Global stock and commodity markets are following developments in European credit markets. Earnings, economic reports and stock-specific news simply aren’t the main drivers of market performance right now.

The basic fear is that the current debt contagion in Europe will prove to be a destabilizing force and instigate a crisis similar to the credit crunch touched off when Lehman Brothers declared bankruptcy. That risk and the actual impact on credit markets outside Europe has been massively overblown by the popular media.

Although the current scare could drag on for a few more weeks, it’s likely to prove a buying opportunity for energy stocks. I still expect oil to trade north of $100 a barrel by year-end and the broader averages to hit new highs for the year. Here’s a rundown of what’s going on in Europe, what to look for and how it affects several key energy-related sectors.

In This Issue

The Stories

“Big picture” themes have been the main driver of our Portfolio recommendations over the past few weeks. Here’s a rundown of what’s moving energy stocks. See A Growth Scare.

Media coverage of Europe’s soveriegn debt crisis has focused on the so-called PIIGS: Portugal, Italy, Ireland, Greece and Spain. Here’s my take on the crisis and the EU’s response. See What It Looks Like When PIIGS Fly.

Austerity measures required by the EU bailout have raised concerns about growth in the region and global economy. See Growth and Austerity.

China and emerging markets drove global economic growth last year; news that Chinese authorities plan to cool the red-hot economy have spooked investors, but these fears are overblown. See China’s Economic Management.

Taking all of these factors into consideration, I update my outlook for US equities, oil prices, energy-related industries and our Portfolio recommendations. See Puzzling It Out.

Here’s the latest update on the TES Indexes. See TES Indexes.

The Stocks

Afren (London: AFR)–Buy @ GBP1.15
Duncan Energy Partners LP (NYSE: DEP)–Buy @ 25
Diamond Offshore (NYSE: DO)–Sell in How They Rate
Ensco (NYSE: ESV)–Hold in How They Rate
Enterprise Products Partners LP (NYSE: EPD)–Buy @ 36
EOG Resources (NYSE: EOG)–Buy @ 115, Stop @ 75
Hercules Offshore (NasdaqGS: HERO)–Hold in How They Rate
Kayne Anderson Energy Fund (NYSE: KYE)–Buy @ 27
Kinder Morgan Energy Partners LP (NYSE: KMP)–Buy @ 70
Linn Energy LLC (NasdaqGS: LINE)–Buy @28
Natural Resource Partners LP (NYSE: NRP)–Buy @ 27
NuStar Energy LP (NYSE: NS)–Buy @ 60
Occidental Petroleum Corp (NYSE: OXY)–Buy @ 95
Penn Virginia Resources (NYSE: PVR)–Buy @ 24
Petrobras (NYSE: PBR A)–Buy @ 50, Stop @ 28.50
Rowan (NYSE: RDC)–Hold in How They Rate
Seadrill (NYSE: SDRL)–Buy @ 29, Stop @ 16.25
Seahawk Drilling (NasdaqGS: HAWK)–Hold in How They Rate
Sunoco Logistics Partners LP (NYSE: SXL)–Buy @ 68
Teekay LNG Partners LP (NYSE: TGP)–Buy @ 30
Tortoise Energy Infrastructure (NYSE: TYG)–Hold
Valero Energy Corp (NYSE: VLO)–Buy @ 20, Stop @ 16.95

A Growth Scare

It’s impossible to discuss energy commodities and related stocks intelligently without paying close attention to macroeconomic and broader market trends. These “big picture” themes have been the main driver of our Portfolio recommendations over the past few weeks.

Neither oil prices nor energy-levered stocks have been immune to the global selloff that started in late April. Investors are fleeing all forms of risk; the only asset classes that have rallied are traditional hedges such as gold and safe havens such as US Treasuries. The current environment is a classic growth scare: Investors are worried about the durability of the economic recovery.

Similar scares occurred during 2002-07 bull market, and each bout of fear catalyzed significant pullbacks in the broader market and in energy-related commodities.


Source: Stockcharts.com

Note that in late 2004 crude oil fell from around $56 a barrel to $40 a barrel–a near 30 percent pullback–but rallied in early 2005 and topped $70 a barrel later that year. And in late 2006 and early 2007 crude tumbled from $80 barrel to the low $50s, a 38 percent correction that set oil up for its historic run to highs near $150 a barrel in mid-2008.

In this cycle, crude oil has dropped from over $87 a barrel to near $71 a barrel, an almost 20 percent decline since early May–a dramatic selloff but hardly unprecedented. From 2002 to mid-2008 we witnessed several corrections of even greater magnitude that didn’t interrupt the long-term uptrend.

Of course, the question is whether the current selloff is simply a reaction to a temporary growth scare, such as the corrections labeled on the above graph, or if it’s something more sinister, akin to what we witnessed in late 2008 and early 2009. The evidence points to a temporary growth scare.

The broader market and oil prices are reacting to three primary macroeconomic concerns:

1. That instability in European sovereign debt markets will spark another global credit crunch similar to what the world experienced after Lehman Brothers declared bankruptcy in September 2008. Another dislocation in credit markets would nip the global economic recovery in the bud.
2. As part of the comprehensive $1 trillion bailout plan announced over the weekend of May 9, the EU is requiring that members with the shakiest fiscal positions undertake austerity measures. Increased fiscal discipline will impact growth in debt-troubled countries like Greece and Portugal, but there’s an ongoing fear this weakness will spread to core markets such as Germany and France. A major European slowdown would impact US growth as well.
3. Longstanding concerns that the Chinese government’s efforts to rein in property speculation and slow the nation’s red-hot economy will result in a major global economic slowdown. China and other developing markets led the global economy out of recession in 2009.

Let’s deal with each of these concerns in turn.

What It Looks Like When PIIGS Fly

Credit markets have been jittery over the past few weeks, but most of the issues have been confined to Europe’s peripheral economies. And the severity of tightening isn’t on par with the collapse in 2008.

