First-Quarter Recap

The S&P 500 Energy Index is up modestly thus far in 2010, but this broad measure fails to reflect the nuances of the group’s performance. In particular, Portfolio recommendations levered to oil, deepwater drilling and coal have outperformed the broader market by a significant margin this year.

In this issue, I introduce a series of proprietary indexes that I use to keep on top of the hottest trends. I’ll also share my early read on trends emerging from first-quarter earnings season.

In This Issue

The Stories

Readers have asked for more information about the proprietary indexes I’ve developed to track trends in the energy patch. I unveil nine TES Indexes and discuss their performance last quarter and implications for our Portfolio recommendations. See The Energy Strategist Indexes.

Earnings season is in full swing. I discuss first-quarter earnings and conference calls from two key names. See Earnings Recap.

I also round up newsworthy items related to other Portfolio recommendations. See Additional Portfolio Updates.

The Stocks

Weatherford International (NYSE: WFT)–Buy @ 26
Baker Hughes
(NYSE: BHI)–Buy @ 55
Schlumberger
(NYSE: SLB)–Buy @ 85
Arch Coal
(NYSE: ACI)–Buy in How They Rate
Peabody Energy
(NYSE: BTU)–Buy @ 52
Bucyrus International
(NasdaqGS: BUCY)–Buy @ 77
Seadrill
(NYSE: SDRL)–Buy @ 27
EOG Resources
(NYSE: EOG)–Buy @ 115
Syngenta
(NYSE: SYT)–Hold in Biofuels Field Bet
Monsanto
(NYSE: MON)–Buy in Biofuels Field Bet

The Energy Strategist Indexes

Investors tend to underestimate the breadth and diversity of the energy sector. It’s a common misconception that energy stocks move as a pack, following the lead of oil prices.

The Energy Strategist celebrates its fifth birthday this month. Over that period I’ve spoken about energy industries and related stocks at dozens of investor conferences, small investing groups and trade shows. You’d be surprised how often I’m asked if ExxonMobil (NYSE: XOM) is the only stock a person needs to own to gain exposure to the energy patch.

I have nothing against ExxonMobil–in fact, I have tremendous respect for management’s track record of generating value. But this single stock isn’t a proxy for the energy sector as a whole. Consider that if you bought ExxonMobil 5 years ago and reinvested all the dividends, you’d be up 24.15 percent–roughly 4.42 percent annualized. 

This return more than doubles the S&P 500’s gain over the same period but pales in comparison to the 90.3 percent gain posted by oil-services giant Schlumberger (NYSE: SLB) or the 116.9 percent return tallied by coal-mining behemoth Peabody Energy (NYSE: BTU). Both of these stocks appear in our model Portfolios. 

ExxonMobil is a highly defensive stock, and the integrated oil company hasn’t grown production much in recent years. The company’s business model mixes refining and production; as I explained in the Feb. 17, 2010, issue A New Dark Age for Refiners, the former business doesn’t necessarily benefit from higher oil prices.

On the other hand, Schlumberger and Peabody Energy offer exposure to major long-term investing themes.

Schlumberger represents a play on the end of easy oil, as the company has the technology needed to identify and produce technically complex oilfields in the deepwater and other challenging environments. Difficult-to-produce fields are becoming an increasingly important component of global oil production; the global energy industry is going high tech and Schlumberger is the industry leader.

Peabody Energy represents a play on coal–particularly Australia’s emergence as a coal exporter to Asia. Although environmental concerns have slowed the construction of coal-fired power plants in developed markets, coal has long been and will continue to be the workhorse for fast-growing developing nations like China and India.

And I’m not just cherry-picking to make a point. Consider the Philadelphia Oil Services Index (OSX).

Source: Bloomberg, The Energy Strategist

This table lists all 15 members of the Philadelphia Index and BJ Services (NYSE: BJS), a name that was recently remoed after it was acquired by Wildcatters Portfolio holding Baker Hughes (NYSE: BHI).

