At last week’s World MoneyShow Orlando, many investors asked me why oil prices continue to decline. My response should be familiar to subscribers, as Oil: $100 Isn’t a Magic Price addressed this issue in some detail.

Global oil prices have remained near or above $100 per barrel for the past several weeks. Why are investors confused? Local supply factors have weighed on the price of West Texas Intermediate (WTI) crude oil, the leading US benchmark. Cushing, Okla.–the delivery point for WTI–is swimming in oil after an influx of crude oil from a new pipeline flooded local storage facilities.

But these issues haven’t afflicted other grades of light, sweet crude: Most of these benchmarks, including Brent crude oil, continue to hover around $100 per barrel. In recent weeks, oil-levered stocks have tracked the price of Brent crude oil, heading higher. In short, investors who pin their purchases on WTI price have missed the boat.

Amid the welter of misleading headlines about WTI prices and the implications of Egypt’s regime change, fourth-quarter earnings results from our Portfolio holdings serve as a reminder of the trends driving global energy markets.

Earnings reports from integrated oil names and services firms suggest that spending on exploration and development has picked up substantially–a thesis we examined in the Dec. 22, 2010, issue Here Comes the Spending. Meanwhile, Peabody Energy Corp’s (NYSE: BTU) fourth-quarter results and conference call indicated that recent floods in Australia have stretched the gap between coal supply and demand even further.

Investors who buy stocks with exposure to these trendsshould outperform in the coming year. Regard any correction in this group as a buying opportunity.

Although supply and demand conditions remain sanguine in oil and coal markets, investors shouldn’t rest on their laurels. We continue to scrutinize individual sectors, industries and Portfolio holdings for signs of weakness. As we noted in the previous issue of The Energy Strategist, the pressure-pumping market–a service that’s crucial to producing North American shale plays–could reach a tipping point in the back half of 2011. A shift in activity from dry-gas plays to liquids-rich fields should ensure that demand remains steady, but an influx of new capacity could oversaturate the market and reduce operators’ pricing power.

We will continue to adjust the model Portfolios to limit exposure to softness in this market.

Peace of mind is hard to come by in both bull and bear markets, especially after the traumatizing financial crisis and market implosion of 2008-09. The Energy Strategist’s monthly online chat sessions feature my responses to readers’ questions and usually last for two hours or more. Access a transcript of the most recent live chat or sign up for an email reminder about our next online meeting, scheduled for March 19, 2011, at 2:00 pm EST.

In This Issue

The Stories

Weatherford International’s fourth-quarter results and management’s commentary suggest that the company is entering the sweet spot of its business cycle. As major international oil and gas projects get underway, the company is poised for margin expansion and robust revenue growth. See Services Snapshot.

Integrated oil companies, including two Portfolio holdings, have ramped up capital expenditures in 2011. Here’s our assesment of where their money is going. See Integrated Oils.

Rising Asian demand for coal and constrained Australian supplies bode well for Peabody Energy Corp. See King Coal.

Want to know which stocks to buy now? Check out the Fresh Money Buys list. See Fresh Money Buys.

The Stocks

Weatherford International (NYSE: WFT)–Buy < 28
Suncor Energy (TSX: SU, NYSE: SU)–Buy < USD48
Schlumberger (NYSE: SLB)–Buy < 90
Chevron Corp (NYSE: CVX)–Buy < 95
Occidental Petroleum Corp (NYSE: OXY)–Buy < 95
Peabody Energy Corp (NYSE: BTU)–Buy < 67
Joy Global (NasdaqGS: JOYG)–Buy < 99
International Coal (NYSE: ICO)–Buy < 9.50
Penn Virginia Resource Partners LP (NYSE: PVR)–Buy < 29
Natural Resource Partners LP (NYSE: NRP)–Buy < 30
Alliance Holdings GP (NasdaqGS: AHGP)–Buy < 55

Services Snapshot

Weatherford International

Key Takeaways:

• Relative to its peers, Weatherford International has little exposure to pressure pumping and US shale gas plays.
• A leading position in Canada gives the firm strong leverage to rising activity in Canada’s oil sands and heavy oil plays.
• Start-up costs and flooding in Australia hampered profit margins in the Eastern Hemisphere, but conditions should improve as the year progresses.
• The services industry will enjoy the sweet spot of its business cycle in 2011-14.

