly well, trading close to 90 cents on the dollar of face value against about 72 cents per dollar when I recommended them in November. That said, I continue to recommend ChesapeakeEnergy 6.375 Percent Bonds of 06/15/15 as a buy up to USD0.95 per USD1. The Nov. 19 issue includes a detailed primer on the bond and preferred markets.

Liquidity concerns surrounding Chesapeake Energy that reached a fever pitch in early December have receded. The company continues to take all the right steps, including further reducing its capital spending plans to conserve cash, taking advantage of the credit thaw to issue USD1.4 billion in bonds to pay down shorter-term credit lines, and working on a joint venture deal with big international producers to help fund its Barnett Shale ventures.

Big independent and integrated oils. Although the big integrated names have fallen recently alongside the S&P 500, they’re handily outperforming the rest of the energy patch over a longer time frame. I highlighted the rationale for owning these names in the Dec. 24, 2008 issue, Buy Income, Super Oils and Gas. My position on this defensive growth sector is unchanged.

Late last year I highlighted a simple three-pronged strategy for tackling the current volatile market: Focus on stocks with high income potential, Super Oils, and natural gas over oil. I also recommended looking to take advantage of rock-bottom valuations in some sectors, such as oil services, to build positions over time.

The income focus has clearly paid off via the outperformance of MLPs and energy bonds and preferreds. The Super Oils and large independent producers have also held up well. Only the third leg of the strategy has been somewhat of a disappointment; natural gas-levered names have slightly underperformed oil-heavy names over the past three months. All told, this strategy fits well with the observations I’ve just made about near-term performance.

I continue to recommend following the same basic strategy. As I noted earlier in today’s report, natural gas production has already started to fall, and the precipitous drop in the rig count will reinforce this trend. And over the longer term Obama’s cap-and-trade and tax policies also point to higher gas prices. I see natural gas-levered stocks performing in-line, at worst, with oil-levered names in coming months. Integrated oils and MLPs should continue to see outperformance for reasons highlighted above.

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Covered Calls

One final strategy I favor right now is covered calls. This is essentially a way to generate an ongoing stream of income from stocks that don’t pay dividends or only offer a small yield. The strategy works best during periods of heightened market volatility; the current environment certainly qualifies. I have two current covered call recommendations in the Gushers Portfolio, one on ExxonMobil (NYSE: XOM) another on Hess (NYSE: HES).

I explained the covered call strategy in the Dec. 24, 2008 issue. I also explained my rationale for recommending covered calls in both ExxonMobil and Hess in the same issue. I updated the ExxonMobil trade in a Feb. 24, 2009 Flash Alert.

I’m adding one more covered call recommendation to the Gushers Portfolio. Buy Peabody Energy (NYSE: BTU) under 25 and sell the June 2009 25 call options for USD3.25 or better. For every 100 shares of Peabody you buy, sell one call option contract.

Peabody is America’s largest coal mining firm, with operations in both the Western US and in Australia. I’m becoming increasingly bullish on coal given the growing signs of a Chinese economic recovery that I highlighted earlier in today’s report. As I explained in the Jan. 7, 2009 issue, Peabody benefits from longer-term contracts that lock in favorable prices for its production.

If Peabody trades above 25 on June 19, 2009 you’ll make a total profit on this trade of about 30 percent. If Peabody simply trades sideways, selling the call will yield a more than 16 percent gain, and you’ll still own the stock. Finally, the sale of the calls means that Peabody would have to fall below about 19.25 before you start to lose money on the stock.

If none of this makes sense to you, be sure to re-read the Dec. 24 issue for details on how to execute a covered call trade.

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