One would assume that the OSX would comprise a tightly defined group oil-services companies. But this index doesn’t always moves as a group.

For one, not all of the companies in the index are truly services firms; for example, Transocean (NYSE: RIG) is a contract driller and Cameron International Corp (NYSE: CAM) makes oilfield equipment. Analysts often discuss services, equipment and contract drilling firms as though these industries belong to the same group–likely because most Wall Street firms assign coverage of these industries to a single team.

But the fundamentals of each business differ markedly. For instance, an oversupply of new rigs coming out of shipyards would depress the day-rates contract drillers charge for rigs and crimp profit margins. At the same time, the oversupply of rigs might benefit services firms; more rigs could translate into more drilling activity and more demand for oilfield services.

Newer readers seeking a primer on the contract drilling industry should consult the June 17, 2009, issue The Drilling Dozen. The data in the issue is nearly a year old, but the background information about different types of drilling rigs and how contractors make their money remains relevant.

There are even broad differences between companies within these subsectors. For example, Rowan Companies (NYSE: RDC) is a contract drilling firm that specializes in shallow-water jackup rigs capable of drilling in harsh environments. Meanwhile, Transocean specializes in floating rigs–semisubmersibles and drillships–designed to drill in deepwater environments. Gushers recommendation Nabors Industries (NYSE: NBR) owns a fleet of onshore rigs. In short, the different rig types target markets that have little or no relation to one another.

This distinction might seem a bit like splitting hairs, but the table demonstrates the salience of these differences. Check out the returns for 2007. The average stock in the OSX rallied nearly 45 percent that year and oil prices were up roughly 65 percent, but natural gas prices were flat.

Because most land-based rigs target natural gas, land-focused contract drillers didn’t perform well that year–shares of Nabors Industries fell 8 percent in 2007. But the deepwater market, which primarily targets large offshore oilfields, boomed amid a rig shortage; Transocean was among the better performers that year. High-end jackups were in tighter supply than land rigs but there was no shortage as with deepwater rigs–Rowan Companies performed a bit better than Nabors Industries but not as well as Transocean.

Of course, there are also stock-specific explanations for some of this divergent performance. For example, Smith International (NYSE: SII) has been the best performer so far this year because it’s being acquired by Schlumberger.

That being said, the Philadelphia Oil Services Index obfuscates a great deal of information. This shortcoming can be costly to naïve investors–consider the vast variation in performance between components of the OSX in each year listed (see the row labeled “Dispersion”).

This isn’t the first time I’ve indentified this energy indexing problem. In several past issues, I’ve included graphs of the proprietary indexes I created to illustrate certain trends. I originally devised these indexes for personal use–they offer a quick look at which energy groups are performing and which aren’t. The Energy Strategist (TES) indexes are far more tightly defined than the OSX and other popular public indices–I choose stocks that closely identify with a particular trend or sub-sector.

A number of subscribers have requested more information about the TES Indexes, their performance, and how I use these indexes to identify hot energy subsectors and key trends. I can’t think of a better time for the TES index series to make its public debut than just as we head into first quarter earnings season; these indexes will become a regular feature going forward.

Readers should keep a few points in mind. The stocks I’ve elected to include in these indexes aren’t necessarily recommendations. Although some of the names in these indexes appear in the three model Portfolios, other don’t even rate a “Buy” in my How They Rate coverage universe. I’ve chosen stocks linked to a certain theme or subsector; for example, the TES Integrated Oils Index is designed to track the performance of integrated oil companies, while the TES North American Natural Gas Index tracks services and production firms leveraged to US and Canadian natural gas markets.

By examining these indexes periodically, we can get a good idea of which subsectors are performing well and identify profitable trends underway or potential signs of trouble ahead. In many cases, these insights would not be available to the investors who look solely at the S&P 500 Energy Index or the Philadelphia Oil Services Index.

All of the indexes are denominated in US dollars; however, I have purposely included a large number of stocks that trade outside of North America. I don’t care about geographic definitions as much as I do about the fundamental trends and businesses that underlie these various indexes.

