Because of constrained supply and reviving demand, the energy patch looks to be in the early stages of a major advance. Gains to date have been impressive, and I’m wary of the potential for a 5 to 10 percent correction at some point before fall. But such a pullback would be a buying opportunity.

Valuations remain under control and, if history is any guide, there’s a lot more upside to come.

In This Issue

Too much attention is paid to supply and demand in the US, not enough to conditions in the emerging markets that powered the last bull run for energy. And we could be on the cusp of a rally similar to the last one. See Another Surprise.

Production figures from OPEC member states are murky, at best. However, we know enough to see that the cartel likely isn’t able to boost output enough to push the oil market into a state of oversupply. See OPEC Outlook.

Sun Tzu once remarked that strategy without tactics is the slowest route to victory, but tactics without strategy is the noise before defeat. In this case, the strategy is to identify and stick with the stocks best-placed to profit from the next major up-cycle in energy stocks. The tactics are to attempt to soften the blow of the inevitable market corrections. See Playing the Cycle.

China’s economy continues to improve at a faster pace than most predicted earlier this year. One of the most obvious impacts of this improvement is that China is once again importing large quantities of all sorts of basic commodities. And if there’s one commodity China desperately needs, it’s coal. See China Coal Play.

I frequently use two techniques to control risk in the TES Portfolios and attempt to lock in gains: trailing stops and options insurance. See Puts and Options.

Why is Chevron (NYSE: CVX) sitting out the current rally? I have an answer to this as well as to questions on Hiland GP Partners (NSDQ: HPGP), Dril-Quip (NYSE: DRQ) and Nabors Industries (NYSE: NBR). See Portfolio Updates.

Another Surprise

About four years ago, I was invited to discuss oil prices on a radio show segment. At the time, West Texas Intermediate (WTI) crude oil was trading at around USD50 a barrel, up from USD35 a year earlier. I was asked where I thought oil was headed and replied that I thought it was headed higher, probably toward the USD70 region.

My arguments were simple. Crude oil demand was rising rapidly thanks to solid growth in energy demand in the developed world coupled with a veritable boom in demand from emerging markets. According to the BP Statistical Review of World Energy, oil demand from countries outside the Organization for Economic Cooperation and Development (OECD), a proxy for emerging markets, grew more than 2 million barrels a day (bbl/d) in 2004 and more than 800,000 bbl/d in 2005. That compares to growth of just 810,000 and 394,000 bbl/d, respectively, from the OECD in the same two years.

Meanwhile, the wild card was, and is today, supply. As I pointed out in the previous TES, despite record spending on oil and gas exploration and development the world’s producers have been unable to significantly boost global oil supply in recent years.

The radio host, who shall remain nameless, proceeded to debate with me about that prediction, pointing out that US crude oil inventories were trading at lofty levels compared to recent historical norms. The host was absolutely correct on that point; check out my chart below.

Source: Energy Information Administration

As you can see, crude oil inventories rose rapidly from early 2004 to mid-2005. Oil inventories were trading at their highest levels since 2001-02, when the US economy was in the heart of a recession and oil changed hands for closer to USD25 a barrel.

To make a long story short, oil prices did rally from that time, and by late in that same summer crude had touched USD70.

I don’t relate this story to show that my prediction was correct; I’ve certainly made some bad calls in my career, as has every newsletter editor, whether they care to admit it or not. Moreover, this particular radio host is extremely knowledgeable and made some very good arguments backed up by real evidence.

But I do think the host’s arguments illustrate three key points. First, many pundits continue to focus too much attention on supply/demand conditions in the US. While the US remains the world’s largest single oil consumer, the vast majority of oil demand growth in recent years has come from the developing world, not the US, Japan and Western Europe.

And 20 years ago OECD countries accounted for 70 percent of global oil demand. Today, that figure is closer to 50 percent and, according to most projections, is likely to continue falling in coming years. We can no longer effectively evaluate the likely path of oil prices without considering what’s going on outside the developed nations.

Second, as I noted earlier, far too many pundits assume there’s plenty of oil globally that can be produced to meet rising demand. I’m not a strict “peak oil” adherent; while the world is closer to peak production than many assume, I suspect global oil production can rise further from current levels around 85 million barrels per day. That said, production can’t rise with oil at USD50 per barrel; prices above the USD70 to USD80 level are required to incentivize new exploration and development.

