To date less than 20 percent of the companies in the S&P 500 have reported third-quarter earnings, but results thus far have been largely eclipsed analysts’ expectations on both an earnings and revenue basis.

For energy companies, the handful of quarterly numbers released to date suggest that the downturn for the oil and gas industry that began in the summer of 2008 drew to a close in the first half of 2008. Though precipitous, the downturn was much shorter than in previous cycles.

As I’ve projected for months, we are now entering the cycle’s sweet spot. North American operations should begin to improve gradually (along with gas prices) into early 2010, while international growth is reaccelerating as oil approaches $80 per barrel. Asian demand for coal and other energy commodities is also on the rise. This confluence of factors should expand profit margins and generate actual revenue and earnings growth.

The coming upturn should rival the energy bull market of 2004 through 2008 in both scope and duration.

In This Issue

Unprecedented weakness in US natural gas prices have scared many investors away from names levered to this volatile commodity. But a confluence of factors indicates that natural gas prices should stage a recovery into 2010. See Natural Gas Headed Higher.

Earnings season is underway once again. I analyze the third-quarter results and conference calls of three key firms and explain their implications for the companies’ themselves and the sectors in which they operate. See ‘Tis the Season.

Natural Gas Headed Higher

US natural gas prices recently broke to their highest levels since January and related stocks are following suit. Nevertheless, many investors remain oblivious to this trend and are missing out on the upside.

Natural gas-levered stocks remain among the best-performing names in my coverage universe; the group is up 27 percent since the end of August compared to 20.1 percent for the Philadelphia Oil Services Index and 14.2 percent for the S&P 500 Energy Index. On a year-to-date basis, my index of gas-levered names is up 67 percent, roughly in line with the Philadelphia Oil Services Index and considerably better than the 17.7 percent gain posted by the S&P 500 Energy Index.

The complexities of the national gas market dissuade many individual investors from buying natural-gas related equities; defining the price of natural gas is a bit more difficult than defining the price of crude oil. The most common measures of current US gas prices are either the spot price of gas or the near-month futures contract traded on the New York Mercantile Exchange (NYMEX).

Most business and mainstream media outlets use one of these two metrics. The graph below tracks the near-month gas futures contract over the past year.


Source: Bloomberg

Natural gas futures that expire in every month of the year trade on the NYMEX. The current near-month contract is for delivery in November 2009; its last trading day is October 29.

As that final day approaches, traders will begin to roll their positions into the next month’s contract; most traders have no intention of accepting delivery of the actual gas.

Next month’s futures contract is for December 2009. The last trading day for this contract is November 24; volume and open interest in this contract is already on the rise as traders begin to roll from the November into the December contract.

The graph above tracks what’s known as a generic contract: It simply rolls from one month’s futures into the next according to a preset schedule, defined in this case by Bloomberg, the data provider. As you can see, the generic near-month futures contract traded as low as 2.80 on August 21–roughly a seven-year low–though gas recently spiked back to just under $5 per million British thermal units.

Near-month futures have been extraordinarily volatile this year, but prices generally trended lower from the beginning of the year through late August before heading higher over the past few weeks.

Some investors may recall hearing reports that natural gas prices sank below $2 per million British thermal units back in August and early September. This price action refers to the spot price of gas: the cost of gas for immediate delivery. The graph below depicts spot gas prices at the Henry Hub in Louisiana over the past year.


Source: Bloomberg

As you can see, the price action in the spot market is even more volatile: Spot prices hit a low of $1.88 per million British thermal units in early September, compared to an annual high of $6.11 per million British thermal units, achieved on January 6.

Futures traders call natural gas the widow-maker for a reason: It’s one of the most volatile traded commodities in the world. But investors focusing on stocks levered to natural gas– gas producers and gas services companies–should not be overly concerned by the day-to-day price swings that occur in the futures and spot markets. Although these two metrics dominate media discussions of the natural gas market, the 12-month natural gas strip is a far more useful meaningful measure for investors in Portfolio recommendations XTO Energy (NYSE: XTO) and Nabors Industries (NYSE: NBR).