Also note that this effort is a work-in-progress; I likely will add more indexes in coming months as I construct and back-test their relevance. The table below lists nine of my proprietary indexes, along with technical data based on the price action and trends. Future iterations will include more fundamental data related to earnings and revenue growth.


Source: The Energy Strategist, Bloomberg

This table includes four data columns. The first two attempt to discern the long-term and short-term trends for the various indexes based on one-year and three-month data. I also provide the year-to-date (YTD) and two-week returns for each index.

The first point to note is that the TES Oil, International Coal and MLP Indexes are the strongest performers so far this year. TES Deepwater, an index that’s leveraged to strength in oil prices, isn’t far behind. Deepwater activities and the end of easy oil were one of the top three energy themes I outlined for this year in the Jan. 6, 2010. issue The Crystal Ball.

I devoted most of the April 7, 2010, issue The Search for More Oil to my favorite plays on rising oil prices. That issue also included reviews of some of the best plays on deepwater drilling in the model Portfolios.

Internationally focused oil-services companies such as Portfolio holdings Baker Hughes, Schlumberger and Weatherford International (NYSE: WFT), all of which are recommended in the Wildcatters Portfolio, are another attractive play on oil prices. The only laggard in that group is Weatherford International, a stock I discuss at length in the section Earnings Recap

Coal is another one of my top three energy themes for 2010. I’m particularly bullish on coal companies with strong international and Australian operations. My favorite plays include Peabody Energy and Bucyrus International (NasdaqGS: BUCY), though I’ll take a look at some additional Australian plays in an upcoming issue.

And in light of the unquestionably positive commentary out of US-focused producer Arch Coal (NYSE: ACI) this quarter, I’m becoming more constructive on North American coal producers (See the Earnings Recap section).

TES Nuclear and Natural Gas were the worst performers, and the latter is the only laggard out of my top three themes for 2010. That being said, the TES Natural Gas Index is down only marginally this year despite weak natural gas prices. My recommendation remains that investors focus on stocks leveraged to the natural gas market–not natural gas itself. Natural gas prices don’t have to soar for these names to do well, though an average price of USD6 for 2010 would help.

Gas-levered stocks have picked up over the past two weeks, reflecting a growing realization that producers with exposure to low-cost plays like the Haynesville and Marcellus Shale still generate profits in this depressed environment. Wildcatters recommendation Range Resources Corp (NYSE: RRC) and Gushers recommendation Petrohawk Energy Corp (NYSE: HK) are two low-cost producers.

And don’t ignore the importance of natural gas liquids (NGL). I explained importance of NGLs in the March 24, 2010, issue Investing in Efficiency. Here’s a quick recap for those of you who may have missed that article: NGLs are produced with natural gas but trade at oil-like prices. If a particular company produces significant quantities of NGLs alongside natural gas, the value of its total hydrocarbon output is a great deal higher than current gas prices would suggest. Please note that the current natural gas price of USD4 per million British thermal units fails to reflect the value of NGLs produced concurrently.

The value of NGLs helps explain why the US rig count has continues to rise even though gas prices remain weak.

Finally, Enterprise Products Partners (NYSE: EPD), Linn Energy (NasdaqGS: LINE) and other master limited partnerships (MLP) have been on fire this year, as improved credit markets have allowed these firms to raise capital to fund acquisitions and expansions. I expect the group to post a wave of distribution (the equivalent of dividend) increases later this year.

I’ll take a closer look at my favorites MLPs and reviewing our current recommendations in an upcoming issue.

Earnings Recap

First-quarter earnings season is just getting underway. Here’s a look at earnings releases from Weatherford International and Arch Coal. In addition to reviewing comments made by these companies, I also examine the implications of these reports for other Portfolio recommendations.

Toward the end of the April 7, 2010, issue The Search for More Oil, I outlined the performance for each of the model Portfolios in the first quarter of 2010; all three portfolios outperformed their benchmarks. However, in what was otherwise a solid quarter for our picks, Wildcatters Portfolio recommendation Weatherford International gave up 11.5 percent and was the worst performer. The stock has also underperformed other major oil-services names since September 2009.