The three EU countries most directly impacted by the European sovereign debt crisis of late are Greece, Portugal and Spain. More broadly, media attention has focuses on the so-called PIIGS: Portugal, Italy, Ireland, Greece and Spain.

Source: Bloomberg

Note that the PIIGS are small economies. Greece has a gross domestic product (GDP) of $356 billion, less than 0.6 of the world economy. By far the largest economies in this block are Italy and Spain, which have GDPs of $2.7 and $1.6 trillion, respectively.

Greece was the epicenter of the recent crisis but its economy isn’t big enough to have much of an impact on global or, for that matter, European debt markets.

The real issue is one of contagion. Investors feared instability in Greek credit markets would spread to the largest PIIGS, Italy and Spain. In turn, a crisis in these larger eurozone economies could infect core EU nations like Germany and the global interbank market; the collapse of the interbank lending market, a sign that banks didn’t trust the solvency of other banks, was one of the most damaging side effects of the 2008 credit crunch.

Because EU banks are major lenders to the weakest economies, a widespread sovereign panic could have sparked a replay of 2008. The only difference in this case would be that the toxic assets are sovereign debt rather than mortgage-backed securities.

A good indicator of potential contagion is Italy’s credit default swaps (CDS). CDS allow investors to insure bonds against default; the higher the cost of swaps, the higher the risk of default.

Italy is the largest economy of the PIIGS and has a high public debt-to-GDP ratio of nearly 119 percent, second only to Greece and significantly higher than Portugal or Spain.

Prior to 2008 the cost of a CDS on a five-year Italian government bond hovered around 10 basis points, equal to 0.1 percent. But at the height of the credit crisis that CDS spiked to around 200 basis points, or a full 2 percent. 

Although the price of CDS for Italy’s sovereign debt declined through much of 2009, they remained elevated relative to pre-crisis historical norms–the summer lows for Italian CDS were between 60 and 70 basis points.

Once again Italian CDS soared over 200 basis points just before the EU announced a trillion-dollar rescue package for fiscally troubled economies. The size of this bailout is nearly three times Greece’s entire GDP; the package is large enough to make all necessary debt repayments and scheduled bond redemptions for the most troubled nations for at least two to three years.

The bailout should quell concerns about a sovereign default in the EU and buy the fiscally challenged nations time to bring deficits under control. The market remains jittery about the PIIGS, but the CDS for a five-year Italian bond has declined steadily; the current price is around 135 basis points, roughly half of where it was before the bailout. 

The cost of CDS protection on Italy’s sovereign debt should continue to fall as investors gain confidence in these measures. In fact, as the first bailout funds flowed to Greece on May 18, the CDS spreads for all of the PIIGS fell sharply.

The yields on sovereign debt issues from Europe’s periphery also provide a glimpse into the market’s perception of default risk.

The yield on a Greek two-year government bond topped 18 percent at the height of the crisis but now stands at around 6.6 percent–roughly the same level as in January of this year. Meanwhile, Spanish and Italian two-year bond yields ballooned to 2.9 percent and 2.4 percent but currently sit at 1.9 percent and 1.5 percent, respectively.

It took months for signs of strain in the interbank lending market to dissipate after the last credit crunch hobbled global markets. I expect markets to gradually regain confidence in Europe’s peripheral nations.

This brings us to the second part of the credit crunch story: the potential for instability in Europe’s sovereign credit markets to spread to the interbank lending market or demand for US corporate bonds. The potential for infection appears limited.


Source: Bloomberg

This graph tracks the TED spread, an indicator that I discussed in almost every issue at the height of the financial crisis and in its immediate aftermath. The indicator measures the difference between the three-month London Interbank Offered Rate (LIBOR) and the yield on three-month US government bonds.

LIBOR is the interest rate banks charge to lend to one another. When LIBOR spikes relative to US bond yields, it’s an indication that banks don’t want to lend money to each other. During the 2008 financial crisis LIBOR spiked after Lehman Brothers declared bankruptcy because that default sparked distrust–a bank wouldn’t lend to another bank if it lacked confidence in its counterparty’s solvency.

The TED spread picked up at the height of the EU’s sovereign crisis in early May but has receded since the bailout was announced. Even at recent highs the TED spread is still at historically low levels and is well off the levels of a year ago. The long-term average for the TED spread is around 30 to 40 basis points, or 0.3 to 0.4 percent. Alarm bells shouldn’t go off for investors unless the spread spikes above 50 basis points and stays at that level.

Another useful indicator is to look at the yield spread between US Treasuries and lower-rated corporate bonds.

Source: Bloomberg

This graph tracks the yield spread between an average 10-year corporate bond that’s rated BBB by Standard & Poor’s and a 10-year US Treasury bond. The higher this spread, the tighter the market and the more debt costs for corporate borrowers.

This graph shows no sign of strain. The spread has contracted steadily from its highs of more than 5 percent in late 2008.

In the first 18 days of May US corporate bond sales are off 59 percent relative to the same period in April, likely because of elevated fear. But confidence returned a week after the EU bailout was announced: US corporations raised $13.6 billion through debt, accounting for most of $19 billion issued from the beginning of the month to May 18.

I also monitor the action in a handful of indices that track credit default swaps for corporate issuers. Check out this graph of the Markit CDX Investment Grade North America Index.

Source: Bloomberg

This index tracks the cost of insuring a basket of investment-grade bonds issued by North American corporations against default. The index showed signs of stress the week before the EU bailout but has backed off sharply since then. Although the Markit CDX Investment Grade North America Index is still elevated compared to levels in 2007, it trades within a normal range.

Here’s a look at a similar index covering the cost of default protection on European corporate issues.

Source: Bloomberg

This pattern should look familiar. Although European corporate debt markets haven’t enjoyed the same rebound in issuance as their North American counterparts, the panic of early May has abated considerably.

Finally, Wildcatters Portfolio holding EOG Resources (NYSE: EOG) came to market this week with two $500 million bond issuances. The first bond is a 2.95 percent bond maturing on June 1, 2015, and the second is a 4.4 percent bond maturing on June 1, 2020. Both bonds now trade above their issue prices and yield just 2.85 percent and 4.35 percent, respectively.