Source: Bloomberg

The 12-month natural gas strip is the average of the next twelve months’ worth of natural gas futures contracts. This would include the every futures contract between the November 2009 contract, which trades at around $4.80 per million British thermal units, and the October 2010 contract, which trades closer to $6.50 per million British thermal units. As my graph shows, the average of all these futures prices is currently just over $6 per million British thermal units.

The general pattern of the 12-month strip differs from those traced by spot gas prices and generic near-month futures. More specifically, the strip bottomed out in April and didn’t establish a new low in August or September. The trend in the 12-month strip this year hasn’t been down but sideways: The strip traded in a broad range between around $4.50 and $5.50 per million British thermal units before breaking higher in September.

And with fewer extreme spikes, the volatility in the strip price pales in comparison to the turbulence evinced by the spot or near-month futures contract.

Why pay more attention to the strip than commonly used measures of natural gas prices? The performance of gas-levered stocks is more closely correlated with movements in the 12-month strip, as demonstrated by a statistic known as a correlation coefficient.

At the risk of skirting the esoteric, suffice it to say that a coefficient of 1.0 means that two assets (stocks, bonds or indices) are perfectly correlated. In other words, the assets move in exactly the same direction all of the time. A correlation coefficient of negative 1.0 describes two assets that move in exactly opposite directions, while a coefficient of 0 means there’s no relationship between the assets under comparison.

In practice, asset pairings rarely demonstrate perfect correlation. Positive coefficients indicate positive correlation and the higher the number, the more closely the two assets mimic one another’s movements.

I ran a series of statistical tests on weekly data from October 2002 to October 2009, seven years’ worth of data. Specifically, I examined the correlation between a long list of gas stocks and the various natural gas price indices I discussed above. That data appears in tabular form below.


Source: Bloomberg

Several popular indices purport to track the performance of North American gas-levered stocks. But in my view none of these indices are completely satisfactory for two reasons. First, most are weighted by market capitalization: One or two large names have an outsized impact on the index’s overall performance. Second, some include names like Schlumberger (NYSE: SLB), a global oil-services firm whose stock price is more closely correlated to oil prices, or BG Group (London: BG, OTC: BRGYY), a play on international gas prices rather than market dynamics in North America.

To avoid these issues, I created an index of 10 firms that are direct plays on the North American gas market. The index is equal-weighted meaning; all constituents have an equal impact on the index’s performance. For reference, the ten stocks are: BJ Services (NYSE: BJS), Chesapeake Energy (NYSE: CHK), Hercules Offshore (NSDQ: HERO), Petrohawk Energy (NYSE: HK), Quicksilver Resources (NYSE: HK), Nabors Industries (NYSE: NBR), Patterson-UTI Energy (NSDQ: PTEN), Range Resources (NYSE: RRC), Southwestern Energy (NYSE: SWN) and XTO Energy (NYSE: XTO). In the table I dubbed this index The Energy Strategist US Gas Index.

Note the correlation coefficients between the various US gas price measures and the TES US Gas Index. Note, in particular, that at 0.50 the 12-month strip exhibits by far the highest positive correlation among the three.

In the table I also note the correlations between several major gas stocks and the various gas price indices. The key point to note is that in all cases, the 12-month strip offers the highest positive correlation. Of the two remaining price indices, near-month futures appear to be a better indicator than spot prices, but the 12-month strip trumps both.

Futures traders may tell you that futures contracts trading one year from now have little meaning; after all, open interest and volume in those contracts are low. That may well be a valid point for futures traders but that quibble doesn’t necessarily hold for those who trade equities.

Of course, it’s always possible to generate false correlations with statistics. But this relationship between the 12-month strip and natural-gas levered stocks makes logical sense: Natural gas producers don’t sell an entire year’s worth of production on the spot market. Accordingly, the price of gas on October 21, 2009, isn’t the price these companies will receive for their production. For these companies, the price of natural gas on a single day is relatively meaningless; pricing trends and average prices have a greater bearing on how natural gas producers will perform in a given year.