I’m willing to forgive a few missteps if I believe the company’s long-term story is intact, but there was a lot riding on Weatherford International’s first-quarter earnings release–I was looking for some sign that firm’s fortunes were turning.

To make a long story short, there’s enough good news in the report to renew my confidence in the stock. Although Weatherford International missed its first-quarter earnings estimates, the numbers were influenced by a long list of extraordinary items. I’m always leery of so-called “one-time” charges because companies sometimes hide ongoing costs as one-time issues to make their results look better. But I don’t believe Weatherford International is engaging in this deception, and evidence suggests that those first-quarter headwinds are abating.

Let’s start with the biggest positive: Management’s outlook for the rest of 2010 and 2011 suggests that profit margins have bottomed and the business is generally on track for growth. In particular, comments about the firm’s Eastern Hemisphere markets–the Middle East, Africa, Asia, Europe and Russia–were positive.

When analyzing earnings releases, it’s important that investors do more than just read the press release and check whether the company beat or missed estimates. Perform a reality check: Watch how the stock responds to the news and how the stock trades as the conference call and question- and-answer period progress. In this case, shares of Weatherford International rallied nearly 6 percent on the session, closing near its intra-day highs amid the heaviest trading volume in three months. Although the entire sector turned in a strong performance on April 20, Weatherford International was a notable outperformer.

A review of the company’s first-quarter numbers reveals that its North American operations were the standout performer; the segment’s revenues jumped 21 percent from a year ago, with the US and Canada splitting the accolades for this increase. At one time Weatherford International was primarily a North American operator–as recently as 2006 the region made up about 55 percent of total revenues. But this quarter US and Canada only chipped in 30 percent of overall sales, and that number will likely trend lower.

Before the Great Recession and commodity price collapse of 2008, Weatherford International had reduced investments in North America in favor of capital spending in the Eastern Hemisphere and Latin America. But management accelerated this transition during the downturn, aggressively paring its US and Canadian presence in line with the decline in drilling activity while maintaining its foreign operations and infrastructure.

Weatherford International’s capacity cutbacks and cost reduction efforts in North America sowed the seeds for outperformance in the first quarter, as drilling activity picked up substantially from last year’s depressed levels. Thanks to lower fixed costs, more of that revenue increase filtered through the company’s bottom line: North American profit margins on earnings before interest and taxation (EBIT) soared nearly 700 basis points (7 percent) to 12.6 percent.

Management noted that none of the jump in North American profit margins stemmed from higher prices, wholly attributing the success to a recovery in volumes and lower fixed costs.

Going forward, the firm’s outlook for North America is best characterized as mildly positive. To get a better idea what that means, here’s a look at the North American rig count.


Source: Bloomberg

This graph tracks the total North American rig count: The red area represents Canadian rigs; the blue area represents US rigs. As you can see, the red area thinned considerably during the broader collapse in drilling activity that occurred from mid-2008 to early 2009. It’s also clear that the collapse in Canadian activity levels in 2008-09 was a completely different trend than the normal seasonal cycles.

US drilling activity was also hit hard but has recovered well, soaring 70 percent from the lows posted in June 2009. Meanwhile, the Canadian rig count has reverted to a more normal, seasonal pattern.

Some investors believe that US drilling activity must be weak because gas prices are around USD4 per million British thermal units and haven’t rallied alongside oil over the past year.  That’s just not the case. Two trends have driven a dramatic rebound: a surge in horizontal drilling activity and a 183-percent jump in the number of rigs targeting crude oil.

US producers’ continued focus on low-cost shale gas plays such as the Haynesville and Marcellus has contributed to the surge in horizontal drilling. In these areas, producers can profitably drill wells and extract gas even if prices hover around USD4 per million British thermal units. Natural gas prices would need to be near USD7 per million British thermal units for conventional wells to yield a profit; vertical drilling activity targeting conventional gas fields has collapsed and continues to languish.