As we’ve seen over the past year, global oil exploration and drilling activity declines rapidly once commodity prices breach the USD70 region. Comments from Schlumberger’s (NYSE: SLB) conference call describe the complete shutdown of activity in some markets.

And third, as a result of constrained global oil supply this cycle is likely to be more prolonged than energy cycles that occurred back in the late 1980s and throughout the ’90s. Consider the case of oil prices and the S&P 500 Energy Index back from early 1994 through late 1996.

Source: Bloomberg

Over this time period, oil prices rallied from lows near usd14 to highs close to USD27. The S&P 500 Energy Index rallied 75 percent over the same time period. As a result of rising global oil prices, global rig count rose 500 rigs between late 1994 and the end of 1996; this increased drilling activity was enough to allow non-OPEC countries (excluding the former Soviet Union) to grow production by a total of 3.1 million bbl/d between the end of 1993 and the beginning of 1997.

Contrast that to the most recent cycle, when global oil prices rose from USD18 to USD147 between 2001 and 2008. The global rig count soared from 1,600 to 3,600 rigs as producers increased their spending to record levels and drilled aggressively. Yet non-OPEC production actually fell during this period. Even if we include the former Soviet Union, production only grew by 1.8 million bbl/d over the five years from 2002 through 2007.

With oil prices rising rapidly, there’s no reason to think that oil producers would not have increased their production markedly to meet all that demand if they were capable of doing so. Many prominent oil bears misjudged the strength and duration of the run-up in oil prices through the summer of 2008 because they failed to appreciate the importance of constrained global oil supply.

It appears that another cycle like that of 2002-08 is starting once again. Despite the fact that oil prices have already doubled from their lat 2008 lows, there are still plenty of pundits that doubt the move. Just as was the case during the oil price run-up of 2002-08, most of those commentators cite the bloated levels of US inventories and relatively high levels of OPEC spare capacity as their rationale for remaining bearish oil.

On both counts, however, I disagree. Check out my chart of US oil inventories below for a closer look.

Source: Energy Information Administration

This chart shows US oil inventories over the past few years, excluding oil in the Strategic Petroleum Reserve (SPR). As you can see, oil inventories recently soared to record levels; you might assume that such bloated inventories would mean weak oil prices.

But note what’s happened over the past four weeks. Oil inventories have fallen at a much faster pace than analysts had expected; I pointed this out in the May 20 issue. Oil inventories have begun to normalize due to a combination of stabilizing demand trends and falling global oil production.

Long-time TES readers know I follow the Conference Board’s Leading Economic Index (LEI) carefully; the year-over-year change in this indicator has an excellent track record of forecasting US economic downturns and rebounds. As I pointed out in the May 22 PF Weekly, the April LEI showed a monthly jump of 1 percent, its largest gain since 2005.

This is the LEI’s first monthly increase since June 2008, long before the Lehman Brothers bankruptcy kicked off a global credit crunch and sent the economy into a tailspin. A stab to the upside of this magnitude suggests that the US economy has stabilized and the recession will end either late in 2009 or early in 2010. Given recent data, I suspect the former.

When you couple a strengthening economy with still relatively low gasoline prices, you have the recipe for a significant rebound in oil demand this summer.

And don’t forget China. China released its Purchasing Managers Index (PMI) earlier this week, and it indicated a third straight month of expansion, yet another sign that the Chinese economy is recovering faster than expected. And my colleague Yiannis Mostrous, editor of Silk Road Investor, believes China will announce a second stimulus package over the next few months, aimed primarily at stimulating domestic demand and consumption. If he’s right, that would be a huge further positive for crude oil demand and prices.

Back to In This Issue

OPEC Outlook

Over the past two issues, I’ve spent considerable time covering non-OPEC oil output and the potential for production declines to accelerate due to weak exploration and production activity. The obvious question is the prospect for OPEC output to increase and push the oil market back into a state of oversupply.

This is unlikely. Since last September, OPEC has agreed to a total of 4.2 million bbl/d in cuts, and according to the International Energy Agency’s (IEA) most recent Oil Market Report, OPEC compliance with recent cuts is hovering around 80 percent.

It wouldn’t surprise me to see that compliance slip a bit if oil prices continue to rise, raising the incentive to produce a bit more oil. But several OPEC members have stated they’d be comfortable with oil prices in the USD70 to USD80 range, a not-so-subtle indication that this is the organization’s unofficial target.