In addition, the spot price only reflects current gas market conditions; the immediate supply and demand balance can change from day to day or hour to hour. Contracts that expire further into the future encapsulate traders’ outlook down the road.

For these reasons I prefer the 12-month strip to more commonly cited gas prices. And the recent uptick in the strip suggests that fundamentals are beginning to improve. Despite the bearish headlines you read about the glut of natural gas currently in storage, the market is looking ahead to what conditions will look lie in a few months time. I discussed these fundamentals in the September 23 issue, Top Three Energy Themes.

And last week’s industrial production figure suggests industrial demand for gas will begin to recover into 2010.

Source: Bloomberg

In July of this year, the latest month for which we have EIA data, US natural gas consumption fell 66 billion cubic feet (bcf), roughly 3.9 percent from a year ago. Declining demand among industrial users accounted for 54 bcf, or 82 percent of that drop.

Accordingly, a recovery in industrial demand is the key to a snapback in total gas demand over the coming months. And industrial demand for gas is highly correlated to the industrial production statistics depicted in the above graph, which tracks year-over-year changes from 1970 onward. The current slump is the most dramatic since the cycle that occurred in 1973 and 1974, a recession that in many ways resembles the recent downturn.

But the latest data suggests that industrial production has recovered from recent lows: The pace of year-over-year decline is less than half what it was earlier in the year. And although 12-month numbers remain negative, in August industrial production jumped 1.2 percent from the previous month and September’s reading was up 0.7 percent sequentially. Economists had expected industrial production to increase just 0.2 percent.

Don’t make the mistake of attributing this improvement to Cash for Clunkers. Most private economists estimate that this government program added roughly 0.2 to 0.3 percent to the September data; excluding Cash for Clunkers, industrial production was still up more than twice as much as economists had forecast.

The recovery in industrial production suggests that industrial demand for gas will bounce back with a vengeance into early 2010, just as production declines begin to accelerate. Pundits who remain bearish on gas because of the storage overhang ignore the perfect storm of rising demand and falling supply that’s brewing.

Don’t fight the proverbial tape when it comes to natural gas: This market is breaking higher and exhibits less volatility than the day-to-day swings in the spot prices suggest. The stocks most directly leveraged to natural gas in the TES Portfolios are: XTO Energy (NYSE: XTO), Chesapeake Energy Preferred D (NYSE: CHK D), Nabors Industries (NYSE: NBR), Seahawk Drilling (NSDQ: HAWK) and, to a lesser extent, Tenaris (NYSE: TS).

‘Tis the Season

Quarterly earnings season is both the busiest and most important time of the year for investors. Longtime subscribers know that I pay close attention not only to whether companies beat or miss their earnings estimates but also to comments made during the accompanying conference calls.

Executives such as Andrew Gould at Schlumberger (NYSE: SLB) and Bernard Duroc-Danner at Weatherford (NYSE: WFT) have historically offered a great deal of color about how their business has fared and its future growth prospects. This is particularly true of the lengthy question and answer (Q&A) sessions that often follow each call.

Third-quarter earnings season has just commenced, so it’s too early to draw any major conclusions. To date earnings have largely surprised to the upside, and results in some sectors showed evidence of revenue growth.

As of the evening of October 20, 79 companies in the S&P 500 had released quarterly earnings, 65 of which managed to beat consensus earnings expectations. On the top line, 56 of the 79 topped consensus expectations for sales.

Thus far three of the ten S&P 500 Economic Sectors are showing year-over-year earnings growth: health care, financial services and information technology. The health care and financial services sectors are the only two that currently register year-over-year sales growth in the third quarter. At present, firms in the technology and consumer staples sectors have reported that third-quarter sales declined less than 5 percent from a year ago.

As you might expect, energy companies are not showing year-over-year sales or earnings growth; the third quarter of 2008 marked a temporary top for oil and gas prices, resulting in tough year-over-year comparables.

But based on comments in recent conference calls, it appears that business troughed for most energy firms in the second quarter and is beginning to pick up again. Among companies that have reported earnings thus far, management teams appear to be more confident in their outlook for 2010 than earlier this summer.