And remember that some of the hottest shale fields produce also produce NGLs and crude oil, further enhancing well economics. NGLs command high prices, while elevated crude prices are prompting firms to aggressively seek out and produce oil.

In the company’s April 20 conference call, Weatherford International CEO Bernard Duroc-Danner noted:

North American activity volume will flatten out from Q2 thereon. The market will not provide further volume gains for H2 ’10 and ’11. There’s likely to be a substitution of possible decline in the gas segment with further strengthening in the oil and oil condensate segments.

Some product lines will be better than others into H2 ’10 and ’11…Overall pricing trends will be constructive, but don’t expect recovery of anywhere close to what was given up in 2009.

Not surprisingly, Duroc-Danner doesn’t expect the US rig count to continue to increase at such a rapid pace; horizontal drilling activity is at record level despite depressed gas prices. But any decline in exclusively gas-focused drilling will be offset by increased drilling for oil and NGLs.

Management also noted that activity in Canada has picked up because of projects targeting heavy oil.

This combination of factors lays the foundation for slow-but-steady improvement in pricing power for Weatherford International’s North American operations. Given the company’s lean cost structure, I expect this market to remain reasonably profitable for the services giant.

But the company’s real growth story is being written outside North America. First-quarter revenue growth in the Eastern Hemisphere was weak. Although seasonal declines are normal in the first quarter–in a healthy market revenues drop 3 to 4 percent sequentially, revenues were off 5 percent in the first quarter of 2010.

Harsh winter weather across North America, Europe and Asia contributed to this poor showing, as the coldest winter in decades brought icy conditions and record snowfall and disrupted drilling activity. For example, China’s Bohai Bay froze over for almost two straight months this winter, an unprecedented situation that made it difficult to move equipment. With the Middle Kingdom accounting for nearly a quarter of Weatherford International’s revenues in Asia, this challenge had a meaningful impact on first-quarter performance.

The firm’s Russian operations likewise suffered setbacks from inclement weather. Siberia is never a warm place, but management noted that conditions in key oil-producing regions of Western Siberia were unusually inhospitable–in some instances, temperatures sank to minus 40 degrees Celsius (104 degrees below zero in Fahrenheit).

Although weather-related challenges impacted all services companies, Weatherford International likely suffered more acutely than many of its competitors; the firm’s concentrated exposure to regions hard-hit by the harsh winter stung results. The only services name whose Russian presence rival Weatherford International’s operations is fellow Wildcatters Portfolio holding Schlumberger. I expect Schlumberger to report similar obstacles during its first-quarter conference call on April 23.

The political climate in Algeria–a key market for Weatherford International–also weighed heavily on revenues in the Eastern Hemisphere. Most Algerian oil and gas development projects ground to a halt after a corruption probe of senior management at the state-owned oil company Sonatrach resulted in the ousting of CEO Mohamed Meziane.

Fortunately for Weatherford International and its shareholders, these first-quarter headwinds are abating. Spring weather has thawed out most energy-producing regions in the northern hemisphere; management noted that activity levels in regions hardest hit by extreme winter weather are already recovering.

As for Algeria, management reported that Weatherford International has five rigs operating in the country. Duroc-Danner also noted that he believes that the political issues in Algeria have been resolved to the satisfaction of the Algerian government.

Weatherford International’s CEO was particularly bullish on the firm’s Russian operations in the company’s first-quarter conference call:

…our clients are essentially oil producers. Gazprom [Russia’s national gas producer] is not a significant client, insofar as they do much of what they need themselves.

So it is an oil-driven market. If oil is sustained at these levels, Russia will respond. Russia responds late–they will respond. So, we are anticipating a strong second half of the year, but even more so a strong 2011.

After Weatherford International acquired the oil-services division of TNK-BP last year, the firm’s Russian operations make up bigger part of the firm’s revenue mix. In fact, its presence in the country is second only to Schlumberger, a much larger firm.