Weatherford International (NYSE: WFT) reported that fourth-quarter revenue increased 14 percent from the prior three-month period and 20 percent from a year ago, topping the other major services firms’ results. For example, fellow Wildcatters Portfolio holding Schlumberger’s (NYSE: SLB) Oilfield Services division grew 9 percent sequentially and 16 percent year over year. Meanwhile Halliburton (NYSE: HAL) and Baker Hughes (NYSE: BHI) posted quarter-over-quarter sales growth of 10 and 8 percent, respectively.

In addition to outperforming its peers, the company also beat its own track record: Sequential revenue growth grew at the fastest pace in the firm’s history, an impressive feat without a major acquisition to pump up results.

Management was appropriately upbeat about the company’s growth prospects as activity in international markets picks up. This enthusiasm is well-founded: Not only has the firm carved out a strong competitive position in key overseas markets, but its limited exposure to the US market for pressure pumping reduces potential downside. As we noted in a recent Flash Alert, the stock is one of our top growth picks for the coming year.

That being said, the fourth quarter wasn’t a slam dunk. Earnings fell short of consensus expectations, reflecting a number of temporary or one-time challenges, including an inventory write-down, catastrophic flooding in Australia and start-up costs on new international projects. But overall results and management’s commentary suggest that profitability and operating margins should surge in the back half of 2011 and early 2012, when a handful of major projects begin to contribute to the top line.

North America: Echoes of Schlumberger

When analyzing oil services stocks, regional business conditions are a key consideration. North America has led the way in recent quarters, thanks to robust drilling activity in unconventional oil and natural gas fields such as North Dakota’s oil-rich Bakken Shale and the up-and-coming Eagle Ford Shale in south Texas. (See the Oct. 20, 2010, issue Rough Guide to Shale Oil and Riding the Services Cycle from Nov. 3, 2010.) 

The wells drilled in these and other plays have become increasingly complex, featuring longer wells and dozens of fracturing stages to optimize production. Services firms generate more revenue from these jobs than they do from conventional drilling.

Weatherford International’s North American operations increased sales by 14 percent from the prior quarter and 70 percent from a year ago, outstripping the firm’s overall revenue growth.

But as Schlumberger CEO Andrew Gould noted in the company’s fourth-quarter conference call, the market for pressure pumping, or fracturing services, could soften in the back half of the year. Hydraulic fracturing involves pumping huge amounts of liquid into a field to crack the reservoir rock and create channels through which the hydrocarbons can flow. This process is essential to extracting the oil and natural gas trapped in impermeable shale formations.

Depressed natural gas prices should prompt producers to finally rein in production in Louisiana’s Haynesville Shale and other formations that don’t also contain oil or high-value natural gas liquids. In fact, the US gas-directed rig count has already tumbled from its peak.

Source: Bloomberg

Although strong activity in oil- and NGL-rich fields will continue to offset some of this weakness, demand is unlikely to expand. Meanwhile, service firms have added fracturing capacity to take advantage of attractive margins–a move that could erode pricing power in the second half of 2011. At the least, the dramatic margin and revenue growth recorded in North America will begin to slow, refocusing investors’ attention on opportunities in international markets.

Weatherford International CEO Bernard Duroc-Danner shared a similar oulook during the company’s conference call to discuss fourth-quarter earnings, noting that US land activity would likely flatten. But Duroc-Danner also stated that the company should enjoy both volume and pricing upside in North America:

We, for historical reasons, tend to be more Canadian than our peers, the balance between the U.S. and Canada is a little bit different than our peers. Fact number two…although we have a stimulation [fracturing] business, which is a good stimulation business, it is not comparable in size and intensity to the ones of our peers.

So therefore, the evolution of our prognosis in the US market and Canadian market is a little bit different. It beats of the drums of all the other product lines. And so into 2011, I think you’re likely to see for us a continued progression in all the other product lines, volume and pricing, independently on what happened and the balance of supply and demand in the shale market. And yes, indeed, Artificial Lift is our largest product line in the United States, for example.

It’s also I think reasonably well known that about 25 percent of everything we sell in the United States is Artificial Lift as it has always been the case. So, yeah, it stands to reason our prognosis there would be a little bit different. And indeed, it has been–although the results have been good in North America, it’s been a bit slower in terms of progression in price and volume, that’s simply because the rhythm of evolution of this product line is not as vertical and violent as it has been in the stimulation market.

Of the four major oil services firms, Weatherford International traditionally derives the largest percent of its revenue from Canada, a resource-rich nation blessed with oil sands and heavy-oil plays.