What follows is a closer look at three key reports released in recent weeks and what it all means for the Portfolio recommendations.

CSX Corporation (NYSE: CSX) is one of the largest freight railroad companies in the US. The company earned $0.74 per share in the third quarter, exceeding analysts’ estimates of $0.71. Sales, on the other hand, aligned with the consensus. Shares of CSX traded higher following the announcement and have more or less held onto those gains.

Newer subscribers might wonder why I discuss earnings from a railroad in an energy newsletter. The answer is two-fold: Railroad traffic tells us a great deal about the state of the US economy, and railroads are key transporters of coal.

Although CSX beat earnings expectations and matched consensus estimates on the top-line, revenues were still down 23 percent–about $672 million–on a year-over-year basis. Rail volumes in the third quarter of 2008 were among the strongest in history, so the year-over-year comparison was unforgiving. Generally speaking, there are four main drivers of revenues for a railroad: price, mix of traffic, fuel surcharge recoveries and volumes of freight transported.

In CSX’s case, net pricing gains in the third quarter totaled about $95 million. CSX tracks pricing trends in terms of what it terms “same-store sales,” core pricing that excludes both changes in cargo mix and the impact of fuel surcharges levied by CSX. Same-store sales pricing was up more than 6 percent this quarter, and management indicated that the company could maintain core pricing above the rate of inflation in 2010. A slight shift in third-quarter cargo mix was negligible enough to ignore.

Two factors contributed to the 23 percent decline in revenues: Lower fuel charges reduced overall revenue by $292 million, while lower volumes accounted for another $456 million in revenue.

Analysts and management expected the decline in revenues from fuel charges. Railroads use diesel fuel to run locomotives and charge shippers a surcharge to offset rising costs. This surcharge is set based on lagged-average fuel prices; when fuel costs increase rapidly the surcharge adjusts only gradually to higher costs–actual fuel costs rise faster than surcharge recoveries. An upturn in fuel prices usually weighs on revenues.

Volume is by far the most important revenue component to watch for CSX. The big drop in volumes of freight transported is, of course, primarily because of the weak US economy. Improving volumes indicate that domestic demand for goods and commodities is on the upswing and that the economy is improving. Railroad volumes also offer some insight into international conditions as well; rail operators distribute containers imported into US ports and transport goods from US factories destined for shipping abroad.

In the third quarter CSX’s total volume dropped 15 percent from a year ago to 1.4 million units, a clear indication that the US economy remains weak. At the same time, volumes improved sequentially across most major categories, a development that’s consistent with recent economic data and suggests that the trough of the recession is in the rearview mirror. In other words, the year-over-year rate of decline in freight volumes slowed markedly in the third quarter, relative to what it was in the first and second quarter.

CSX also broke down overall traffic volume by key cargo categories. Prospects for coal shipments figured prominently in these discussions, with management rightly sounding a cautious note.

As I’ve outlined over the past several months, the US coal market faces several near-term challenges. Utilities have above-average inventories of coal and are likely to delay new deliveries well into 2010 until they’ve made a dent in some of that excess supply–currently near record levels of 76 days’ worth.  

In CSX’s third-quarter conference call, management offered a bit more detail about what factors might turn the tide for US coal shipments:

we expect the fourth quarter run rate [in terms of coal volumes] to be very similar to what the third quarter run rate was. 2010, we expect that we’ll continue with headwinds into 2010. You’ve got to remember that there are about four factors that will be affecting 2010: gas prices, whether or not industrial production come back to robust levels or just continues the slow steady improvement it’s got now, what the winter weather will be producing. And remember that these coal utility stockpiles that we have only represent about a 5 percent overhang, so the utilities draw that down, you may see ups and downs in 2010.

CSX expects coal volume to remain relatively flat until utilities work off some of their excess inventories. As noted in the company’s conference call, the price of natural gas is actually one of the most important swing factors for coal prices and shipment volumes.