The success of this acquisition hinges Weatherford’s ability to attract new clients. Traditionally, the TNK-BP served only the BP (NYSE: BP) joint venture; the new owner is offering its services to all producers. According to CEO Duroc-Danner, Weatherford has inked contracts with two new clients, Rosneft (Moscow: ROSN) and Lukoil (OTC: LUKOY).

Russia is currently the world’s largest oil producer, and Weatherford International’s local operations target oil-focused activities. With oil prices above USD80 a barrel, it’s reasonable to expect a significant uptick in business going forward.

Management has made no secret that the 2008 collapse in activity caught it by surprise. At the time, the company was intent on expanding its international operations and had too much capacity in most of its foreign markets. Although fellow Wildcatters recommendations Schlumberger and Baker Hughes had also beefed up their overseas operations, Weatherford International was arguably the most leveraged to upside in the energy-services market when the downturn hit. As activity ramps up in these markets, the company should benefit handsomely.

A couple of additional points are worth noting.

First, management has said it will have nine rigs operating in Iraq by July, providing another source of upside in the second half.

Second, Weatherford’s stock has underperformed lately relative to its peers because Mexico decided to scale back activity at the Chicontepec, a heavy oilfield where the company had a major contract.

That contract is now winding down, and the effects of Mexico’s about-face on Chicontepec are in the rearview mirror. Meanwhile, an uptick in activity in Columbia and Brazil has offset some of the decline in Latin America.

Shares of Weatherford International trade at a significant discount to the competition–it’s a $23 to $25 stock if the valuation gap closes. Baker Hughes and Schlumberger have valuation upside because the first quarter likely marked the trough for profit margins and presents a good buying opportunity. If the second half of 2010 plays out as I expect, Weatherford’s shares could trade in the neighborhood of $30 over the next year or so. Weatherford International is a buy under 26.

Both Schlumberger and Baker Hughes have yet to report earnings; I’ll provide detailed analysis of both stocks in an upcoming issue. Baker Hughes has the best near-term upside momentum of any of the major services names–the stock is up nearly 25 percent in 2010. Management’s reorganization of its international business should continue to pay off. I’m raising my buy target on Baker Hughes to 55 in recognition of further upside.

Schlumberger is a must-own services firm. The company boasts the most advanced technology of any services major, and its offerings are geared toward exploration rather than development.

I expect exploration activity to ramp up over the next year or two as high oil prices temp companies to allocate more of their budget to locating new finds. Schlumberger rates a buy under 85.

Arch Coal (NYSE: ACI) doesn’t appear in the model Portfolios, and I’ve rated the stock a “Hold” in my How They Rate coverage universe for more than a year. Arch is heavily exposed to the US market, where high stockpiles at utilities have depressed domestic coal prices.

My favorite coal-mining name is Peabody Energy, a US-based miner that has shifted its focus to Australia in recent years. Peabody is benefiting from strong coal demand from and shortages in Asia at the same time the US market has been in the doldrums.

But Arch’s first-quarter results and conference call piqued my interest for two reasons: Not only was the company among the first coal-mining outfits to announce earnings, but the contrast between management’s tone in the fourth quarter and on Monday couldn’t be greater.

I discussed Arch’s fourth-quarter conference call in the Feb. 3, 1010, issue Earning Their Keep, noting that the company missed estimates, analysts slashed their outlook and the stock sold off roughly 14 percent in one day.

What a difference three months make. Management’s renewed confidence has strengthened my outlook for a recovery in US coal markets in the back half of 2010. An improving US market and robust Asian demand make the coal sector one of my top plays for 2010.

In his prepared remarks during the company’s conference call, CEO Steve Leer noted that the markets for metallurgical (met) coal are red hot because of a rapid and powerful rebound in steel demand. Met coal is use to fire blast furnaces for steelmaking and is in high demand in Asia, where an insufficient supply of scrap metal prevents the use of electric arc furnaces.