And remember that a small number of big member states, most notably Saudi Arabia, are the key to OPEC’s overall production. These key players can and do cut production below their stated quota if needed to offset cheating from other member states. In fact, Saudi Arabia is already complying 110 percent with its quota, meaning that the desert kingdom is already working to offset cheating from countries such as Venezuela and Iran. In other words, if the biggest producers want to push production lower they can, with or without cooperation from smaller producers.

And helping to keep compliance higher is that with prices in the USD40 to USD50 range most OPEC members can’t produce oil profitably; the quick fall in prices since last July seemed to scare many OPEC member states. Even Saudi Arabia delayed planned production capacity expansion projects. OPEC countries are likely to be willing to risk another similar collapse anytime soon.

At the most recent meeting in late May, key OPEC ministers said that the world was ready economically to cope with oil prices in that key USD70 to USD80 range. OPEC Secretary General Abdullah al-Badri has said that global inventory levels will be a major factor behind any OPEC decision to boost output. As noted earlier, inventories are falling in the US and some other developed countries but remain at elevated levels. Until that situation changes, OPEC is likely to keep production cuts in place.

According to IEA data, OPEC’s spare capacity–oil production that can be brought online quickly and maintained–stands at 6.3 million bbl/d, more than 3 million of which is in Saudi Arabia. Nigeria and the United Arab Emirates are the two other large holders of spare capacity with 740,000 and 610,000 bbl/d of spare capacity, respectively.  Last July, OPEC’s spare capacity stood at 2.63 million bbl/d, roughly half in Saudi Arabia.

But the rise in OPEC’s spare capacity to date is almost totally a function of demand, not increases in OPEC’s ability to produce. Last July, the IEA estimated OPEC’s total potential capacity at 31.77 million bbl/d; today that total potential capacity is just 32.10 million for the same 11 countries. This total potential capacity will likely rise by a further 1 million bbl/d over the next few months as Saudi Arabia completes expansion projects on some of its key fields, most notably the Khurais oilfield.

Last year global oil demand stood at nearly 86 million bbl/d, compared to less than 83 million this year. When you consider that non-OPEC oil production is likely already falling, a return to those more normal demand levels in 2010 would quickly force production hikes from OPEC to balance the oil market. Such production hikes would quickly force OPEC’s spare capacity back into the 3 million to 4 million bbl/d range, a level considered tight by historical norms.

While it may seem counterintuitive, OPEC production hikes are often bullish for oil prices. Oil prices rose in 2007 and early 2008, even with OPEC increasing production, and fell late last year and early this year, even though OPEC was cutting production. This apparent paradox arises because when OPEC raises production, it’s effectively cutting its own spare capacity. In other words, higher production leaves less of an idled capacity cushion to absorb supply and demand shocks.

And it’s unclear how much of OPEC’s spare capacity is truly “spare.” Estimates as to individual OPEC members’ potential production capacity are, at best, rough estimates; individual nations have the incentive to inflate those figures because doing so increases their clout in the cartel. I suspect that only Saudi Arabia and a couple of the other largest producers have any real spare capacity. Production from some other countries, such as Venezuela, may already be falling precipitously due to lack of investment.

The bottom line is that even OPEC nations can’t survive longer term with oil in the 50s; this is evidenced by the cancellation of planned projects within OPEC since last summer. And as global oil demand returns to more normal levels and non-OPEC production begins to decline, OPEC’s spare capacity can quickly disappear putting the oil market back in an ultra-tight supply position as it was last summer.

Back to In This Issue

Playing the Cycle

Given this backdrop, I’m maintaining my target for crude oil prices. I look for prices to rise into the USD75 to USD80 range by the end of summer and USD100 a barrel in early 2010.

As I discussed the issue at length in the previous TES and again in last week’s Flash Alert, I won’t get into another detailed rundown of my outlook for natural gas prices. Suffice to say that the EIA-914 Monthly Natural Gas Production Report remains an important data point to watch; I’m looking for evidence of an accelerating decline in US gas production this year as a key upside catalyst for gas.

The latest EIA-914 survey was released on the last trading day of May and covered March production data; check out my chart below.

Source: Energy Information Administration

To create this chart I excluded Gulf of Mexico production, as it was heavily skewed by hurricane disruptions in August and September of last year. Because these storms also had an impact on onshore processing volumes, data from last October and November is skewed somewhat even after this adjustment.

As you can see, the month-over-month change in US natural gas production was negative once again in March after a blip to the upside in February. Moreover, there’s a clear decline in year-over-year production since last summer; the year-over-year growth in production has fallen to half its total last summer.

