Editor’s Note: Because there are five Wednesdays in June, the next issue of The Energy Strategist will be delivered on June 23. During this three-week production break, Elliott will issue Flash Alerts as needed to keep readers apprised of key developments affecting Portfolio recommendations and global energy markets.

A steady stream of negative news and sensationalist headlines is behind the extreme volatility in global markets. News from Europe or the Gulf of Mexico seems to nip every promising rally in the bud.

News-driven markets are tough to navigate because stocks move on emotion and panic, not underlying fundamentals. The good news is that the S&P 500 has touched 1,045–a target I outlined in the last issue–and the prevailing negative sentiment is overdone. I expect markets to stabilize, setting the stage for rally later this summer. 

I recommend a three-pronged strategy for this market. First, focus your investment dollars on my summer safe-haven plays. These stocks have no exposure to headline risk from the oil spill in the Gulf of Mexico, and some names may even benefit from the disaster.

Second, I’ve re-examined the prospects for companies with exposure to the Macondo disaster, taking into account the recent stepped-up rhetoric from the Obama Administration and the failure of BP’s (NYSE: BP) latest efforts to stop the flow of oil. In this issue I outline several opportunities to take advantage of the market’s overreaction and highlight a way to use options to hedge against downside.

Finally, a summer rally will provide opportunities to take short positions in a stock or stocks that have real downside exposure to the Gulf spill.

In This Issue

The Stories

Europe’s ongoing sovereign debt scare and the Macondo well disaster continue to produce their fair share of tape bombs. I outline my game plan for navigating these volatile markets. See Tape Bombs.

Is a double-dip recession in the cards? I tune out the noise and look at the underlying fundamentals. See No Double Dipping.

I’ve examined the EU’s sovereign debt crisis at some length in previous issues. Expect this story to generate further headline risk this summer, but don’t believe the hype. See Credit Shock.

My summer outlook for the broader market and various energy commodities underpins my strategy. See Summer Outlook.

The ongoing disaster in the Gulf of Mexico continues to grab headlines and wreak havoc on stocks in the energy sector. Here’s my take on how the spill will impact energy-related industries and which groups offer the best investment opportunities. See The Macondo Disaster.

There are safe havens amid all this headline risk and volatility. See Safe Havens.

The Stocks

BP (NYSE: BP)–Buy in How They Rate
Anadarko Petroleum Corp (NYSE: APC)–Buy in How They Rate
Seadrill (NYSE: SDRL)–Buy @ 29, No Stop
Cameron International Corp (NYSE: CAM)–Buy in How They Rate
Weatherford International (NYSE: WFT)–Buy @ 26
Schlumberger (NYSE: SLB)–Buy @ 85
Baker Hughes (NYSE: BHI)–Buy @ 55 with one $35 Oct. 2010 put option for each share
Afren (London: AFR)–Buy @ GBP1.15
Petrobras (NYSE: PBR.A)–Buy @ 37
EOG Resources (NYSE: EOG)–Buy @ 115
Occidental Petroleum Corp (NYSE: OXY)–Buy @ 85
Range Resources Corp (NYSE: RRC)–Buy @ 60
Petrohawk Energy Corp (NYSE: HK)–Buy @ 30
Nabors Industries (NYSE: NBR)–Buy @ 28
Tenaris (NYSE: TS)–Buy @ 47
Valero Energy (NYSE: VLO)–Buy @ 20, Stop @ 16.25

Tape Bombs

A “tape bomb” is a piece of news that causes the entire market to sell off. It’s perhaps the most succinct description I’ve heard of what global markets have faced in recent weeks. It seems that every time the market begins to find its footing and rally, another tape bomb sends the broader averages lower yet again. 

The European credit crisis has brought its fair share of tape bombs, including the German government’s surprise decision to restrict short-selling, a series of negative comments from European Central Bank (ECB) president Jean-Claude Trichet and the latest news about Spain’s troubled banks. The oil spill in the Gulf of Mexico has also produced a bevy of tape bombs, including the failure of BP’s “top-kill” to stem flow from the well, President Obama’s increasingly severe rhetoric toward the industry, and the expansion of the Gulf drilling moratorium outlined in Tuesday’s Flash Alert, Politics and the Gulf of Mexico.

There’s good news and bad news to report. Let’s start with the bad news: This headline risk could continue for some time and will cap potential gains for the broader market over the summer months.