I’ve written previously about improving prices for met and pulverized coal injection (PCI), another grade of coal that can be substituted for met in certain blast furnaces. Over the past couple of weeks I’ve released two Flash Alerts concerning Peabody Energy’s ongoing bid to purchase Australia’s Macarthur Coal (Australia: MCC). Peabody’s management clearly shares Leer’s belief in the sustainability of met and PCI coal pricing; Macarthur is a major Australian PCI exporter.

Robust demand for steel has likewise benefited US mining firms with exposure to met and PCI coal. Accordingly, Arch now expects to produce 6 to 7 tons of met and PCI coal in 2010. To put that in context, Arch only managed to sell 4.5 million tons of met coal in 2008, the last time demand was this strong.

And Arch plans to sink USD10 million into its Cumberland River mine to boost this facility’s production of met coal by another million tons. The economics behind this expenditure are compelling: Met coal sells for around USD150 per ton–an additional 1 million tons implies $150 million in incremental revenues. This would increase Arch’s met coal output to roughly 8 million tons per annum.

Arch has committed only 4.5 million tons of capacity for 2010 delivery; the company has some upside exposure to higher prices. Of the 6 to 7 million tons of met coal Arch plans to sell in 2010, the company expects about one-third to go to domestic consumers and the remainder to find its way to the export market.

Management’s discussion of met coal confirms a trend that I’ve discussed at length in this newsletter and further strengthen my investment thesis for Peabody Energy. But comments about the US market for steam coal–a variety used in power plants–really stood out.   

Demand for steam coal suffered during the 2007-08 recession along with electricity consumption. Low US natural gas prices further exacerbated this problem, as some power companies switched from coal to natural gas. This substitution not only reduces demand for coal but also contributed to the oversupply at US utilities, many of which sought to delay new shipments–a challenge for the railroad industry.

But comments from Arch’s management suggest the situation is improving. US electricity generation is up 2.6 percent this year, compared to a 4-percent decline in the year-ago period, and management expects US coal consumption to increase roughly 6 percent this year. The mining giant noted that cold weather pushed up demand for electricity over the winter and reduced coal stockpiles from record levels that prevailed at the end of 2009. Management also asserted that US inventories of Powder River Basin (PRB) coal–a type of coal mined in the western US–stand at about 58 days of supply, only slightly above average for this time of year.

Because Arch’s operations are heavily geared toward production of PRB coal, this is a major positive for the company. It’s also good news for Peabody Energy, whose US operations are heavily geared toward PRB coal.

The company’s forecast for US coal production is perhaps even more noteworthy. The US Energy Information Administration (EIA) estimates that US coal production is off 5.2 percent year to date; given the strength in the met coal markets, it’s a good bet that the production decline is centered in steam coal.

Mine output in Central Appalachia (CAPP), the traditional heart of US coal mining, has suffered the biggest decline, down around 10 percent.

Amid a strong market for both steam and met coal, CAPP yielded about 235 million tons in 2008; this year management expects the area to produce 160 to 170 million tons–a decline of 30 percent. In addition, Arch expects production in Northern Appalachia to be down 15 million tons and 15 million tons worth of steam coal to be sold as met call–a phenomenon known as “crossover.” Total production declines of roughly 100 million tons and an uptick in electricity consumption should reduce stockpiles and send prices higher.

Regulatory issues could also weigh on CAPP’s production. New regulations and environmental opposition to so-called “mountaintop mines” have made it next to impossible to permit new surface mines in the region. And safety regulations are likely to tighten in the wake of the deadly tragedy in Massey Energy’s (NYSE: MEE) West Virginia mine. Investors may remember that another tragic mine accident at the Sago mine in 2005 resulted in stricter regulations in CAPP. Analysts estimate that this resulted in a roughly 5 percent decline in mining productivity.

To date, the recent tragedy has prompted the government to step up its inspections and monitoring of mines. Additional regulations are a distinct possibility going forward.

Adding to the complexity, Arch’s management pointed out that much of the met coal produced in the US comes from deep mines and relatively thin seams–qualities that increase the danger and will likely be a focus of regulatory and supervisory scrutiny.