Although Canada boasts massive shale gas plays, development of these fields has proceeded more slowly than those south of the border. Rock-bottom natural gas prices have inhibited activity in recent years, but insufficient supporting infrastructure–pipelines, storage capacity and other midstream assets–in these regions are another impediment. Until gas prices rally, oil production will drive growth in the Canadian services market.

That bodes well for Weatherford International, which stands to benefit from increased activity in Canada’s service-intensive oil sands and heavy-oil plays.

The model Portfolio features direct exposure to this trend through Suncor Energy (TSX: SU, NYSE: SU), a leading producer in the oil sands. The firm’s recent merger with Petro-Canada continues to progress well and balances its higher-cost operations in the oil sands with a portfolio of conventional oil and gas fields.

With oil prices on the rise and the company embarking on an ambitious plan to grow production to more than 1 million barrels per day over the next 10 years, Suncor Energy now rates a buy up to USD48.

Duroc-Danner also called attention to Weatherford International’s artificial-lift business, a suite of products and services that optimize oil production from older wells. As oil fields mature, underground pressures subside and production wanes. Electric submersible pumps and other artificial-lift products help pump oil from mature wells.

This oil-focused business line accounts for nearly one-quarter of Weatherford International’s US sales, and the firm is renowned for its expertise in squeezing additional production from mature fields Demand for these services will only increase as the world’s oil fields age.

With less exposure to a softening market for pressure pumping and outsized exposure to Canadian oil production, Weatherford International is in pole position for the coming year. We also continue to favor Schlumberger, which rates a buy up to 90, for its disproportionate exposure to international markets.

Latin America

Weatherford International’s Latin American revenue soared by 31 percent sequentially in the fourth quarter, but declined 28 percent from the prior year. Much of the outsized quarter-over-quarter gain stems from a $55 million charge the firm took as it wound down its Mexican operations in the third quarter of 2010. By the same token, the company’s fourth-quarter results in 2009 benefited from its extensive presence south of the border.

Mexico has been a real headache for the four major services firms, though Weatherford International has suffered the most because of its disproportionate exposure to this market.

A few years ago, Mexico’s national oil company (NOC) sought to develop Chicontepec, an onshore heavy-oil field, to replace rapidly dwindling production at the formerly prolific Cantarell field. The NOC engaged Weatherford International and other services outfits to handle development and production of Chicontepec as part of an integrated project management deal. Weatherford International rapidly scaled up its infrastructure in Mexico to support what was expected to be a major, multiyear deal.

Although output increased and Weatherford met most of its targets in terms of drilling wells, the production gains didn’t come as swiftly as decision-makers had hoped; such projects requires a considerable amount of up-front capital investment, and production takes time to ramp up. Even worse, politicians decried the vast sums of cash the NOC was spending to ramp up output.

Bowing to political pressure, policymakers cut the NOC’s budget and sank most of the capital into developments around key offshore fields such as Cantarell and KMZ. Activity in Chicontepec and many of the nation’s other onshore fields ground to a halt.

Mexico’s policy shift wasn’t that big of a deal to Schlumberger’s overall revenue, but this reversal dealt a major blow Weatherford International, which regarded the contract as entrée into a lucrative market–management had expected high demand for the company’s expertise in maximizing production from mature fields.

The government’s about-face left the big services companies with far too much capacity in Mexico, including now-idled rigs and excess equipment that needed to be shifted to new markets–a nightmare for profitability. Services firms typically incur high costs in the early stages of executing a new contract; the payoff comes a few quarters later, when operations begin to generate revenue. In this case, the services companies assumed substantial start-up and relocation costs for only a quarter or two of meaningful revenue.

Management teams were disillusioned with what transpired in Mexico, but judging from his comments during Weatherford International’s fourth-quarter conference call, Duroc-Danner has grown cautiously optimistic about business prospects in the country:

One has to look at the basis from which we are rebooting in Mexico. It’s a very low basis…the constraints they’re under are just about sponged up. In other words, they have gone through the belt tightening that was required by the congressional authorities. So, you’ve got a budgetary turnaround. That’s factor No. 2.

Factor No. 3, there is genuinely, best I can tell, great interest with our client in their country to reform, bring in some foreign interest in some contractual forms, not necessarily the traditional ones, and that also is constructive. So, you throw the fact that we’re coming from a very low base, item one, so that you can almost have to be better.

Item two, the issues of overspending that plagued them is pretty much behind them. Item three, the intent is to do things a little bit maybe more with more creativity and the fact, lastly, that decline rates remain what they are whether you are looking at the Southern Basin or Northern Basin, you know, whether it’s in Veracruz or whether you are looking at Cantarell and KMZ in the offshore and the deep-water plays. All of this, the intent is definitely to be more active.