I regard this as further evidence that the precipitous decline in the US rig count–the number of rigs actively drilling for gas–since last August is beginning to reduce production of gas.

I expect US gas production to begin falling more rapidly in May; this will begin to show up in EIA-914 data released in late July. By year’s end falling gas production coupled with a recovery in industrial demand should push prices back above USD6 per million British thermal units (MMBtu). We’re now playing this move directly via US Natural Gas Fund (NYSE: UNG), recommended in last week’s Flash Alert. The natural gas exchange traded fund rates a buy under USD16.

This remains an out-of-consensus play; market sentiment is overwhelmingly bearish on natural gas prices. The good news is that this bearish consensus is already reflected in current natural gas prices. It seems that many investors were surprised by the big rally in gas during the Thursday, May 28 and Monday, June 1 trading sessions in the wake of the natural gas storage report.

But these rallies shouldn’t come as a huge surprise. Washed-out markets such as natural gas often behave unusually in response to fundamental news. With everyone convinced the fundamentals are bearish, there aren’t many sellers left to push prices lower. When that’s the case, traders have a tendency to cover their shorts or go long a market at the first whiff of good news.

This is why the gas market soared after the EIA reported a slightly lower-than-expected jump in gas storage last Thursday. On Monday, I suspect the catalyst was a combination of a better-than-expected reading on China’s PMI and a big rally in crude oil prices. Don’t be surprised if gas continues to push higher over the next few months, even as pundits continue to complain that the fundamentals don’t support the move.

Given ongoing supply constraints in the oil market and a likely readjustment of supply for natural gas, is suspect we’re in for another long energy cycle akin to the 2002-08 move. Check out my chart below for a closer look at what this means for related stocks.

Source: Bloomberg

Source: StockCharts.com

This chart shows the price-to-sales ratio for the Philadelphia Oil Services Index (OSX) going back to early 1997 and the Oil Services Index over the same time period. As you can see valuations for the OSX sank to around 1 in late 1998/early 1999 and again in 2001-02, the last two cyclical bear markets in energy stocks.

After the 1998-99 low, the OSX proceeded to nearly triple to its 2000 highs. Valuations topped out at about 3.5 times sales in 2000.

In the wake of the 2001-02 lows in the OSX, the index soared roughly six-fold to its 2008 highs. Valuations topped out again at around 3.50 in early 2006. The reason that valuations topped out in 2006, more than two years ahead of the index, is that sales growth more than kept pace with the rallies in the services stocks.

One of the most common questions I was asked at last weekend’s KCI Wealth Summit was if energy stocks were still a good buy in light of the roughly 80 percent rally off the late-2008 lows for the Oil Services Index. My answer is that these stocks aren’t overvalued from a fundamental perspective; the current price-to-sales ratio for the index is less than 1.4, not far above the lows of 1998-99 and 2001-02 on a valuation basis. The rally in the OSX started from a slightly lower valuation level on this cycle, hitting a low of about 0.75 times sales late in 2008.

Of course, my chart shows trailing price-to-sales ratios for the OSX. You’d be right to assume that total sales for the group are likely to drop in 2009; based on current year forecasts, the index is trading at 1.6 times sales. But even on that basis, the index is trading well under its 1997-2009 average valuation of 2.2 times sales. And the index is still trading at well under that 3.5 times sales level that has marked the end of the initial run-up from both the 2001-02 and 1998-99 bottoms.

Granted, this is just a rough estimate of the potential for the OSX over the next few years. But if the OSX were to hit 3.5 times estimated 2009 sales, it could more than take out its 2008 highs, reaching a level around 400. That’s more than a doubling from the current quote and is probably a conservative target when you consider the six-fold gain in the index between 2002 and 2008.

Of course, this is just a broad roadmap for the long-term path of the Oil Services Index given past cyclical patterns and my outlook for energy prices. This doesn’t mean you can expect a slow and steady advance in coming years. If you squint at my long-term chart of the Oil Services Index above, you’ll see several corrections within the broader up-trends. While those pullbacks might seem small in the context of the broader rally, each retrenchment caused plenty of pain for investors when it occurred.

I suspect we’ll see a correction in oil prices, the stock market and energy-related names at some point between now and early fall. This move will most likely be catalyzed by a combination of profit-taking and another growth scare. Economic recoveries rarely proceed without the occasional setbacks, and it’s likely we’ll see some noise in the economic data in coming months.