This summer some utilities took advantage of the prevailing weakness in natural gas prices cut back output from coal-fired facilities and fire up gas-fired plants. A rally in natural gas would tend to reverse this fuel-switching and push demand bolster demand for coal. As I noted earlier in today’s issue, I expect US natural gas prices to trend higher into early 2010, a development that could boost demand for coal.

Industrial production figures also bear watching. A recovery in industrial production would suggest an uptick in demand for metallurgical coal used in steelmaking and electricity generation as well as coal used to power manufacturing. CSX noted a gradual recovery in industrial production, but this comment occurred before the September data came out. This is another bullish point for coal demand.

The third factor CSX’s management mentioned in its conference is the most difficult to forecast: the weather. On one hand, the El Nino condition in the Pacific is consistent with a slightly warmer-than-average winter in parts of the US. On the other hand, October has brought some early cold weather across much of the country and near-term weather models predict that the next few weeks will be colder than usual.

All told, the US National Oceanographic and Atmospheric Administration (NOAA) expects this winter to be 1 percent warmer than last winter and about 1 percent warmer than the 30-year average. More specifically, the agency predicts that the weather will be warmer than last season in December and January but colder in February and March.

But regional temperatures are also important: The West and Midwest, for example, contain a large number of homes that use natural gas for heat. The West is facing colder-than-normal winter, while winter in the Midwest is expected to be somewhat milder. A slight shift in temperatures could have a major impact on demand for electricity, coal and natural gas. In a scenario where the weather is 10 percent colder than expected–well within the margin of error on long-range forecasts–the EIA predicts that natural gas in storage would revert to normal levels. That would imply sharply higher demand for natural gas and, by extension, coal.

Though excluded from the above excerpt, export demand is another factor that bears consideration. Demand for US coal exports is weak this year, especially compared to record levels in 2008. But this could change quickly; demand is on the rise in China and other developing markets. I covered the importance of rising demand for coal among developing economies in the August 5 and September 23 issues of TES, Buying Coal and Gas and Top Three Energy Themes.

US coal inventories are unquestionably bloated and that glut won’t be cured overnight. At the same time, the levers of coal demand that management mentioned appear to be either neutral or positive–I foresee US coal inventories beginning to normalize by the middle of 2010.

That being said, CSX’s management concerns about the near-term prospects for US coal market reinforce two investment themes in TES. First, I prefer coal stocks with significant leverage to the Australian coal mining market, the most direct beneficiary of growth in coal demand in China, India and other developing markets in Asia. Accordingly, my favorite coal plays remain Gushers Portfolio denizen Peabody Energy (NYSE: BTU) and coal mining equipment firm Bucyrus (NSDQ: BUCY) in the Wildcatters Portfolio.

US-focused coal miners have performed well and, in certain cases, better than Peabody over the near term. Many of these miners carry high debt loads– International Coal Group (NYSE: ICO), for example, was on the verge of bankruptcy–so normalizing credit markets have provided a big tailwind. In addition, the US mining firms tend to be highly volatile, reacting very quickly to shifts in energy demand.

But the comments from CSX’s management should give investors pause. At the risk of slight near-term underperformance, the continued weakness in US coal markets leads me to reiterate my preference for mining firms with exposure to Australia and other international markets.

And consider that one of the necessary conditions for a recovery in US coal markets is an uptick in gas prices. In my view, it makes more sense to play rising gas prices with gas-levered stocks rather than with US-centric coal mining firms.

Weatherford International (NYSE: WFT) earned $0.13 per share in the quarter, roughly in line with expectations. Broadly, however, the management team characterized the quarter as disappointing, largely because of unexpected weakness in the company’s international markets.

As a result, Weatherford’s stock traded slightly lower in the wake of the report and remains down around 2.5 percent from its prerelease closing price. This is hardly a disaster, but it’s worth noting that over the past few weeks Weatherford has underperformed the other big services companies such as Halliburton (NYSE: HAL) and longtime recommendation Schlumberger (NYSE: SLB).