You put all of that together and where do we end up? We end up being cautiously optimistic. So, I think it is the right position to have.

Having reduced the company’s presence in Mexico, Duroc-Danner can afford to be optimistic about business prospects in the country: After all, activity can only increase from current levels. With oil production continuing to decline at an alarming rate–Mexico is in danger of becoming a net importer over the next decade–the country is once again seeking to entice foreign firms into investing in the country’s oil projects. This likely will prove a tough sell to services firms that have finally put the Chicontepec debacle in the rearview.

Meanwhile, activity remains robust outside Mexico. In fact, Duroc-Danner noted that he regards Latin America as the market that’s least likely to fall short of expectations in 2011. The firm has several major contracts in Colombia and Brazil that will add significantly to first-quarter revenue.

Eastern Hemisphere

Weatherford International’s operations in the Eastern Hemisphere boast the best growth prospects. Activity in these markets–especially Africa and the Middle East–isn’t as sensitive to commodity prices as the firm’s business in the Americas. Huge, multiyear projects predominate in these markets, endeavors that take time and considerable investment to ramp up but offer impressive long-term growth.

These markets are entering the sweet spot of the business cycle. Duroc-Danner likened 2012-14 to 2005-07, when spending on exploration and production also increased rapidly. That’s good news for investors: Shares of Weatherford International returned 281 percent between 2004 (like 2011, a transitional year) and 2007.

In the fourth quarter, revenue in the Eastern Hemisphere jumped 10 percent sequentially and 13 percent over the same period one year ago. Although the firm posted respectable top-line growth, profit margins declined by 220 basis points. Much of this weakness stemmed from one-off events or headwinds that should abate over the next few quarters.

For example, the company has exposure to onshore plays in Queensland, a province that was hard hit by the massive floods in Australia. Shutdowns and delays related to the catastrophe reduced earnings by $0.01 per share. The company also wrote down the value of some inventory, which took $0.05 from earnings per share.

Mobilization expenses from key projects in the Middle East and Africa also ate into margins. Once the company has the people, equipment and infrastructure in place, these start-up costs decline and revenue from the project begins to flow. Higher mobilization costs, a precursor to margin expansion and revenue growth, should encourage investors. Management expects these efforts to gradually pay off in 2011.

The firm is particularly bullish on its prospects in Algeria, where the NOC Sonatrach appears to have stabilized after a series of scandals prompted a shake-up of the management team. Weatherford International expects business to pick up in the coming year. During its conference call to discuss fourth-quarter results, the company’s CEO provided a good synopsis of its prospects in Algeria:

As a reminder, in Algeria, after some delays because our client went through a reorganization, a number of different integrated projects, contracts were signed with four large companies. We were one of the four.

Happily, we have the largest commitment, which was five, five strings. Our peers had four, three and two, if I recall correctly. Now, the five strings–of the five strings, four of the five have been in country. My goodness, they have been in country since Q3. So, you can understand the mobilization burden with the equipment and the people and everything else, that involves–it’s not only rigs, it’s everything else, since it is the whole gamut of integration and it’s destined for a gas field called Berkine, which is a high pressure, high temperature field. So it has a lot of equipment.

So all the equipment and the organization was there, and we didn’t have–we didn’t have the ability to deploy a single one on well sites. Why? Let’s just call it client delays and the like and this and that. I will add that this is not specific to Weatherford, but it is actually–it’s a general situation. I will say that given the fact that we have the largest contract, having five and our peers having four, three and two, and due to the fact that we are the smaller of the four, we have the biggest contract, but we’re the smallest of the four. So, you can understand it has the biggest effect on us.

We made some progress in Q4, but not in the commercial sense, in the sense that we didn’t have anything deployed. We made some progress in working through all the organizational issues with our clients, and now I think, Brad, to give you a sense of progression, I would say that by the end of the first quarter, it is likely, if not, it is probable, it is likely, it is planned that four of the four or three of the four will be turning with the full equipment components also turning with it. The fifth one being in country, also in Q1.

So put another way, I don’t think we have any commercial, as in booking of business, progress in Q4. But we have operational progress and I can now tell you with some degree of certainty, I hope, that by the end of Q1, we’ll have three of the four that are in country turning, probably four of the four.