Last issue, I examined global credit markets and concluded that the risk of a credit contagion akin to what we witnessed in 2008 is slim. Further, the slowdown in Greece and other peripheral EU economies will have little or no impact on US economic growth.

Nonetheless, I can almost guarantee that Europe’s sovereign debt crisis will produce more tape bombs in coming months; the market can and will flinch after every negative comment from EU officials, signs of social unrest or any negative headlines to from EU banks.

As for the Macondo spill, the consensus opinion is that BP won’t be able to stop the spill until August, when it’s slated to complete two relief wells. Even assuming the company’s plan proves successful, there’s still plenty of room for tape bombs–an extension to the drilling moratorium, hurricane-related complications, and talk of stringent regulations on deepwater drilling are all possibilities. 

The main problem with headline risk and tape bombs is that they tend to produce volatile, emotional markets that have little regard for underlying fundamental forces.

The good news is that there are plenty of opportunities to make money in a market rife with headline risk.

First, remember that fundamentals will ultimately win out. The broader market averages already evince signs of news fatigue; institutional investors have already sold down their exposure to risky assets, and stocks are beginning to price in a good deal of bad news. Note that the market hasn’t reacted quite as dramatically to recent tape bombs relative to its movements in early May. 

As I noted in last week’s issue of The Energy Letter and the most recent issue of this publication, oil prices have plenty of support in the mid- to upper $60s. Lower prices likely will encourage US demand growth, while the Macondo debacle spells weaker supply and higher prices. I continue to regard the dip in oil-levered and select energy stocks as a massive buying opportunity.

Clear winners and losers are beginning to emerge in the energy patch. Although stocks leveraged to US offshore and deepwater spending have suffered across the board, high-yield master limited partnerships (MLP), refiners, onshore producers in North America and energy plays focused on reserves outside the US have all exhibited signs of strength. I see several safe havens emerging that will do well this summer regardless of BP’s ongoing troubles offshore.

Finally, there are enormous opportunities for traders and those willing to get a bit more creative with stock options.

To summarize, I recommend a three-part strategy for playing energy this summer:

1. Focus on safe-haven sectors. This list would include stocks that aren’t vulnerable to headline risk from the Gulf of Mexico or that stand to benefit from new regulations imposed in the wake of the spill. By safe havens, I don’t necessarily mean slow-moving or defensive energy subsectors. And because institutional investors are reallocating funds from BP, Transocean (NYSE: RIG) and other at-risk names to other energy groups, these stocks will benefit from sector rotation over the summer.
2. Tend to some hedges. Examples of hedges include stocks that can perform well in an environment of range-bound or lower oil prices. Examples include refiners, transportation stocks and airlines. And in the event of a bounce, I’m eyeing several stocks as potential short candidates or put-option plays. One name on my radar is Diamond Offshore (NYSE: DO), a company that faces significant negative impacts from the Macondo spill.
3. Add downside protection with options. Many investors look at stock options as a way of making aggressive speculative bets on a stock or index. Options can be used in that manner, but there are several ways to use options as a means of hedging downside risk in your portfolio.

No Double Dipping

Memorial Day traditionally marks the unofficial start of summer, a time when many institutional players simply aren’t at their desks and trading activity tends to ebb.

But summer is never a quiet time for the energy industry. This year, the headlines will be dominated by BP’s efforts to permanently plug the Macondo well and the spill’s political fallout. Summer also marks the peak period of US oil demand. With the economy on the mend and retail gasoline prices off their recent peak, investors will be watching for signs of a further pick-up in US oil demand.

And don’t forget about the weather. Current seasonal predictions suggest that the US and Europe are in for a hot summer, setting the stage for a jump in demand for electricity and key power-generating commodities such as coal and natural gas. Most forecasters are also projecting a much worse-than-normal Atlantic hurricane season; the potential for multiple storms to impact the Gulf tends to put a floor under natural gas prices.

As I’ve written in recent issues, risk of a double-dip recession is minimal and fears of a global credit contagion are massively overblown. US economic data remains broadly supportive of upside. The latest reading of the ISM Manufacturing Index is a case in point.

Source: Bloomberg

The ISM Manufacturing Index, a measure of US manufacturing activity fell from 60.4 in April to 59.7 in May. But levels above 50 indicate growth in manufacturing, and the ISM tends to be weak in May because of seasonal factors. Economists had called for the index to decline to 59, so the May report was better than expected.

Furthermore, the general trend remains positive for manufacturing; the index has been above 50 for XX consecutive months.