The market had no problem absorbing this large bond issue, and the yields suggest that high-quality corporations can still raise capital at attractive rates.

Linn Energy, LLC (NasdaqGS: LINE), another Wildcatters Portfolio recommendation, issued a $1.3 billion bond in early April. Demand has been solid for the bond, and it continues to trade well above its issue price. Standard & Poor’s has assigned Linn Energy a “B” credit rating, so the bond falls into the high-yield category. However, the bond’s current yield is around 8.65 percent, well under the yield on Linn Energy’s units. This is a further sign that US corporate credit markets continue to function.

All of these indicators point to the same basic conclusion. The sovereign credit crisis that began in Greece spread to other heavily indebted countries in the EU, sparking concerns about French, German and UK banks’ exposure to the PIIGs. The crisis never reached full bloom, and most credit market indicators have begun to normalize.

But don’t expect credit markets to stabilize in an orderly and consistent manner.

German authorities and Chancellor Angela Merkel threw a curve ball at the markets on May 18, announcing a ban on naked trading of credit default swaps on European government bonds. In other words, investors can buy CDS to hedge exposure to European bonds in a portfolio but not as a speculative short on the EU bond markets. The nation also banned short sales on 10 major European banks and insurers. The measures are reminiscent of some of the short-selling restrictions the US put in place at the height of the 2008 financial crisis.

It’s hard to say anything positive about this move.

For one, the unexpected ban invites speculation that German authorities know something the market doesn’t and are panicking about the potential for an EU-wide contagion.

Second, the CDS market allows participants to insure their exposure to European bonds and aids the flow of capital into Europe. The sudden rule change could dry up liquidity in the CDS market and hardly encourages investors to deploy funds.

And banning short-selling likewise reduces a market’s liquidity. If a stock, bond or other asset is overvalued it will eventually fall whether or not short sellers are allowed to participate. 

There’s no way to know why this step was taken. I’d guess that the basic rationale is the same as it was in the US–blatant populism. The EU bailout package isn’t popular among Germans, but I suspect the idea that foreign speculators are profiting from Europe’s mess is even less popular.

Don’t forget that the German legislature is preparing to debate and still needs to pass the trillion-dollar bailout plan. The deal is likely to pass by a wide margin, and it’s possible this increased regulation is viewed as a way of making the bailout more palatable politically.

Famed economist John Maynard Keynes was once asked why he changed his position on a particular economic issue. The witty Briton replied: “When the facts change, I change my mind, what do you do sir?” I will continue to monitor these indicators over the next few months and will modify my view if there are signs the credit crunch is spreading.

Growth and Austerity

The trillion-dollar EU bailout consists of a EUR60 billion contribution to the EU stabilization fund, EUR440 billion in guarantees from member states and EUR250 billion from the International Monetary Fund. These measures are on top of a separate EUR110 billion bailout for Greece, the first country to become infected by the sovereign credit contagion.

These measures can calm sovereign credit markets and prevent contagion but don’t cure the underlying economic ills that started the crisis–that is, high debt-to-GDP ratios caused by large deficits.

Countries in such vulnerable fiscal states usually wouldn’t have access to credit markets or would have to pay a high price. The bailout guarantees offer a stop-gap measure and a temporary alternative to public bond markets; however, weak EU nations must still address their fiscal positions or the same basic problems will recur. The bailout buys time for the PIIGS but isn’t a solution.

As part of the EU bailout package, countries are required to take steps to improve their fiscal positions and reduce deficits. The measures, known as fiscal austerity packages, ultimately can reduce deficits but also dampen dampening economic growth.

Greece, for example, has already passed two harsh austerity measures this year that amount to roughly 5 percent of GDP: a tax reform bill to improve tax collections and a pension reform plan that increases the retirement age.

A recent article in the New York Times, Greek Wealth is Everywhere but Tax Forms, illustrated the scope of tax evasion underway in Greece. According to that article, only 324 residents in Athens’ affluent northern suburbs claimed to own swimming pools on their tax returns, while aerial surveys suggested the area is home to nearly 17,000 pools.

The list of austerity measures includes a pay freeze for all public-sector workers, the elimination of bonuses for high-income public workers, termination of public contract workers, measures seeking to tie the official retirement age to life expectancy and increases in value-added tax and the tax on alcohol, fuel and cigarettes. 

These unpopular moves have already sparked high-profile protests. But the current center-left government passed the reforms with relatively large majorities and is arguably in a better position to sell these measures to the populace and its more left-leaning elements than a center-right government. 

These measures also represent one of the harshest and most immediate austerity regimes ever enacted by a country but should go a long way towards improving the country’s fiscal position over time.

That being said, Greece’s economy will contract. Consensus estimates predict that Greece’s GDP will fall about 3.9 percent in 2010 and another 1 percent in 2011 as the unemployment rate climbs from less than 10 percent at the end of 2009 to nearly 13 percent in 2011.

If these forecasts are correct, Greece’s economy would contract for three straight years–2009, 2010 and 2011–before mounting a recovery sometime in 2012. These estimates represent a significant downside revision compared to what was expected at the beginning of the year.

And Greece isn’t alone. Spain and Portugal have also introduced spending cuts that are expected to cut growth in 2010 and 2011, though the scope of the cuts pales in comparison to what Greece has instituted. Neither of these economies is expected to shrink in 2010 or 2011, though analysts are calling for slower GDP growth.

Ireland got the jump on the other PIIGS by introducing fiscal austerity measures a year ago that included large public-sector pay cuts. That’s one reason Ireland attracted less attention than the other PIIGS during the recent scare.

Although fiscal reforms in Europe’s periphery may facilitate longer-term stability, these measures are a short-term negative for GDP growth prospects. But the real question isn’t what’s happening in Greece and Portugal but in the EU as a whole. Fiscal austerity in Europe’s fringe will impact overall EU growth to an extent, but these economies aren’t large enough to tip the broader European economy into recession.