Delays in Algeria hit Weatherford International harder than its competitors: Although the firm was the smallest oil services company to win a major contract from Sonatrach, it secured the largest contract available. Hired to run five strings (rigs) on the project, Weatherford International has already relocated four rigs to Algeria. By the end of the first quarter, Weatherford expects three or four of these rigs to be in operation, producing the first revenue from what should be a long-term arrangement.

The company has also faced some higher costs and delays in the start-up of its Iraqi contracts. Weatherford International has eight or nine strings operating in the country, and plans to expand the fleet to 12 by year-end. The firm is well-positioned to win additional contracts that come up for bid this year. Management expects major start-up costs to have dissipated by the end of the second quarter, bolstering margins significantly.

Duroc-Danner also noted increased interest from its customers, from specific inquiries to actual tenders, and emphasized that the market hasn’t been this strong since 2008.

With its strong growth prospects in international markets and emphasis on oil-related services in North America, Weatherford International is poised for a strong 2011. Buy Weatherford International up to 28.

Integrated Oils

Chevron Corp

Key Takeaways:

• Grew production 2.2 percent in 2010, expects 1 percent growth in 2011.
• Continue to rationalize downstream operations.
• Capital budget for 2011 increased 20 percent from 2010, reflecting increased confidence in stability of oil prices.
• Expects to resume activity in Gulf of Mexico.

A core holding in any energy-focused portfolio, Chevron Corp (NYSE: CVX) boasts a balance sheet that’s stronger than many sovereign ledgers, unparalleled geographic diversity of operations and exposure to a wide range of different projects. These strengths have enabled the company to increase its dividend for 23 consecutive years and approve yet another share buyback program, this time for up to $750 million.

Given the scope of Chevron’s operations, individual projects rarely alter the company’s production mix. This also means that management tends to focus on the firm’s overall performance in its prepared remarks, though the Q-and-A section usually provides a bit more color on specific operations.

In the fourth quarter, Chevron generated net income of $5.3 billion, or $2.64 per share, up 70 percent from a year ago.

Upstream operations generated a profit of $4.85 billion, fueled by higher prices for crude oil and a 0.3 percent increase in production. For the full year, the company managed to grow its oil-equivalent output by roughly 2.2 percent, surpassing its midyear forecast for a 2 percent increase. Management expects production to expand by roughly 1 percent in 2011.

US upstream volumes and earnings declined in the fourth quarter, reflecting reduced activity in the deepwater Gulf of Mexico and planned reductions in natural gas output. But international earnings increased, thanks to higher price realizations and 3 percent production growth in Kazakhstan.

Meanwhile, the company’s downstream earnings benefited from a number of asset sales, as management continues its three-year plan to divest noncore operations. At this point, the company has exited seven countries and most markets on the US east coast. Chevron will further prune its downstream portfolio in 2011, focusing on marketing assets that aren’t supported by the company’s refining operations. Management also reported strong interest in its UK refining and marketing operations.

With the global recovery in full swing, oil demand continues to rise, especially in emerging markets. Our outlook calls for oil prices to remain above $100 per barrel and approach $120 at some point in 2011. Chevron apparently agrees with this forecast: The super major increased its 2011 capital budget to $26 billion, roughly 20 percent higher than in the prior year. This announcement reflects growing confidence in the sustainability of oil prices and reflects a trend we discussed at length in Here Comes the Spending.

Much of this money will flow to projects in the Asia-Pacific region, one of the company’s key growth areas.

In addition to the massive Gorgon LNG project in Australia that will serve India, China and other key Asian markets, management also plans to direct funds to exploration and production efforts in the Gulf of Thailand. The company noted that it made five additional natural gas discoveries in Western Australia, providing additional support for Gorgon and the Wheatstone LNG project, on which management expects a final investment decision in 2011. Management affirmed that the firm has commitments for 80 to 90 percent of the LNG volumes from each of these mega projects. The company also will likely sanction a natural gas project offshore Vietnam, a prospect that has services firms salivating.

Despite the company’s extensive natural gas projects in the Asia-Pacific region, management hasn’t made too big of a splash in North American shale gas plays–a wise move, given depressed US natural gas prices. Chevron’s pending acquisition of Atlas Energy (NSDQ: ATLS), a producer in the Marcellus Shale, pales in comparison to ExxonMobil Corp’s (NYSE: XOM) oft-criticized takeout of XTO Energy. Chevron did well to secure a low-cost, long-lived asset at a relatively cheap price.