Investors may also begin to look beyond the end of the recession to the realization that the current US economic recovery will be relatively weak compared to the past few cycles. I’m not looking for the market to collapse outright, but a retrenchment on the order of 5 to 10 percent this summer that sets us up for a further advance later this year would be in line with historical precedents. If and when such a pullback comes this year, it will offer an outstanding buying opportunity.

Famed Chinese philosopher Sun Tzu once remarked that strategy without tactics is the slowest route to victory, but tactics without strategy is the noise before defeat. In this case, the strategy is to identify and stick with the stocks best-placed to profit from the next major up-cycle in energy stocks. The tactics are to attempt to soften the blow of the inevitable market corrections. After all, several TES recommendations are showing gains of 50 percent or more over just the past quarter; it’s important to take some steps to protect those gains.

In this regard, I recommend two basic strategies: Raise your stops and buy put insurance. I’m aware that many subscribers are unfamiliar with the options market. Even worse, options have unfairly garnered a reputation as ultra-risky instruments designed to make aggressive bets on individual stocks and indices. Although it’s certainly true that options can be employed in that manner, this isn’t what I’m recommending. For more on these strategies see Puts and Options, below.

New subscribers should also pay careful attention to my recommended “Buy Under” targets. Do not buy stocks that are trading above these target levels. I continuously revise these targets to reflect current market conditions and they’re set to protect you from getting into names that look extended short-term.

Back to In This Issue

China Coal Play

As I noted above, China’s economy continues to improve at a faster pace than most predicted earlier this year. One of the most obvious impacts of this improvement is that China is once again importing large quantities of all sorts of basic commodities.

And if there’s one commodity China desperately needs, it’s coal. China is the world’s largest steelmaker and therefore requires metallurgical coal to make steel. And because the country gets 80 percent of its electricity from coal, China also needs the commodity to keep pace with its dramatic growth in power demand.

Source: Bloomberg

This chart shows China’s total coal imports going back to the end of 2004. As you can see, Chinese coal imports recently surged to record-high levels, hitting a recent high of 9.16 million tons. That’s roughly double the prior high visible on the chart.

Another sign of the rapid ramp in demand for commodities from emerging nations is the spike in so-called dry bulk rates in recent weeks. Dry bulk ships are ocean-going ships designed to carry dry commodities such as coal, iron ore and grains. Check out my chart of the Baltic Dry Index below.

Source: Bloomberg

The Baltic Dry Index is a measure of the rates that dry bulk carriers charge to transport goods. While rates remain well under last year’s highs, the index has more than tripled off its lows, indicating a tightening in the supply/demand relationship for these ships.

The rally in the Baltic Dry Index also indicates an ongoing loosening in credit conditions. In most cases, dry bulk shipments are secured by what’s known as a letter of credit, typically written by a bank. One of the reasons that the Baltic Dry Index collapsed to such low levels last year was that, thanks to the ongoing credit turmoil, banks stopped writing letters of credit.

Longer-term demand for coal from all emerging markets is set to accelerate rapidly in coming years. According to EIA projections, coal-fired generating capacity in developing nations is set to more than double between 2006 and 2030 and nearly triple in China.

The obvious question is where China and other key emerging markets will get the coal imports they need. There are two likely sources: Indonesia and Australia.

Indonesia is currently the world’s largest source of thermal coal, the lower energy content coal that’s burned in power plants. And Australia is a key exporter of thermal coal as well as being the dominant player in global metallurgical coal exports. Metallurgical, or “coking,” coal is used to make steel. But check out the charts below.

Source: Energy Information Administration

Source: Energy Information Administration

Thanks to a series of planned expansions to mining and export capacity, Australia is likely to see stronger growth in thermal coal exports than Indonesia. According to most estimates, Australia will regain its position as the world’s largest thermal coal exporter over the next few years. Indonesia, South Africa and South America will continue to round out the top four exporters.

At the same time, Australia will remain far and away the world’s largest met coal exporter; the US and Canada are a distant second and third, respectively. But Australia’s dominance of this market is only set to rise for the foreseeable future.

Companies with strong leverage to coal mining operations in Australia are well-placed to benefit from rising demand for coal imports from emerging markets. That list includes Peabody Energy (NYSE: BTU), the largest US-based miner with reserves in both the Western US and Australia. The company also recently announced it’s eyeing further coal investments in Asia; Peabody appears particularly interested in acquiring a thermal coal position in Indonesia.