Friday’s non-farm payroll report is another key piece of economic data. The consensus expects the release to show that the US added 500,000 in May. Economists estimate that the US Census Bureau accounted for 300,000 of these jobs, suggesting that the private sector created 175,000 to 200,000 jobs last month. The market will react primarily to the pace of private-sector hiring.

Here’s a look at the non-farm payrolls data over the past few years.

Source: Bloomberg

Last summer I made the case that the US economy was emerging from recession; the Conference Board’s Leading Economic Index (LEI) had turned positive on a year-over-year basis and global credit conditions were easing.

Each time I explained my outlook, I received e-mail asking about the jobs market. It’s a common misconception that economic growth can’t occur without job creation.

But employment is usually a lagging indicator. In the early stages of a downturn, companies are usually reluctant to lay off workers because of fears that they’ll be understaffed if the downturn proves short-lived. By the same token it takes companies a while to gain enough confidence in a recovery to resume hiring.

Every business cycle includes a small cadre of market bears who argue that employment is no longer a lagging indicator but a sign of what’s ahead. Remember that the most expensive words in finance are “this time it’s different”–employment and, in particular, the unemployment rate remain lagging indicators for the economy as a whole. As you can see in the graph above, US private payrolls began to grow a few months ago–long after the economy troughed.

An uptick in employment will reinforce the economic cycle; job creation drives consumer confidence, spending and income growth. If May’s employment report indicates that over 200,000 jobs were created, this reading would drive a stake through one of the last remaining bearish arguments against the US economy.

Data out of Europe’s core economies also remains on track. One indicator to keep an eye on is the Eurozone Manufacturing Purchasing Managers Index (PMI).

Source: Bloomberg

PMI readings above 50 reflect an expansion in manufacturing activity. At 55.8, the index is only slightly off the 57.6 reached in April; manufacturing activity continues to pick up.

And if you’re predicting a double-dip recession, you’re not playing the odds. A good working definition of a double-dip recession is an instance where the economy exits recession and then re-enters within one calendar year.

Consider the official business cycle dates from the National Bureau of Economic Research (NBER). From 1854 onward there were a total of 33 economic expansions, but only three of these expansions lasted 12 months or less. If we widen the definition to include expansions of 18 months or less, the number of double-dips climbs to just five.

By my definition, the last double-dip recession occurred in the early 1980s. The economy expanded from March 1975 to January 1980, then entered a recession that lasted a total of six months. (Incidentally, this recession was the shortest of any in US history as declared by the NBER).

The economy then expanded from July 1980 to July 1981, before re-entering recession. This time the recession was both far longer and far deeper; the economy shrank for 16 straight months, and some indicators suggested that the contraction was on par with the recent downturn.

Happily, that nasty retrenchment gave way to a series of much stronger cycles. The US economy enjoyed three of its longest expansions in history from November 1982 to November 2007.

But consider what precipitated the double-dip in the early ‘80s. In June 1980, the federal funds rate hovered around 9 percent, but by December of that year, under the leadership of Federal Reserve Chairman Paul Volcker, the rate was around 20 percent.

The Fed kept rates in the upper-teens to low 20s until mid-1981, and rates didn’t break below 10 percent until late August of 1982.

In other words, the Volcker Fed engineered the vicious double-dip recession of the early ’80s in an effort to break inflation’s back. The strategy was painful in the short term, but inflation fell steadily in ensuing years, paving the way for a new era of prosperity. It took a massive monetary-policy intervention to kill the economy’s upside momentum in the early 1980s.

No such monetary policy shock looms this cycle. In fact, until the EU’s sovereign debt scare began to grab the headlines in late April, one of the main headwinds markets were expected to face over the coming year was the gradual reversal of extraordinarily accommodative monetary policy put in place during the 2008 crisis. In fact, many economists had expected the Fed to hike rates sometime in the back half of 2010. But the threat of credit contagion from Europe, no matter how remote, will likely keep the Fed on hold until 2011.

For the record, to find another double-dip recession, we have to go back to the 10-month expansion in the early 1920s and the 12-month upturn that got underway in late 1914.

A Credit Shock

Bearish analysts argue that tightening in global credit markets–a product of Europe’s sovereign debt scare–could shock the economy into a double-dip recession.