In the coming years, we look forward to more news on its unconventional plays in Poland and Romania. The company should sink its first well in its Polish acreage in 2011; should these efforts produce appreciable amounts of natural gas, demand from Continental Europe–eager to reduce its reliance on Russian supplies–could prove lucrative. Nevertheless, this project has a ways to go before it approaches full-scale production, if it ever does.

Although we continue to favor Chevron’s measured approach to North American natural gas, the company is the leading leaseholder in the Gulf of Mexico. As in previous quarters, analysts plied CEO John Watson with questions about the company’s outlook for drilling activity in the deepwater Gulf. This time, Watson emphasized that exploration and development wells are off the table until regulators begin issuing permits, though he noted “we’ve made some assumptions about…when [we’ll] get back to work this year” that are baked into the company’s guidance.

Although Chevron’s production growth may slow in the intermediate term, the company’s sound balance sheet, capable management and attractive production profile make it a core holding. That being said, at this point in the cycle, we prefer smaller names that will be able to grow output meaningfully in the near term. Chevron Corp rates a buy under 95.

Occidental Petroleum Corp

Key Takeaways:

• Divestment of Argentinean assets will weigh on production growth in first quarter. Once closed, acquisitions in North Dakota and south Texas will more than make up for this lost output.
• Exploration activity in California and ongoing drilling could provide upside catalysts.
• Operations in Iraq’s Zubair oil field expected to contribute to earnings in first or second quarter.

Wildcatters Portfolio holding Occidental Petroleum Corp (NYSE: OXY) reported fourth-quarter core income of $1.3 billion, up 22 percent from a year ago and slightly higher than consensus expectations. Full-year core income came in at $4.7 billion, a 51 percent increase from the prior year.

Not only did higher price realizations on crude oil boost earnings, but the company also managed to expand its overall output by 5.1 percent to 748,000 barrels of oil equivalent per day–on the low end of management’s forecast for 5 to 8 percent production growth.

In the fourth quarter, management announced a deal to divest its troubled Argentinean operations–which hadn’t been profitable for four years–to China Petroleum & Chemical Corp (NYSE: SNP). After taxes, the long-anticipated deal will net Occidental Petroleum roughly $2.5 billion.

This lost production will be offset by output from the 180,000 additional acres the company acquired in the Bakken Shale and Three Forks portion of the Williston Basin. This deal, worth $1.4 billion, significantly expands the firm’s operations in the area and should enable the company to expand production to 30,000 barrels of oil equivalent per day over the next five years. The firm currently has seven rigs operating in the Bakken and will increase this number to 12 by year-end.

Occidental Petroleum also paid $1.8 billion to Royal Dutch Shell (NYSE: RDS.A) for 92,800 acres in south Texas that contain more than 360 billion cubic feet of gas equivalent in proven, developed reserves. Higher-value condensate and natural gas liquids account for about 30 percent of revenue from the field.

Overall, management expects to produce 740,000 to 750,000 barrels of oil equivalent per day in the first quarter of 2011, as increased production in existing plays will be offset by the lost output from its Argentinean assets. The deals in North Dakota and south Texas won’t close until later in the first quarter.

Despite this temporary hiccup, the company’s US upstream operations offer plenty of upside. The leading producer of hydrocarbons in Texas, Occidental Petroleum’s operations within the state are centered in the Permian Basin, an area with a long production history that’s been revitalized by advances in squeezing oil from mature wells. Management estimates that the company is responsible for roughly 20 percent of the oil produce in the Permian.

Carbon dioxide (CO2) injections account for about 60 percent of the company’s Permian output, while 30 percent is generated by water flooding. Both technologies facilitate production in mature fields by artificialy increasing well pressure. Primary drilling and production account for just 10 percent of output, though management has noted that its acreage contains over 2,000 prospective drilling sites and that the firm continues to sink test wells in the promising Bone Springs area.

Once the Occidental Petroleum’s Century Plant comes online, the company should have sufficient volumes of CO2 to ramp up production in the Permian. The first train came onstream in the fourth quarter, while the second should be ready in 2012. These operations provide a reliable, low-cost source of oil.

But the firm’s most exciting domestic opportunity is in California, where it has a growing inventory of more than 3,700 drilling locations, the majority of which are prospective for oil and located in areas that are held by production. Few investors would regard California as a huge energy producer–probably because the population boom of the 1940s and huge oil discoveries in the Middle East distracted many producers from developing the area.

Beginning in 1998 with the acquisition of its Elk Hills acreage from the government, Occidental’s geologists have made some unprecedented discoveries in the state, including a massive conventional find in Kern Country that management estimates could contain upward of 175 to 250 million barrels of oil equivalent.