Momentum in the core European economies such as France and Germany remains solid. And EU authorities have made it clear that not every EU country will face financial austerity requirements.

More broadly, the strengthening economic recovery in the US is unlikely to be derailed by austerity in Southern Europe. Consider that less than one-fifth of S&P 500 earnings come from Europe, and the vast majority of these earnings would come from the larger core nations.

Total US exports to the EU were about $21 billion in March, the most recent month for which we have data. Germany, France and the UK together account for $11.2 billion of that total while Spain and Italy are around $1.8 billion combined. And Italy and Spain taken together would dwarf the contribution of Greece and Portugal.

The EU sovereign debt crisis is a relatively new phenomenon, and it’ll take time for it to impact economic statistics. One useful indicator to watch is the Eurozone Manufacturing Purchasing Managers Index (PMI).


Source: Bloomberg

Interpretating of the Eurozone Manufacturing PMI is simple: Levels above 50 indicate expansion in manufacturing, while levels below 50 indicate contraction. The current reading indicates that EU manufacturing activity is expanding rapidly.

I’ve written extensively about the US economic recovery and won’t bore readers with another lengthy discourse on the subject. Suffice it to say that one of the last causes of widespread concern–the employment situation–appears to be turning for the better. As longtime readers know, I monitor US Leading Economic Index (LEI) closely; the next release is due May 20, and I’ll analyze the data in the May 22 issue of my free weekly e-zine, Personal Finance Weekly. 

At present I regard fiscal austerity in the EU as the major driver of the global growth scare that’s affecting energy markets. However, these fears also look way overblown given the momentum in the US and core EU markets and the small size of the economies most directly impacted by austerity.

China’s Economic Management

Traders have worried about the Chinese government’s attempts to slow the economy and reduce speculation in the stock and housing markets at least a half dozen times over the past five years. Such worries are nothing new.

Western investors historically have been too quick to label strong growth in China as a “bubble” and tend to overestimate the actual slowdown in the economy when the government reins in growth. One analyst who has been consistently correct about the outlook for China over the past few years is my longtime friend and editor of the Silk Road Investor, Yiannis Mostrous.

In early 2009 Yiannis projected that China’s economy would grow at least 8 percent on the year. At the time most analysts expected Chinese growth to remain sluggish; the Middle Kingdom’s economy grew around 8.7 percent last year.

Given Yiannis’ track record, I take his prognostications seriously. Yiannis shared his latest outlook in the May 12 issue of Global ETF Profits, a new advisory he co-edits with Benjamin Shepherd:

Investors’ worries are twofold. First, there’s widespread concern that the Chinese housing market is ready to collapse under intense speculation. Second, investors fear the Chinese government will overreact and slam the brakes too hard, as it did in 2008.

We beg to differ. The Chinese government has traditionally been supportive of homeownership. In the late 1990s it essentially transferred government-owned apartments to their occupants. After this move the homeownership rate in China’s urban areas skyrocketed to 70 percent overnight.

Because the homeownership rate has risen, an even greater part of the population–mainly in the urban areas–is enjoying the benefits of rising real estate prices. This substantial subset would also appreciate the government doing everything it can to prevent a violent decline. Although the government has stepped in to cool the housing market, it will do everything in its power to sustain the real estate cycle.

This doesn’t mean mistakes won’t be made; what we expect is that those from two years ago won’t be repeated. And there’s no sign yet that Chinese authorities have selected a path of total ruin for the housing market this time around.

On the bubble issue things are much simpler to evaluate. Demand remains strong because a significant part of the population in the big cities is in the process of upgrading from the old apartments they received more than 10 years ago, while people in smaller cities are eager to obtain their first homes. And China’s leaders have expanded plans call for urbanized growth in the so-called second- and third-tier cities; the housing sector should remain in growth mode for some time.

Chinese real estate finance isn’t fancy. In other words, home equity loans, option ARMs, extensive securitization and the like don’t exist. Twenty five percent of all housing transactions are in cash. The rest of the market operates through simple mortgages, where the minimum down payment is 20 percent. Many new homebuyers put down 30 or even 40 percent.

Accordingly, China’s banks have manageable, if not necessarily small, exposure to the property sector. In 2009 loans to real estate developers accounted for 6.3 percent of total outstanding loans, while mortgages accounted for 12 percent. The banking system’s total exposure to real estate loans is slightly north of 18 percent–not a large number by Chinese or international standards.

Absent a massive blunder, the Chinese real estate market will cool down but much less than the market currently discounts–and it certainly won’t collapse–because of policy decisions.

I’m inclined to agree with Yiannis’ outlook for China. In the first quarter of 2010, the Chinese economy grew at the blistering pace of 11.9 percent, well above most expectations. Growth of that magnitude is unsustainable, but the Chinese economy likely will grow 9 percent in 2010, hardly a collapse.

And don’t ignore India, Asia’s third-largest economy. The Indian government recently pledged to bump up spending on basic infrastructure such as ports, roads and bridges; the lack of basic modern infrastructure traditionally has impeded Indian growth.

In recent years China has spent considerably more on infrastructure than India, but that’s beginning to change; the Indian government doubled its target for infrastructure spending from USD500 billion to USD1 trillion between 2012 and 2017.

If India successfully modernizes its basic infrastructure, the country’s economic growth could accelerate. Some analysts now believe that India could overtake China to become the fastest- growing economy in the region.

Global oil demand would benefit from if India’s growth rate accelerated, but the biggest winner among energy commodities would be thermal coal, a variety used in power plants.

India plans to rapidly expand its coal-fired power plant capacity over the next few years and was already expected to be the world’s fastest-growing coal consumer. An uptick in India’s economic growth ramp up demand for coal, most likely sourced from Australia.

Puzzling It Out

To summarize: My base case is that the current downdraft is a correction of the cyclical bull market in stocks that began in March 2009.