Taken together, I believe that Weatherford’s somewhat disappointing results and the stock’s recent underperformance make for a great buying opportunity–not a cause for any real alarm. Investors largely overreacted to some one-off issues in the company’s international markets and are ignoring signs of reaccelerating growth.

(The oil-services industry remains one of my favorite long-term plays and one of the best ways to gain exposure to the end of easy oil. For those unfamiliar with the industry or my investment thesis, check out the August 19 issue, Mapping the Cycle, as well as the most recent two issues Top Three Energy Themes and The Golden Triangle).

It’s a useful simplification to divide the world into two pieces: North America and International. As longtime readers know, the North American market is heavily leveraged to natural gas and is extremely sensitive to commodity prices–producers adjust activity levels quickly to match demand, resulting in a great deal of volatility. International markets offer long-term growth opportunities and are far less sensitive to commodity prices.

Given that backdrop, you might have already guessed that North American market for oil services has languished, thanks in part to two culprits: ultra-weak gas prices and a collapse in drilling activity.

In the third quarter, Weatherford’s North American revenues increased $49 million from the second quarter, while profit margins improved from breakeven to 5.4 percent. North America accounted for less than one-third of Weatherford’s revenues, a product of management’s ongoing efforts to downsize its operations in the US and Canada in favor of overseas opportunities.

Revenues from Weatherford’s Canadian business were weaker than management had expected, but a seasonal uptick in activity represented an improvement over last quarter’s numbers.

From my view, pricing trends were encouraging. During the Weatherford’s third-quarter conference call, CEO Bernard Duroc-Danner noted:

We see no more instances of pricing weaknesses [in North America] for pretty much a quarter. The pricing declines in Q3 but nothing more flowing through the quarter [it was] pricing decisions made in Q1 and Q2. This we had anticipated. This is not a surprise. But we see no further declines in any markets…none of that. I cannot report to you today any instances of pricing increases in international markets — the ones [price increases] I saw cross my desk were small ones in North America.

Early in 2009 weak drilling activity and the ongoing credit crunch enabled North American energy producers to win price cuts for key services. Some of these price cuts were negotiated in the first two quarters of the year but went into effect in the third quarter. That outcome wasn’t unexpected.

What’s striking about Duroc-Donner’s comments is that Weatherford has been able to hike prices for key services. At another point in the call management noted that this trend began to pick up in late in the third quarter.

I see a few reasons for this development. For one, crude oil prices have soared and Weatherford may be winning price increases related to services related to oil production. At the same time, gas prices are beginning to reach levels that make it profitable to drill in certain regions. As I noted earlier in today’s report, I suspect that gas prices will continue their ascent, which should boost activity levels.

Although I expect the North American oil-services market to remain weak into 2010, management’s recent comments suggest that this business troughed in the first half of 2009. And because Weatherford has cut costs aggressively, even a modest rebound in activity should drop through to the bottom line. In fact, management noted that it is incrementally more constructive on North America now compared to one quarter ago and expects this business to rebound strongly in the second half of next year.

As encouraging as these early signs of a turn in North America might be, international markets are the real key to Weatherford’s long-term growth. Its Eastern Hemisphere operations, which include the Middle East, North Africa and Asia, accounts for 45 percent of total revenues.

Although revenues in this geographic segment were up 1 percent sequentially, these results fell short of management’s expectations. Average pricing was down 4 percent across the board, which was roughly what management had suggested to analysts; however, delays in mobilizing equipment for anticipated new projects weighed on volumes. These issues aren’t a major cause for concern; services firms often experience delays in starting up complex new projects.

Meanwhile, results from its Latin American operations also suffered because of delays. Weatherford is one of the biggest contractors in Mexico’s Chicontepec oilfield, but flooding limited its ability to drill and complete new wells in this area.

One of the first questions management fielded in Weatherford’s recent conference call asked whether these delays were one-off problems or longer-term issues:

Analyst: It seems that many of the items that adversely affected the third quarter such as the rains at Chico[ntepec], the gas drilling of iar crews, operating issues in Nigeria, start-up costs in Iraq and the delayed startups should be rectified by the fourth quarter, or at least significantly improved in the fourth quarter, is that correct?