And that says nothing about the approximately 870,000 acres the company holds in prospective shale plays. A long history of seismic activity in the area has essentially pre-fractured the field, substantially lowering costs. The company has identified 520 geologically viable shale drilling locations in California, roughly 250 of which are outside Elk Hills and Kern County. In 2011, management plans to drill 107 shale wells outside Elk Hills proper.

The firm will also sink 28 exploration wells in California, 14 of which will be in potential conventional plays. At a minimum, this exploration activity will yield additional shale drilling location–anything more would serve as an upside catalyst for the stock.

Management continues to leverage the firm’s experience in maximizing production from mature fields to win business in the Middle East. The firm recently inked a 30-year contract with the Abu Dhabi National Oil Company to participate in the development of the Shah natural gas field, one of the region’s largest. The company will have a 40 percent stake in the play, and management expects capital expenditures of roughly $4 billion. But the field won’t enter production until 2014.

In the meantime, Occidental’s operations in Iraq offer the most near-term upside. Along with Proven Reserves holding Eni (Italy: E, NYSE: ENI) and Korea Gas, the company is in a consortium to develop Iraq’s Zubair field. Management expects this operation to be accretive to earnings in the first or second quarter of 2011.

Over the long haul, Occidental’s expertise in maximizing production from onshore fields should enable it to grow its business in the Middle East. Meanwhile, the Permian Basin provides a solid production base and plenty of opportunity to expand through bolt-on acquisitions. The company’s dominant acreage position in California also shows promise.

Nevertheless, the stock price has run up considerably in recent weeks and could be due for a correction, especially with first-quarter production growth expected to be lackluster–largely because of the divestment of its Argentinean assets. Occidental Petroleum rates a buy under 95.

Coal King

Peabody Energy Corp

Key Takeaways:

• Management expects its Australian coal output to increase despite catastrophic flooding, suggesting that the company’s operations are in better shape than some of its peers.
• Recent price increases in Asian spot market appear sustainable, and Peabody Energy has plenty of uncommitted coal.

Coal mining giant Peabody Energy Corp (NYSE: BTU) reported strong fourth-quarter and full-year results, with its Australian operations once again leading the way. The firm sold roughly 246 million tons of coal in 2010, only 27 million of which came from its mines in Australia. But its Australian business generated earnings before interest, taxation, depreciation and amortization (EBITDA) of USD1.82 billion, compared to about $1.1 billion for its US business.

Although its Australian EBITDA grew by more than 40 percent in 2010, the 14 percent increase in US EBITDA was a respectable result. Cost-cutting initiatives and improved prices boosted margins at Peabody Energy’s mines in the Illinois Basin and the Powder River Basin in the western US.

The model Portfolios contain a number of other coal-related stocks, including International Coal (NYSE: ICO), mining equipment giant Joy Global (NasdaqGS: JOYG) and a handful of master limited partnerships. Investors seeking an in-depth analysis of the US and international coal markets should check out the Nov. 17, 2010, issue Buy Coal-Related Stocks This Holiday Season.

There are two main types of coal: metallurgical (met) coal, the variety used in steelmaking, and thermal coal, the kind burned in power plants. Met coal is in tight supply and commands a significant premium to thermal coal prices.

Nevertheless, Asia’s appetite for thermal coal continues to increase, led by rapidly rising demand in China and India. The latter country’s fleet of coal-fired power plants suggests that it will be a key market for Australian coal producers.

At home, the story is much different. US thermal coal prices continue to struggle, as utilities have yet to work through excess inventories built up during the 2007-09 recession. Whereas strong demand for US met coal has propped up that market, exports of thermal coal–and upside from strong Asian demand–remain limited.

Devastating floods in the Australian provinces of Queensland and New South Wales–key regions for coal production and home to export terminals and rail links–have further tightened Asian markets for met and thermal coal. Australia is far and away the world’s leading exporter of met coal and shares the top spot with Indonesia in terms of thermal coal output.

Spot prices of met coal soared 50 percent between October 2010 and the end of January 2011, while thermal coal prices were up 35 percent. During Peabody Energy’s conference call to discuss fourth-quarter results, analysts plied CEO Gregory Boyce with questions about the sustainability of recent price increases. Boyce’s response suggested that spot prices will remain strong in Asian markets:

[O]ur view is that we’ve opened up a significant gap between supply and demand with demand continuing to be extremely strong. And to have a view that pricing is going to recover in a short period of time is not a view that we have. Now at some point in time in the future, we’re going to obviously see a recovery in terms of the production base but in the meantime demand continues to grow. So, the gap we’ve opened up, I think there’s a significant portion of that gap that will be permanent. Albeit when things do normalize we’ll see some of the top end come down a little bit, but we don’t see that occurring in a very short period of time.