Macro concerns are driving the market, energy commodities and energy-oriented stocks–not stock-specific issues. Usually earnings are the main driver of stocks at this time of year, but that’s clearly not the case: 82 percent of S&P 500 companies reporting to date have beaten earnings expectations for the first quarter, and nearly 70 percent have beaten on the top line. And earnings season has been even rosier for energy stocks in the S&P 500, with a higher percentage of companies beating on both sales and earnings than for the market as a whole.

Although macroeconomic and credit risks exist, the market is overplaying these factors. The still-fresh memory of the 2008 credit contagion is driving the overreaction.

Here’s a basic review of what I see ahead for the broader market, various energy-related sectors and key energy commodities.

Broader US Markets

The broader market will fall a bit further in coming weeks. Some believe that technical analysis–the analysis of charts– is voodoo but in my experience it’s a legitimate and useful tool, especially when emotions run high. At a minimum, I expect the S&P 500 to touch its 200-day moving average of around 1,100 again before the pullback is over.

I also see the annual lows the S&P 500 set this February as a likely near-term target. This would put the S&P 500 under 1,050, roughly a 15-percent pullback from its April highs. If the February lows are breached by a significant margin in the near term, I would reassess my view that this is only a correction.

As a roadmap for the current market, I continue to look to the S&P 500’s movements in 2004. I explained the similarities between 2003-04 and 2009-10 in The Crystal Ball, and the pattern remains consistent, though the markets topped out earlier in spring 2004. If the pattern holds, markets will stabilize and trade sideways to slightly lower into the summer before rallying into year-end.

Although two historical periods rarely correspond exactly, market trading history has a tendency to rhyme, and there are some fundamental similarities to 2003-04. At a minimum, putting a correction in historical context can reduce anxiety and emotion, enabling you to make better trading decisions.

Another point to note is that the US stock market appears strong relative to international markets. The European debt crisis has exposed some of the problems inherent in a system where monetary policy is controlled centrally but fiscal policy is largely exposed to the whims of national governments. Accordingly, the euro has lost some credibility as a reserve currency, and the dollar has picked up some fans.

Demand for US assets is on the rise. According to data from the US Treasury Dept, global demand for US assets rose to a monthly record level of $140.5 billion in March, double what had been anticipated. As you might expect, the majority of the purchases were focused on US Treasuries; however, foreign demand for US corporate bonds rose for the first time since May, 2009 and foreigners also bought US equities.

Inflows into the US should keep interest rates low for a time despite the country’s staggering deficits. Buying interest in US stocks and corporate bonds is also encouraging and reflects the fact the strength of the US recovery.

Crude Oil

US West Texas Intermediate (WTI) crude oil prices are down around 20 percent from highs reached less than a month ago. Prices sliced through $70 a barrel this week, and there’s room for further downside in the near term. Crude oil should find technical support around $65 or $66 a barrel, and there’s a bit of resistance at $60 a barrel.

I expect crude prices to stabilize in this region and mount a recovery; I stand by my long-held outlook that oil will reach $100 a barrel by year-end.  

There are several fundamental trends in the crude oil market to keep an eye on.

First, the market is focused on Europe and is largely ignoring the potential for a significant US supply disruption resulting from BP’s (NYSE: BP) Macondo spill in the Gulf of Mexico. As fears surrounding the EU debt crisis fade, I expect the supply disruptions from the spill to be in the headlines yet again. I analyzed this spill at great length in the most recent issue, Opportunity amid Crisis.

The only update worth noting is that the US government has, as I expected, put a freeze on new drilling permits in the Gulf pending its investigation into the Horizon incident. This would have no impact on permits issued prior to April 20 or on projects currently underway, but it means at least a near-term slowdown in some Gulf drilling activity.

This shouldn’t be a big problem for most deepwater contractors, including Transocean (NYSE: RIG) and Gushers recommendation Seadrill (NYSE: SDRL), because these companies lease their rigs under multiyear deals and get paid whether or not the lessee uses the rigs. For the reasons I outlined in the last issue, Transocean isn’t a recommendation in the model Portfolios. I continue to prefer Seadrill thanks to its young fleet, high dividend and lack of exposure to the Gulf drilling permit moratorium. Buy Seadrill under 29.

Companies with heavy jackup exposure in the Gulf are most at risk. Jackups are used to drill wells in shallow waters and tend to be booked under relatively short-term contracts. Lack of new permits may make it tough to roll over jackups in the region once current contracts expire.

The fundamental impact won’t be huge unless the ban extends well into 2011, but this will be a negative for jackup-focused contractors such as Rowan (NYSE: RDC), Ensco (NYSE: ESV), Seahawk Drilling (NasdaqGS: HAWK) and Hercules Offshore (NasdaqGS: HERO). None of these stocks have featured in the model Portfolios since the autumn 2009, but I’m cutting all to a “Hold” in the How They Rate coverage universe for now.

I continue to recommend Noble Corp (NYSE: NE) in the Wildcatters Portfolio; the company is one of the best-managed drillers in my coverage universe. That being, said near-term upside catalysts suggest investors should favor Seadrill over Noble for now.

As I noted in the last issue, Diamond Offshore (NYSE: DO), rated a Sell in my How They Rate Coverage Universe, is among the most vulnerable contract drillers. With its older fleet, the company stands to lose out from any new regulations governing the age and equipment on deepwater rigs in the Gulf.

And because Seadrill offers a superior yield, I expect yield-hungry investors to desert Diamond in favor of Seadrill. I continue to look for a short-term rally in shares of Diamond Offshore to recommend a short position for a trade.

Another important trend to watch is the spread between the price of West Texas Intermediate (WTI) and Brent Crude oil. WTI is the US crude oil benchmark, while Brent is regarded as the international oil benchmark.


Source: Bloomberg

Over the past 20 years WTI has traded at an average premium of $1.38 per barrel to Brent. Although both Brent and WTI are light, sweet crude oils–both grades are low in sulfur and relatively easy to refine–WTI is of a slightly better quality than Brent and commands a slight premium.

However, in recent sessions the normal relationship has broken down; Brent trades at a premium as high as $5.50. The graph confirms that this is an unusual, albeit not unprecedented pattern, for the WTI-Brent spread.