Duroc-Danner: Yes I — when one has a bad quarter, I think it’s just best to go out and put out a good quarter afterwards, and I think that answers all the questions. But as a point of logic, yes you are correct.

Analysts repeatedly asked about the one-off nature of these issues. Based on management’s response, a good deal of the missed volumes will be pushed off into later quarters but not lost.

Another point to bring up concerns Mexico. There has been some debate within Mexico about reevaluating the development of the Chicontepec field. Some politicians have expressed frustration that Pemex, the national oil company, has incurred substantial development costs but hasn’t produced substantial volume growth. Mexico will have to drill around 1,000 new wells per year in Chicontepec to produce an incremental 75,000 barrels of new oil production per day. One can imagine how many years and wells it will take for the country to boost production to the planned 500,000 barrels per day.

It appears Pemex may look to reevaluate its plans in Chicontepec in light of this experience, which could delay future contract awards. But investors have overreacted to this issue as well.

Mexican oil production plummeted 9.1 percent in 2008 and is down considerably this year. All told, Mexican production has fallen about 700,000 barrels per day since its peak in 2004. This decline is mainly due to a much faster-than-expected drop in production from its Cantarell oilfield. Ultimately, Pemex will likely develop more big offshore fields in the deepwater–an expensive and time consuming prospect. In the short term, Chicontepec represents a large and underdeveloped field–the country’s best chance to stem the production collapse.

Duroc-Danner’s response to an analyst’s question about Chicontepec is instructive:

If you look at Chicontepec what you have is a very large heavy oil reservoir, which is in the early stages of its development. Heavy oil has a long learning curve before you find the optimal way to drill and produce the reservoir. And, I think both Pemex and its vendors, its service companies are going through this learning curve. And, at some point, the drilling and production and completion and production path will mature and it will essentially be an exercise in increasing efficiency and productivity. All of this is to say that Pemex is looking for the right level of activity on Chicontepec, whether it is at the present level, whether it is at a lower level or at a higher level and also what are the optimum zones that one has to go after. And [Pemex and the service companies] are also resolving some of the issue sthey might have with either completion techniques or topside problems. So, all of this is being looked at and worked on. This is normal.

This quote indicates just how complex the Chicontepec development is. Heavy oil is tougher to refine and flows less readily than lighter crudes; producing such oil presents myriad technical challenge. In this regard the importance Chicontepec and similar oilfields to global production gives credence to my end of easy oil thesis.

Although Chicontepec may well be one of the largest oilfields in Mexico, producing 500,000 barrels per day from the field will require billions of dollars in investment and thousands of wells.

Management went on to reinforce that Pemex’s budgetary decisions shouldn’t endanger Weatherford’s short-term contracts; these changes would affect the size and timing of follow-on contracting work in 2011 and thereafter. Management expressed its confidence that Mexico would be a $2 billion revenue market in 2010 compared to around $1 to $1.2 billion this year–an impressive incremental growth rate.

I expect Mexican oil production to continue its overall decline, which should prompt Pemex to spend aggressively on Chicontepec. And the national oil company lacks the technology needed to produce the field without the help of the big services companies like Schlumberger and Weatherford.

Factoring in this outlook for its Mexican operations, management noted that it expects international revenues to increase 30 percent or more in 2010, the fastest rate of growth for any of the major services companies I follow.

That incremental revenue from Mexico is one component of the company’s 30 percent growth. Iraq and Russia hold other opportunities for 2010. Weatherford already has existing service contracts in Iraq and expects around 300 million in new revenue from the country in 2010.

In addition, it appears that the Iraqi government will sweeten contract terms for foreign companies after a weak round of bidding in June. Of the ten contracts up for bidding, only one offer was ultimately accepted–BP (NYSE: BP) and China National Petroleum Corp $15 billion bid to develop the massive Rumaila oilfield. Encouragingly, the Iraq government is reportedly in talks with several companies that bid in its first contracting auction back in June but failed to agree to terms.