Although I don’t recommend Peabody Energy directly, I recommended Peabody Energy covered calls in the March 4, 2009 issue and updated that recommendation in the April 22, 2009 issue.

Peabody has performed well since that recommendation, but due to the run-up in Peabody’s share price the covered calls no longer offer sufficient upside potential. The Peabody Energy covered call is now a hold.

Hold the Peabody covered calls if you own them, but don’t enter the recommendation if you haven’t already done so.

For a direct play on the Australian coal market, I’m eyeing two companies: Macarthur Coal Ltd (Australia: MCC, OTC: MACDF) and Felix Resources (Australia: FLX, OTC: FLRFF).

Macarthur Coal is Queensland-based coal miner we rode to a 128 percent gain last year during the big coal price run-up. The stock is 23.4 percent owned by CITIC Group, a China-based investment fund that has interests in a long list of commodity plays. Steel plays ArcelorMittal (NYSE: MT) and POSCO (NYSE: PKX) own 19.9 percent and 10 percent stakes in the firm, respectively.

Macarthur firm owns a 73.3 percent share of a joint venture controlling the Coppabella and Moorvale mines in Queensland, Australia, which combined have total output of 7.9 million metric tons of coal annually. These mines have traditionally focused on a type of coal known as pulverized coal injection (PCI) coal.

PCI coal is crushed and injected into steel blast furnaces as a replacement for expensive metallurgical coal; Macarthur’s two mines produce nearly half of Australia’s exports of PCI grade coal. This connection to the steel industry is exactly why Asian steel producers have taken an equity interest in Macarthur.

Global steel output collapsed after last summer and that, in turn, resulted in falling demand for metallurgical and PCI coal such as that produced by Macarthur. Not surprisingly, the stock collapsed. Also hurting Macarthur was the fact that persistent rumors that the firm was soon to be acquired had kept a bid under the stock for months. As the credit crunch intensified and commodity markets soured, traders marked down the odds of such a bid.

Macarthur has combated the decline in PCI sales by boosting its exports of thermal coal; demand for thermal coal in Asia has held up better than demand for met coal. Peabody, among other major producers, has also remarked that demand for thermal coal in Asia may be quicker to recover than demand for met and PCI coal.

That said, Macarthur has noted an uptick in sales of met and PCI coal to China, as China’s steel industry is faring far better than other nations’. This could be partly due to China’s ongoing stimulus package that’s pushed demand for heavy construction projects, a steel-intensive business.

As I noted earlier, the big surge in Chinese coal imports coupled with the uptick in the Baltic Dry Index suggests that a recovery in demand for all types of coal is likely already in progress. Macarthur Coal is well-placed to take advantage of this reacceleration of demand, as it has several new mines in various stages of development.

Perhaps more importantly, Macarthur ships all of its coal out of the world’s largest coal export port, the Dalrymple Bay Coal terminal (DBCT). The DBCT is currently undergoing a massive expansion project, and Macarthur has been able to secure additional guaranteed export capacity; its total export capacity is set to rise from a current 5.1 million tons annually to 7.7 million tons by 2011.

After 2012, the company has also secured additional capacity out of another export port than will add another 3 million tons per year of export capacity. Since a shortage of coal export capacity was a major problem for many miners last year, this is an advantage for Macarthur.

Macarthur has risen sharply over the past few weeks but remains well below its 2008 high. Valuations look steep on near-term operating projections, but this reflects primarily the difficult operating environment that Macarthur’s been facing lately; as I noted earlier, demand in Asia and other emerging markets appears to be reaccelerating.

I also like the fact that Macarthur partners with CITIC on many of its key mines and new mine exploration projects. This is a sure sign that China sees the value of Macarthur’s mines and is keen to secure access to these resources. I’m maintaining Macarthur Coal Ltd as a buy in How They Rate but will look for a shallow pullback for a better opportunity to jump into the stock.

I urge you to purchase Macarthur Coal shares directly on the Australia Securities Exchange; Interactive Brokers and some other capable outfits can handle these trades easily and for commissions that aren’t much higher than what you’d pay to buy or sell on a US exchange.

Alternatively, you can buy the stock on the US over-the-counter (OTC) market using the symbol MACDF. Buying OTC shares gives you less liquidity and makes it tougher to get in and get out of the stock.

If you’re looking for a quote, type the symbol MCC.AX into Yahoo! Finance to discover Macarthur’s trading price in Australian dollars.