Brent represents international oil supply and demand, while WTI reflects the US oil market. The unusual premium for Brent suggests that traders regard global oil markets as tighter than in the US.

Over the past few years a big jump in the Brent-WTI spread reliably has signaled that WTI oil prices were at or near a low.

The Brent-WTI spread pattern is consistent with my forecast that crude oil prices will be well-supported just below current levels.

Two other factors suggest the recent dip in oil prices is a temporary phenomenon.

First, contango in the crude oil futures market has increased markedly in recent weeks; in other words, much of the weakness in crude oil prices has been focused on spot oil and near-term future contracts. For example, although June 2010 US crude oil futures are trading at just under $70 a barrel, the June 2011 futures are over $80 a barrel; the futures market appears to be pricing in a rather quick recovery in crude prices to over $80 a barrel.

Second, although oil-levered stocks have fallen alongside oil and the broader markets in recent weeks, the declines have not been as dramatic. The exceptions are stocks directly connected with the Macondo spill. The TES Oil Index–my proprietary index of companies directly tied to oil production and exploration–is off just 5.3 percent over the past two weeks, whereas crude prices are down 16 percent. As oil stocks tend to reflect long-term fundamentals, this bodes well for upside.

I continue to like oil-focused exploration and production companies, including Africa-focused explorer Afren (London: AFR), US unconventional oil explorer EOG Resources (NYSE: EOG), Brazilian deepwater specialist Petrobras (NYSE: PBR) and Occidental Petroleum Corp (NYSE: OXY), a firm with a hot new oil play in California. All of these plays remain buys in the model portfolios.

Getting Refined

One of the best-performing groups in my coverage universe of late has been the North American refiners. There are a few legitimate reasons for that superior performance.

First, the group was already trading at depressed valuations, and sentiment was negative heading into this crisis; the stocks just didn’t have that much additional downside. I explained some of the long-term headwinds facing the refiners in the February 17 issue A New Dark Age for Refiners and provided a lengthy rationale for buying Valero Energy Corp (NYSE: VLO) as a trade on improving refining profitability and rising US oil demand. So far, this trade has worked out well; Valero has been a steady stock in a volatile market.

Refining margins continue to see upside. The recent selloff in oil prices has helped margins by lowering refiners’ feedstock costs. The price of oil has fallen faster than the prices of gasoline, diesel fuel and other refined products. The 3-2-1 crack spread I highlighted in the February 17 issue has exploded from around $7 a barrel in mid-February to $16 a barrel as of the most recent reading. That’s the highest crack spread in well over a year.

More important, signs of an uptick in US crude oil demand are emerging.  The US Energy Information Administration compares demand for oil over the most recent four-week period compared to the same period a year ago in each of its weekly inventory reports. As of the most recent report, US motor gasoline demand is up 2.7 percent year over year, US distillate (diesel and heating oil) demand is up 7.5 percent and jet fuel demand is up 1.8 percent.

The recovery in US oil demand is linked to the broader US economic rebound. As I noted earlier, the US recovery isn’t likely to be undercut by European credit contagion; in fact, investors may favor US-oriented sectors such as in the near term.

Valero is a buy under 20, with a stop-loss order at 16.95. 

Master Limited Partnerships

In a market roiled by macroeconomic concerns and commodity-price volatility, energy-related master limited partnerships (MLP) remain one of my favorite plays. MLPs are companies organized as partnerships that trade on the major exchanges just like any other stock.

Because MLPs are partnerships, not corporations, they don’t pay any corporate level tax. The US corporate tax is the second-highest in the world, so this is a major advantage.

As partnerships, MLPs pass through the majority of their income to investors in the form of regular distributions; the average MLP currently yields around 7 percent. Each investor is responsible for paying tax on their share of distributions received. But MLP distributions are highly tax-advantaged and offer a significant tax shield for investors.

Because MLP distributions aren’t dividends, MLP unitholders receive a Form K-1 at tax time instead of a Form 1099. 

But there are some big tax benefits to owning MLPs. Because of depreciation allowance, 80 to 90 percent of the distribution you receive from a typical MLP is considered a return of capital by the IRS. You don’t pay taxes immediately on this portion of the distribution.

Instead, return of capital payments serve to reduce your cost basis in the MLP. You’re not taxed on the return of capital until you sell the units.

In other words, 80 to 90 percent of the distribution you receive from the MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But the piece taxed at full income tax rates is only 10 to 20 percent of the total distribution; there’s still a huge deferred tax shield for unitholders.

Most MLPs are involved in the midstream energy business, owning assets such as pipelines, storage facilities and gas processing plants. The hallmark of these assets is that they’re highly cash generative and have little sensitivity to either commodity prices or economic conditions. For example, pipeline tariffs are not based on the value of the commodities that flow through the network but on the volume of oil or gas. And, in many cases, shippers actually pay a fee for pipeline capacity whether they actually ship gas or not.

The only macroeconomic factor that I can see derailing the MLPs as a group is a major freeze-up in global credit markets akin to what we witnessed in 2008, the the worst year ever for the MLPs. That year the Alerian MLP Index dropped 37 percent because investors feared partnerships wouldn’t be able to raise the credit needed to fund new pipelines and other expansion projects. The group rebounded nicely in 2009 as credit markets normalized, rallying to a best-ever gain of more than 76 percent.

As I noted earlier, I don’t see evidence that the EU crisis is spreading to US credit markets. Access to capital remains solid. Wildcatter recommendation Linn Energy is just one publicly traded partnership that completed a major bond issue over the past two months. The partnership had planned to issue $500 million in bonds, but management increased the offering to a hefty $1.3 billion to meet demand.

Just a few weeks ago many of my recommended MLPs traded above my buy targets. This recent dip gives investors a second chance to jump into the group. The table below shows all of the buy-rated MLPs in the model Portfolios, their current yields and my advice. Note that I am altering my buy under targets on a handful of these recommendations.