These developments have raised concerns among utilities about future coal supply, especially from CAPP. All of this bodes well for Arch, Peabody and other PRB producers, as less-dangerous surface mines predominate in the region. Moreover, coal seams in the Western US haven’t been mined for as long as seams in the East; coal seams are thicker and easier to mine outside CAPP.

Arch reports that prices for PRB coal are up about 40 percent from their lows and about 25 percent since the beginning of the year. Arch has sold most of its steam coal production for 2010 but has a large amount of uncommitted tons for 2011 and beyond, as management expects prices to rise.

This confluence of positive developments prompted Arch Coal raised its earnings guidance for 2010, and comments from management suggest improved visibility for US coal prices and volumes.

I am boosting Arch Coal from a “Hold” to a “Buy” in How They Rate. I will also take a closer look at the other mining firms in my coverage universe over the next few weeks and consider adding one to the model Portfolios. For now, Peabody Energy is a buy under 52.  I’m boosting my buy target on mining-equipment manufacturer Bucyrus International from 66 to 74.

Additional Portfolio Updates

On April 15 deepwater drilling giant Seadrill (NYSE: SDRL) moved its primary listing from the Oslo exchange to the New York Stock Exchange (NYSE). This is not a typo–the NYSE now allows companies to choose four-letter symbols. As I noted in previous issues, the transition to the NYSE is a major positive for two reasons: It makes Seadrill a far easier stock to buy for US-based investors and increased the firm’s visibility.

Most subscribers who bought shares Seadrill before the re-listing likely owned the over-the-counter offering that traded under the symbol SDRLF. If that’s the case, your broker should have transferred your position into the NYSE-listed shares. Although the pricing should be the same, trading volumes and liquidity will be far superior for the NYSE-traded stock.

I am boosting my buy target for Seadrill slightly from 25 to 27.

EOG Resources’ (NYSE: EOG) analyst conference was a big upside catalyst for the stock–just as I projected in the March 3, 2010 issue The Explorers. The company outlined several new US oil and NGL plays it’s targeting in the US. The list includes the Niobrara oil find in Wyoming and Colorado, where the company has assembled 400,000 leased acres.

In addition, the Eagle Ford Shale in South Texas is known primarily as a natural gas play, but that’s unfair–some areas of the play are extremely rich in NGLs, and much of the acreage EOG is targeting yields crude oil rather than natural gas. The bottom line: EOG is taking the basic technologies of horizontal drilling and fracturing developed for US unconventional gas plays and applying the same techniques to oilfields. The result of this effort is high oil-focused production growth.

Based on these considerations, I’ve decided to boost my buy target for EOG Resources from 110 to 115.

Finally, many of the agriculture plays outlined in the Dec. 2, 2009 issue Bumper Crop have weakened since late March. The list includes fertilizer producers Mosaic (NYSE: MOS) and Potash Corp of Saskatchewan (NYSE: POT) and seed giant Monsanto (NYSE: MON).

Much of the weakness stems from concerns that near-term catalysts for upside have dissipated, especially for potash fertilizer prices. In addition, rumors of merger and acquisition activity that were swirling in the fertilizer space have died down.

I’m not concerned about the intermediate-term picture. Inventories of fertilizer remain tight, and I expect to hear more bullish commentary from fertilizer producers in coming weeks as they report earnings results.

The only change I’m making to the recommendations outlined in the Dec. 2 issue is to cut Syngenta (NYSE: SYT) from a buy to a hold. The reason is that seed giant Monsanto has cut prices on its genetically modified seeds. Monsanto’s prices were higher than the rest of the industry because its technology is roughly two years ahead.  But those high prices had prompted some farmers to use older seeds from other producers like Syngenta.

Lower prices from Monsanto should enable the giant to regain some of its lost market share. Monsanto remains a buy as part of the Biofuels Field Bet.

Stock Talk

Add New Comments

You must be logged in to post to Stock Talk OR create an account