Felix Resources has three operating coal mines: Minerva (51 percent owned), Yarrabee (fully owned) and Ashton (60 percent owned). The former two mines are located in Queensland, on Australia’s Northeast coast; the Ashton mine is in New South Wales, along the nation’s southeast coast near Sydney.

Minerva is primarily a thermal coal mine producing about 2.7 million metric tons per annum (MMtpa), and Yarrabee is a mixture steam coal/PCI coal mine capable of producing 1.8 MMtpa. Ashton is Felix’s largest mine in terms of total production, with output of 3.9 MMtpa of primarily coking coal.

Like Macarthur, Felix has room to grow its production in coming years and take advantage of strong coal demand. The firm recently scrapped plans to boost output from its Yarrabee mine from 1.8 MMtpa to 2.8 MMtpa due to weak PCI prices; as I noted earlier, I expect coal prices to improve and this project to eventually get the go-ahead.

But Felix’s biggest near-term growth opportunity is its 80 percent-owned Moorlarben mine in Queensland that could see first commercial production later this year. This mine will ultimately ramp up to be Felix’s largest mine producing 12.8 MMtpa of primarily thermal coal.

Overall the combination of Moorlarben and the Yarrabee expansion should push Felix’s total production up from around 4 MMtpa last year to over 16 MMtpa by the end of 2011; that’s a four-fold expansion in total output.

Felix currently exports much of its coal via the Newcastle coal terminal in New South Wales, and it’s part of a venture that’s adding capacity to this port. This is critical, as Felix will need to have access to reliable port capacity if it’s to take advantage of the export market for its new coal production.

While much of Felix’s scheduled growth in coming years is on the thermal side of its business, the company recently noted that it has seen a big up-tick in interest for its coking and PCI coal from China because Australian prices are currently cheaper than some of China’s domestic supplies. This bodes well for sales in the near term. Felix Resources, a new addition to the Gushers Portfolio, is a buy under AUD14.50.

Puts and Options

I frequently use two techniques to control risk in the TES Portfolios and attempt to lock in gains: trailing stops and options insurance.

Both strategies are explained at some length in the special report The ABCs of Options to Hedge Risk. I explain another related options strategy called a collar in a February 26, 2008 Flash Alert, Insurance with Collars.

Trailing stops are probably the simplest strategy for controlling risk. A stop is simply an order you leave with your broker to automatically sell you out of your holding once it touches a certain pre-set “stop” price. All of my recommended stops are listed in the Portfolio tables. Note that I don’t recommend stops on all stocks; in particular, I tend to omit stops on income-oriented plays designed to produce returns by building up cash distributions over time.

When I first recommend a new position, I set a stop to limit risk. As that recommendation moves higher, however, I trail the stop higher as well. As the stop moves higher, we incrementally lock in additional gains. Please check the Portfolio tables for my latest recommendations, as I’ve trailed stops higher on several big winners to lock in gains.

Options insurance offers investors a chance to limit their downside risk and lock in gains on winners without limiting upside potential. It’s an extremely versatile strategy that I’ve recommended on several occasions; if you heeded my advice in the June 12, 2008 Flash Alert Unsteady as She Goes, you locked in some enormous gains on five of my recommendations ahead of the big energy stock selloff that began the following month.  The strategy allowed you to hold onto the vast majority of your gains despite the worst correction in the energy patch in years.

Because some readers do not feel comfortable using options, I don’t factor put insurance into my Portfolio return calculations. You don’t have to take these positions to profit from TES recommendations, but it can certainly help you sleep easier through the inevitable corrections.

Here’s a rundown of options insurance on two holdings I’m recommending at this time.

Oil sands giant and Wildcatters holding Suncor Energy (NYSE: SU) is up around 35 percent since my March 18, 2009 recommendation. To hedge that gain, purchase the September 2009 USD30 Put Option (Symbol: SU UF) currently trading near USD2.50. Buy one put option contract per 100 shares you wish to hedge.

Fast-growing deepwater equipment player Dril-Quip (NYSE: DRQ), a member of my aggressive growth Gushers Portfolio, is up about 40 percent since my April 1, 2009 recommendation. To hedge the gain in that stock, consider buying the September USD40 Put Option (Symbol: DRQ UH) currently trading near USD4. Buy one put option contract per 100 shares you wish to hedge.