Source: Bloomberg

Here’s a rundown of recent results and my take on each of these recommendations.

Enterprise Products Partners LP (NYSE: EPD) is one of the oldest and largest MLPs in the US and also among the group’s most consistent, reliable wealth builders. As we noted in the March 29 Flash Alert Dan Duncan, RIP, Enterprise’s revered founder Dan Duncan passed away in March. This caused a temporary sell-off in the MLP, but Duncan’s hand-picked management team has since shown that they have absolutely no intention of changing the strategy that Duncan put in place.

Duncan’s estate has also signaled their confidence in the strategy and existing management team by agreeing to reinvest the distributions they receive from their holdings in Enterprise. Those reinvestments could total more than $150 million over the balance of 2010–a huge endorsement for the stock. As investors we can only wish that more companies exhibited the consistently shareholder-friendly policies that Enterprise and Dan Duncan have over the years.

Duncan’s passing hasn’t slowed Enterprise’s appetite for deals. The company announced the $1.2 billion acquisition of natural gas gathering and treating facilities in Louisiana’s Haynesville Shale. Haynesville gas is cheap to produce, and drilling activity has remained robust despite weak gas prices. However, Haynesville gas also tends to be relatively high in carbon dioxide–natural gas treating plants are used to remove CO2 from the gas stream.

As I explained in the April 28 issue of The Energy Letter Why Some Natural Gas is Worth $7.28, many producers drilling in unconventional gas shale plays are targeting natural gas liquids (NGL), not gas itself. Enterprise is well placed to take advantage because it’s one of the largest owners of NGL pipelines, natural-gas processing facilities and fractionation plants.

In fact, earlier this month, Enterprise signed a six-year deal to process and fractionate natural gas for Wildcatter  recommendation Anadarko Petroleum Corp (NYSE: APC). Processing involves the removal of NGLs from raw gas. Fractionation is the separation of a barrel of NGLs into its constituent products.

Enterprise recently raised $2 billion in capital via a bond issue, a sign its access to capital hasn’t been impacted by the crisis. Buy Enterprise Products Partners LP under 36.

Duncan Energy Partners LP (NYSE: DEP) is Enterprise’s sister MLP and part of the same organization. Though much smaller, Duncan also has a strong position in processing and NGL pipelines, markets likely to remain hot due to the growing supply of NGLs from US shale gas plays.

I had considered cutting Duncan to a hold before the crisis, as it didn’t offer a yield advantage over the larger Enterprise. However, the recent dip has pushed the yield around 0.5 percent above that of Enterprise, and both MLPs offer among the lowest risk in my coverage universe. Duncan Energy Partners LP is a buy under 25.

Kinder Morgan Energy Partners LP (NYSE: KMP) announced a joint venture with a key Haynesville producer and fellow Portfolio recommendation, Petrohawk Energy Corp (NYSE: HK). Dubbed KinderHawk, this joint venture involves 170 miles of gathering pipelines that Kinder plans to more than double by the end of 2010.

And KinderHawk isn’t Kinder Morgan Energy Partners’ only exposure to US shale plays. During the MLP giant’s first-quarter conference call, management revealed that it’s in early discussions about a pipeline which would transport NGLs produced in the Marcellus Shale to the Midwest. Marcellus Shale produces wet gas–gas high in NGLs–and lacks sufficient processing and pipeline capacity to handle the projected growth in output.

Kinder Morgan Energy Partners is gauging producers’ interest in a 250-mile pipeline extending from the heart of the Marcellus to an interconnect point with its existing Conchin pipeline. From that point, the NGLs could be transported via Conchin to major markets in Chicago and Sarnia, Ontario. The MLP believes it could initially handle 75,000 barrels per day of NGLs. A modest expansion could bump capacity up to 175,000 barrels per day.

This is the type of organic expansion project for which Kinder Morgan Energy Partners is famous. After identifying an emerging need, the MLP proposes a solution and arranges long-term, fee-based deals with producers to guarantee profitability before breaking ground.

Management also mentioned in passing that it’s also looking at the possibility of using the western reaches of the Conchin to transport oil out of the Bakken Shale, another are sort of pipeline capacity. At present, EOG Resources relies on freight rail to transport a significant portion of the oil it produces in the region to market.

And while these growth projects suggest a rosy future for the MLP, current operating conditions have also improved. Business has ticked up across the firm’s five operating segments, all of which should finish the year above budget. Kinder Morgan Energy Partners hiked its quarterly payout from $1.05 to $1.07 and has announced a year-end target distribution rate of $1.10.

But that target distribution rate now looks conservative. The MLP covered its new first-quarter distribution rate 1.1 times. Based on new projections, the outfit will likely generate significantly higher distributable cash flow than initially forecast.

A few comments from Kinder Morgan Energy Partners’ conference call are worth noting. First, the company has invested heavily in terminals and other infrastructure needed to blend ethanol with gasoline. This business has grown to the point that it handles nearly one-third of all ethanol volumes produced in the United States. In particular, the MLP has expanded its operations in California where the mandated gasoline-ethanol blend rate increased recently from 5.7 to 10 percent. Mandated increases in ethanol consumption over the next few years are another growth tailwind for Kinder Morgan Energy Partners.

And despite a forced shutdown of the Rockies Express pipeline (REX) early in the quarter, the MLP’s natural gas segment still produced results that beat expectations. Buy Kinder Morgan Energy Partners LP under 70.

NuStar Energy LP (NYSE: NS) operates in two major business lines: crude oil midstream and asphalt refining. The crude oil and refined products midstream business essentially involves transporting crude to refineries and refined products like gasoline from refineries to market. At its oil terminals and storage facilities, NuStar also handles some basic ancillary services such as fuel blending.

The refined products midstream business is about as conservative as it gets. Tariffs are reset annually based on inflation to protect the MLP’s return of capital. And while refined products volumes dipped somewhat during the recession of 2008-09, demand in the US market is returning.

