If history’s any guide, we should see some impressive gains in energy-related stocks over the next 12 to 18 months. The turn in this cycle is predicated on two basic facts: Global demand is stabilizing, and global production declines are accelerating.

The latest evidence of a turn for the better in the US is the 1 percent monthly gain in the Conference Board’s Leading Economic Index (LEI). April’s jump in LEI was above expectations and was the largest such move since the fall of 2005.

I expect further upside in LEI when the May data is released late next month. In particular, consumer confidence appears to have hit bottom; the Conference Board index of consumer confidence released this week soared from 40.8 last month to 54.9, well above expectations for a 42.6 reading.

Meanwhile, signs continue to mount that the Chinese economy is recovering at a far faster pace than anyone had expected at the beginning of this year.

With global demand finally hitting bottom, the focus has turned once again to supply. As I noted in the April 29 TEL, with oil and natural gas prices depressed, exploration and development spending has dried up. Without investment, global oil production capacity has begun to fall. The longer oil prices remain below the USD70 to USD80 range, the further and faster supplies will contract.

These tightening supply and demand fundamentals are all finally beginning to show up in US inventory data. Over the past few weeks, US oil and gasoline inventory reports have shown faster-than-expected drops. Although there’s still a glut of oil in storage, that excess is evaporating quickly. If current trends continue, the market could look tight again by the end of this summer’s driving season.

As I explained in the previous TEL, the story for US natural gas prices is a bit more complex. Last week’s storage report showed a build of more than 100 billion cubic feet; this indicates that the US gas market remains oversupplied. That report was also enough to end a significant rally in gas that began roughly a month ago.

But we’re currently in the heart of gas’s shoulder season, a period of weak demand between winter heating and summer cooling season. During this time, weekly storage reports are inherently volatile and unpredictable.

More importantly, the consensus remains extremely bearish on natural gas prices. Most analysts predict that gas storage levels will hit maximum by next fall; there just won’t be enough storage capacity to handle all of the gas being produced, forcing producers to shut in wells. And current forecasts call for a relatively cool summer and a relatively uneventful Atlantic hurricane season.

With these bearish expectations already baked into the proverbial cake, there just isn’t much potential newsflow to push natural gas prices below current prices in the mid-USD3 per MMBtu range.

Meanwhile, I see plenty of potential bullish surprises. Chief among those is that we’ll see a major downshift in production of gas this summer as the near 60 percent collapse in the US natural gas-directed rig count finally begins to filter through in the form of lower production.

Most of the gas-focused exploration and production (E&P) firms I analyzed in the May 20 issue of The Energy Strategist have suggested this key production tipping point will occur in May.

Playing the Cycle

With the energy investing cycle now turning higher, the obvious question is how best to profit from the turn. Long-time Energy Strategist and Energy Letter readers know that oil services and equipment stocks are among my long-term favorites.

The reason is simple: The world is running out of easy oil. The easy-to-produce onshore oilfields that once formed the mainstay of global production are mature and are experiencing declining production. Mexico’s giant Cantarell field has seen its production plummet from a peak of more than 2 million barrels a day in 2004 to less than 1 million barrels a day more recently. And there’s growing evidence that even some of the giant oilfields in the Middle East are already past their peak production levels.

To fight declines from these legacy fields, global producers are scrambling. In most cases that means targeting more technically complex fields such as those in deepwater or in the Arctic. It also means drilling more complex horizontal wells or simply targeting smaller fields.

To make a long story short, the more complex a field is to produce, the higher the demand for services and advanced oilfield equipment.

The last two times the Philadelphia Oil Services Index (OSX) saw corrections of the magnitude it’s seen over the past year were 1998 and 2002. Let’s start by examining how the current pattern in the OSX compares to the 1998-99 cycle.

Source: Bloomberg

This chart shows normalized data for the Oil Services Index. The white line represents the performance of the index from early August 1997 through mid-2000. It includes the final two months of the 1997 bull market in the oil services, the down-cycle from late 1997 through the beginning of 1999, and the subsequent rally. The orange line shows the current path of the OSX, starting two months before its late-June top.

The patterns are remarkably similar. The oil services stocks dropped more quickly in this year’s cycle than they did back in 1997-98. This is mainly the result of the fact that the recession and credit crunch have been severe this cycle.

In 1997-98 there was no global recession, and credit wasn’t as tough to come by as it is today. Although this cycle has been faster, the magnitude is similar.

Note what happened back in 1999 and into 2000, even after the Nasdaq began to fall apart in the spring of 2000: The Philadelphia Oil Services index returned roughly 150 percent between March of 2000 and mid-summer of the following year.

If I’m correct about the cycle turning for energy, I suspect we’ll see returns of at least that magnitude over the next 18 months. This is truly a great time to invest in the group.

Speaking Engagements

Eight score and one year ago, with the onset of the California Gold Rush, San Francisco earned a reputation as a prospector’s town. It’s time again to seek paths to prosperity–and to enjoy one of the most beautiful natural settings in the US, if not the world.

Venture west for the San Francisco Money Show Aug. 21-23, 2009, at the The San Francisco Marriott and discover how Elliott Gue, Roger Conrad and GS Early can help you profit in these adventurous times.

Elliott will detail the new direction for Personal Finance and provide his forecast on energy markets for 2009.

Roger will discuss utilities, Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0.

GS, a constant at PF for two decades, will be there to speak on emerging tech, nanotech and defense tech.

Click here or call 800-970-4355 and refer to priority code 014315 to register as a guest of The Energy Letter.