And remember a few basic ground rules about my recommended options:

• If you don’t feel comfortable with this strategy, don’t execute the trade, or consider only using it to cover one of your stocks;
• If you aren’t comfortable with the concept or idea of options, consider starting out small, or just avoid the idea entirely;
• Don’t buy the options unless you’re also long the stock;
• Don’t buy the options unless you’re showing at least a 20 percent gain in that stock;
• If you do make this trade, cancel all outstanding stop orders on the underlying stock;
• Buy one contract for every 100 shares of stock you own to fully cover your position.

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Portfolio Updates

At last weekend’s KCI Wealth Summit I was asked on several occasions why the integrated Super Oils like Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM) are underperforming the rest of the energy patch.

There’s nothing magical about the Super Oils; they’re primarily exploration and production (E&P) companies attached to a refining operation. But since they tend to have low costs of production and relatively bulletproof balance sheets, they’re typically seen by most institutional investors as defensive plays. As a result, the companies typically outperform the rest of the energy patch during weak markets.

But when investors are betting on a recovery, they typically look for more beta. In other words, traders look for more leverage to that cyclical upswing. In many cases that means selling down exposure to Super Oils and redeploying that cash into faster-moving sectors such as the services.

All that said, Chevron and Exxon will both benefit from higher oil prices and the stocks will eventually participate in the rally.

On a stock-specific note, Chevron is also awaiting a USD27 billion verdict from an Ecuadorian judge concerning charges that it polluted the rainforest. This relates to activities undertaken by Texaco, a firm Chevron bought in 2001. Texaco did spend USD40 million on clean-up and was cleared of liability by the Ecuadorian government. Chevron is also claiming that the state-owned oil company did pollute after Texaco had left the region.

There doesn’t appear to be much merit to this suit, and I doubt it would have received much publicity if it hadn’t become the subject of some verbal exchanges at Chevron’s annual meeting. If the judge does come down on Chevron with a harsh verdict, that ruling would certainly be appealed. I’d be inclined to view any such decision as a buying opportunity. Chevron remains a buy in the Proven Reserves Portfolio. ExxonMobil is a buy-rated member of my How They Rate coverage universe.

Hiland GP Partners (NSDQ: HPGP) is a master limited partnership (MLP) that I cut to a hold in the December 3, 20008 issue due to its exposure to Gathering and Processing (G&P) margins.

Unlike most of the MLPs, Hiland has exposure to commodity prices and got slammed late last year as oil and gas prices collapsed. While the G&P business at Hiland remains troubled, I’ve recommended holding onto the MLP on speculation it will see a major benefit from any recovery in commodity prices.

To thicken the plot, the chairman of Hiland, Harold Hamm, offered to take both Hiland GP and Hiland Holdings (NSDQ: HLND) private at USD3.20 and USD9.50, respectively, early this year. Because Hamm controls the majority of outstanding Hiland GP stock, taking that firm private would be relatively easy, though he doesn’t control much of Hiland Holdings stock directly.

Hamm subsequently withdrew his bid but has now returned with a lower offer of USD2.40 for the Hiland GP and USD7.75 for Hiland Holdings. The deal would be scheduled to close in the third quarter. Because Hiland GP was trading below USD2.40, the stock jumped about 25 percent on the news.

These offers strike me as low given the recovery in commodity prices of late. Because the deal isn’t scheduled to close until the third quarter, there’s still a chance the offer could be sweetened to tempt public unitholders to accept the bid.

For now, I advise holding Hiland GP and waiting to see how the deal plays out. In particular, if Hiland GP rises above USD2.40 in coming weeks, it could be an indication the market expects a competing bid.

The good news in this otherwise dark cloud is that the Hiland GP going-private offer appears to have sparked interest in other MLPs with G&P exposure. It suggests that other companies may look at the current depressed commodity price environment as a good opportunity to snap up G&P assets at fire-sale prices.

Gushers Portfolio recommendation Dril-Quip (NYSE: DRQ) recently received a USD180 million contract award from Brazilian national oil company Petrobras (NYSE: PBR) to supply subsea wellhead systems. This is equipment installed on the seafloor and used to produce deepwater wells.

The deal highlights Dril-Qui’s leverage to the attractive and fast-growing deepwater drilling environment. Dril-Quip rates a buy under 42.

Although the US land rig count continues to fall, the pace of that decline has moderated somewhat. This is a key inflection point for the contract drillers like Nabors Industries (NYSE: NBR).

The stock remains a great play on my bullish natural gas theme. Buy Nabors Industries under 20.

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