It appears that a consortium led by Portfolio recommendation Eni (NYSE: E), Occidental Petroleum (NYSE: OXY) and Kogas is close to clinching deal to work the Zubair oilfield. Meanwhile, Lukoil (OTC: LUKOY) and ConocoPhillips (NYSE: COP) also appear on the verge of closing a deal to produce the West Qurna oilfield.

Weatherford’s management hinted that the Iraqi government might even make some new awards directly without going through and auction process.

That bodes well for Weatherford’s prospects. Iraq is a huge oil-producing country and all of these prospective deals will require the involvement of oilfield-services firms. Because Weatherford is already a player in Iraq, it’s a natural choice for handling new contracts in the country.

The Russian story isn’t as intrigue-laden but still offers promising growth opportunities. Russian drilling activity is sensitive to oil prices; with oil now near $80 a barrel, spending will likely pick up again. And Weatherford is in a prime position to benefit thanks to its recent purchase of the oilfield services division of BP’s Russian joint venture, TNK-BP. Based on comments made during the call, it appears that the integration of that acquisition is still in its early stages but is proceeding according to plan.

The recent weakness in Weatherford’s stock suggests that investors have overreacted to what amounts to a number of single-quarter issues. Use the recent dip to take advantage of this opportunity: Buy Weatherford up to 26.

Gushers Portfolio holding Peabody Energy (NYSE: BTU) also reported its third quarter results and share prices have reacted positively. Although I discussed coal in depth in my analysis of CSX Corp’s third-quarter results, I’ll touch on a few takeaways from Peabody’s conference call that prompted me to raise my buy target to $47.

The weakness in US coal markets remains a challenge, but Peabody has taken steps to shore up profitability in the US, cutting back planned production and locking in contracts for 2010 at fixed prices. Peabody now has no unsold volumes of coal for next year: It’s 100 percent sold out under contracts, so the firm has no exposure to any shifts in US coal prices. Because the firm is now producing coal from its lowest-cost US mines, it’s in a position to make money in a weak market while waiting for the inventories to normalize.

Peabody’s management also expects the US to become an important supplier of coal to strong Asian markets and noted that its mines in the US Powder River Basin could export thermal (power plant) coal to Asia out of West Coast ports. However, this isn’t a 2010 story.

Strong demand for both thermal and metallurgical coal from India and China is a growth story that will play out in 2010. Peabody noted that Indian industrial production figures are up more than 10 percent, and India and China are two of the only major steel producers in the world to actually increase production this year. Neither country has enough metallurgical coal to meet demand and will need to step up imports.

Meanwhile, both India and China continue to build coal-fired power capacity at a breakneck pace. Peabody noted that despite the financial crisis, plans to build new coal-fired facilities in these countries haven’t stalled. India’s coal-fired generation is up 7 percent amid a global recession, and the country believes it could face as much as a 200 million ton per year shortage by 2014. Much of this demand will be met with coal exports from Australia and, to a lesser extent, Indonesia.

And China has continued to close smaller mines, forcing it to accelerate imports. Chinese coal imports in September came in at 12 million tons, up from August levels and higher than many expected. This suggests there’s no real slowdown in China’s demand for imported coal.

All told, Peabody expects total demand for seaborne coal shipments to grow at an annualized rate of 7 to 8 percent over the coming years. Peabody is in excellent position satisfy these needs, as it plans to double its Australian production over the next five years and has secured significant port capacity to handle these shipments. In fact, Peabody noted it’s already signing contracts to supply coal at much higher prices than current coal price indices suggest.

Management also noted that recent acquisitions in Australia–for example, the proposed purchase of Gushers holding Felix Resources (AUS: FLX; OTC: FLRFF)–suggest that Peabody’s Australian operations are worth more than the company’s overall market value. This assumes no value for the trading operation Peabody set up in Singapore, the company’s investments in Mongolia or its massive operations in the US. This makes no fundamental sense in my view; I am raising my buy target on Peabody to reflect the company’s bullish call and outlook. Buy Peabody Energy outright under 47 and continue to hold the recommended covered calls if you own them.