Boyce indicates that demand for both varieties of coal has remained strong despite the recent surge in spot prices. In fact, the company’s outlook calls for the global coal trade to hit new highs in 2011. The recent flooding has enlarged the shortfall between growing demand and constrained supplies; when production normalizes, prices should remain elevated for some time because of the accumulated supply-demand gap.

Management also emphasized that the disruption from the 2010-11 flooding would be far more severe than the deluge of 2007-08, the last time coal prices spiked. Whereas this earlier flood reduced near-term supply by 7 to 8 million tons, the most recent catastrophe is expected to reduce output by at least 15 to 20 million.

Changes to how coal is prices are another positive for Peabody Energy. Three years ago, coal was primarily priced through annual contracts; today, prices are determined quarterly, ensuring that prices are more responsive to changes in supply and demand conditions.

In addition, Peabody is well-positioned to profit from ongoing tightness in global met and thermal coal markets. The company produced some 27 million tons of coal from Australia last year, 9.8 million tons of which were met coal. Management’s forecast calls for its Australian operations to produce 28 to 30 million tons of coal, more than a third of which will be met coal. In other words, the company expects its output to increase despite the flooding.

The catastrophe didn’t disrupt Peabody Energy’s operations to the extent that some of its competitors were affected. For example, management noted that as of the end of January, the company’s mines in New South Wales were up and running after experiencing some downtime in the fourth quarter.

Queensland suffered more damage than New South Wales, but management emphasized that it doesn’t have any operations in the port corridor between Blackwater and Gladstone, the area that bore the brunt of the flooding. That’s not to suggest that Peabody Energy’s mines weren’t affected; the company continues to operate some mines under force majeure, a clause that allows producers to delay shipments because of natural disasters and other events beyond their control. Other mines were still being pumped to remove water as of the end of January. Meanwhile, Queensland Rail continues to work on track repairs to bring their network back to normal operating capacity.

Regardless of the extent to which the flooding disrupts Peabody Energy’s operations, significantly higher spot prices should provide adequate compensation for these hardships–especially with the company sitting on a sizable amount of uncommitted supply.

As for the US thermal coal market, management expects supply and demand conditions to improve considerably in 2012. The company has already sold much of its 2011 production at fixed prices, but the amount of uncommitted coal increases in the following year.

Management also remains bullish about the prospect of exporting coal from the US. The company is working on a plan to send as much as 20 to 25 million tons of thermal coal to Asia via a West Coast port. The company will ship this cargo on a capsize dry-bulk carrier, the largest class available, to reduce costs.

The company will need to work with railroad operators to ensure that it’s easy to ship coal between its mines and any new export facility. US steam coal exports from the West coast to Asia probably won’t impact Peabody’s earnings for some time, but this trend could be a longer-term catalyst for the stock. Management indicated that further announcements on this front will be forthcoming in 2011.

Management’s comments on fourth-quarter results and guidance for the coming year boosts our confidence in the company’s prospects and the sustainability of recent increases in spot coal prices. With a significant amount of unsold tons, Peabody Energy should reap the rewards of higher coal prices. Buy Peabody Energy Corp under 67.

We continue to like Joy Global, a mining equipment firm that should fare well as mining outfits ramp up production to take advantage of higher prices. Buy Joy Global up to 99. US-based International coal has the potential to significantly expand its met coal output in coming years. Buy International Coal on dips below 9.50.

Penn Virginia Resource Partners LP (NYSE: PVR) rates a buy under 29, while Natural Resource Partners LP (NYSE: NRP) is a buy up to 30. We’re also raising the buy target on Alliance Holdings GP (NasdaqGS: AHGP) to 55.

Fresh Money Buys

The stocks recommended in the three model Portfolios represent my favorite picks. The three Portfolios are designed to target different levels of risk: Proven Reserves is the most conservative the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays but have the most potential upside.

I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve compiled a list of 18 Fresh Money Buys that includes 16 names and two hedges.

I’ve classified each recommendation by risk level–high, low or moderate–and included a brief rationale for buying each stock. Conservative investors should focus the majority of their assets in low- and moderate-risk plays, while aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset exposure to energy stocks.