The asphalt refining business is a riskier proposition. The MLP actually owns refineries that convert heavy crude products into asphalt used in construction and highway projects. The ownership of this business exposes NuStar to some degree of refining margins, a concept I discussed earlier with reference to Valero.

That exposure is mitigated in a few different ways. First, not all refineries can produce asphalt, and overall capacity has declined in recent years; NuStar is one of the largest players in the business. In addition, NuStar doesn’t distribute all of the cash flows it earns form this segment of the business; when margins drop, this withheld cash acts as a cushion shielding the MLP’s payout.

The first quarter is a weak one for asphalt demand because winter weather prevents construction. Accordingly, I’m not overly concerned that NuStar didn’t cover its distribution last quarter. In fact, it’s likely that planned organic growth projects and a seasonal increase in refining activity will mean the MLP can actually grow its payout slightly this year. NuStar Energy LP rates a buy under 60.

Penn Virginia Resources (NYSE: PVR) and Natural Resource Partners LP (NYSE: NRP) are both coal-focused MLPs. Coal MLPs typically don’t operate coal mines but own the mines and charge producers a royalty based on the volume of coal produced.

A typical lease provides several different sources of revenue for a coal MLP. First, coal MLPs normally take a guaranteed minimum fee whether the firm leasing their properties mines coal or leaves its mines idle. Even in weak coal markets, this minimum contractual fee means that the MLP is guaranteed some base level of cash flow.

On top of those contractual minimums, coal leases generally provide for a fixed fee per ton sold and a percent of the gross sales price generated by coal mined from their properties. This offers the coal MLP multiple layers of protection.

First, per-ton fees are based on volumes of coal mined, not the value of the coal; fluctuations in coal prices don’t necessarily impact an MLP’s cash flows. However, the percent of sales royalties offers the coal MLP an upside cash flow bonus in periods of high coal prices. In effect, the MLP takes on relatively limited downside in exchange for significant upside potential.

Of course, weakness in coal prices and demand spells lower output from mines and falling coal volume fees. However, this effect is limited somewhat by the fact that most mining firms contract with utilities in multiyear deals. These contracts typically force the utility to accept delivery of some coal each year, regardless of current mining conditions; the nature of the coal contracting business helps to mitigate the risks of fluctuating coal output from an MLP’s mines.

That being said, it’s extremely important to note that these factors mitigate but do not eliminate risk; coal MLPs still carry significantly more commodity and economic risk that the straight fee-based midstream MLPs.

As I’ve explained in recent issues, volumes of coal produced in the US have been relatively weak over the past year because utilities have too much coal in their stockpiles. That being said, the situation is improving thanks to strong demand and pricing for metallurgical coal–coal used in steelmaking–and the fact that inventory coal stockpiles are falling back to more normal levels.

Of the two coal MLPs, Penn Virginia Resources carries the lower risk profile thanks to its diversification into the natural gas midstream business in recent years. One particularly attractive growth prospect for Penn-Virginia is a deal it inked with fellow Portfolio recommendation Range Resources (NYSE: RRC) to handle gas gathering in the Marcellus region. Marcellus is an attractive growth area because the gas in this region tends to be high in NGLs. Penn Virginia Resources and Natural Resource Partners LP both rate buys.

Teekay LNG Partners LP (NYSE: TGP) owns tanker ships that transport liquefied natural gas (LNG). The partnership leases these vessels under 15- and 20-year fixed-rate contracts to major producers. It’s important to note that regardless of gas demand or pricing, Teekay gets paid a fixed rate for its ships–this is a steady business with no exposure to commodity prices or the economy.

Upside for Teekay comes from building new ships; the firm doesn’t build a ship until it has a contract in place to generate cash flows. Teekay LNG has been growing its payout at a steady clip and has had no trouble financing new deals for ships by either issuing units or taking on debt. Buy Teekay LNG Partners LP under 30.

I’ve issued several Flash Alerts concerning Linn Energy LLC (NasdaqGS: LINE) over the past few months. Suffice it to say that the firm has raised considerable capital through issuance of new units and the $1.3 billion bond offering I discussed earlier in today’s issue.

The company is using those funds to buy oil and gas-producing assets such as recent buys in the Permian Basin of Texas and Michigan’s Antrim Shale. Such deals should be almost immediately accretive to cash flows.

As Linn is a producer of oil and gas, revenues vary with commodity prices. But the company offsets this risk by hedging oil and gas production for years into the future; Linn is fully hedged for this year and next and has significant hedges covering 2012 oil and gas production.

As Linn continues to deploy capital in new acquisitions I look for the partnership to hike its distribution before the end of 2010. Buy Linn Energy LLC under 28. 

Much like NuStar, Sunoco Logistics Partners LP (NYSE: SXL) is in the midstream business but it doesn’t have exposure to actual refining.

Sunoco is benefiting from the general up-tick in US oil and refined products demand. In the most recent quarter, the MLP boosted its distribution for the 27th time out of the last 28 quarters, a remarkable record.

The distribution is nearly 10 percent higher than it was a year ago, and Sunoco covers its payout 1.6 times–among the highest coverage ratios of any MLP in my universe.  Buy Sunoco Logistics Partners LP under 68.

Finally, I am cutting closed-end MLP fund Tortoise Energy Infrastructure (NYSE: TYG) from a buy to a hold as of this issue. This move has nothing to do with the quality of the MLPs the fund holds; rather, the fund is now trading at a 25 percent premium to its net asset value (NAV). That’s a fancy way of saying that the closed-end fund is worth more than the value of all of the MLPs it holds in its portfolio.

Investors looking for a replacement should consider the Kayne Anderson Energy Fund (NYSE: KYE) as a buy under 27. The fund holds a similar mix of MLPs but has a premium of closer to 6 percent. I will look to boost my target on the Tortoise fund again as the premium evaporates.

The TES Indexes

As I’ve reviewed the major sector movers in the TES portfolios in the text of this issue, I won’t belabor the point here. Here’s a rundown of the TES Indexes I introduced in the April 21 issue, First-Quarter Recap.

Source: Bloomberg, The Energy Strategist