Although a contagion on the scale of what happened in 2008 would have that effect, credit market indicators still aren’t even close to the distressed levels witnessed in 2008. I wrote extensively about indicators of credit market health in The Big Picture: Energy Stocks and Europe’s Debt Crisis, but here’s a quick update. Let’s start with a look at the TED Spread.

Source: Bloomberg

The TED spread is a popular indicator of conditions in the interbank lending market. It’s calculated by comparing the three-month London Interbank Offered Rate (LIBOR) to the yield on a three-month US Treasury bond. LIBOR is the interest rates banks charge to loan to one another; an elevated TED spread indicates that banks are reluctant to lend to one another.

At the height of the 2008 credit crisis, Lehman Brothers’ bankruptcy sparked fear that other big financial institutions might be teetering on the edge of insolvency. LIBOR skyrocketed, the TED spread soared and the interbank lending market ground to a halt. Because LIBOR and the interbank market are key benchmark rates for all sorts of loans, these issues spread across the credit spectrum.

As you can see, the TED spread has ticked up but remains at less than 40 basis points (0.40 percent)–roughly one-tenth highs reached during the credit crunch. At current levels the TED spread is in line with its long-term average.

Risks to the interbank lending market still exist, particularly in Europe. French and German banks have the most exposure to loans in fiscally troubled Greece, Portugal, Spain and Italy. And some Spanish banks are suffering from bad loans related to the country’s real estate boom and bust over the past few years.

However, these risks have had only a minor impact on LIBOR thus far. And the EU’s trillion-dollar bailout package, coupled with fiscal austerity measures in affected countries, should further reduce risks of a massive sovereign default that puts major European banks in financial trouble.

Prices for credit default swaps (CDS) on debt issued by Italy and Spain show signs of stress. CDS are a means of insuring a bond against default; a rising price for CDS suggests growing risks of default. Here’s a look at the CDS market for both Italy and Spain’s bond issues.

Source: Bloomberg

As you can see, CDS prices rose sharply in late April, fell when the EU announced its bailout package and soared once again in mid-May. A significant decline in these CDS prices would represent a major fundamental support for global markets.

I expect these CDS markets to begin to stabilize over the next few weeks; despite all the headlines about riots and protests, the fiscally troubled EU countries are successfully passing massive austerity packages.

How nervous are traders? The media emphasized that the Spanish austerity bill passed last week by a single vote. But the main opposition to these measures came from Spain’s major opposition party, the center-right Popular Party. Why did the Popular Party vote against the austerity package? Its members sought deeper spending cuts. The close vote is hardly a sign of Spain’s reluctance to take the steps needed to shore up its fiscal situation. And the bill included unpopular measures such as significant pay cuts for public-sector employees.

And that’s not the only example of irrationality. On Monday and Tuesday the euro tumbled in value against the US dollar, retesting recent lows around $1.21. Many attributed this drop to a report from the ECB estimating the potential write-downs EU banks would need to take. Specifically, the ECB’s semiannual Financial Stability Review indicated that banks potentially face around EUR195 billion (USD240 billion) in write-downs for 2010 and 2010–EUR 90 billion this year and EUR105 billion in 2011.

Yet this estimate is lower than the EUR553 billion in write-downs the ECB said EU banks could face in its December report.

This knee-jerk selling suggests that negativity is running high–just the sort of sentiment that occurs at market lows. It also represents a marked contrast to mid-April when market participants embraced risk and appeared upbeat the economy and market’s prospects.

And credit concerns should gradually ebb as EU members approve the bailout package and fiscally strained governments continue to pass major spending cuts. Also, I expect headline risks to subside this summer, as many Europeans will be on holiday.

More broadly, unless we see a big jump in the TED spread or other signs that the EU’s sovereign crisis is infecting global credit markets, the risk that these issues will precipitate a double-dip recession appears remote.

Summer Market Outlook

Given that macroeconomic backdrop, here’s an updated look at my expectations for key markets over the summer.

Stocks

I outlined my general outlook for the broader US markets and crude oil in the last issue of The Energy Strategist and offered additional analysis of global oil markets in last week’s installment of The Energy Letter. My take is unchanged, so I won’t belabor the point in this issue.

The S&P 500 touched its February lows of just less than 1,050 and held that level–a normal 15 percent pullback from the April highs that I had forecast. I continue to regard the selloff as a correction within a cyclical bull market that started in March 2009, not the beginning of a new bear market.

Ultimately, panic over the EU’s sovereign debt challenges and positive news about the economy and corporate profits will put a floor under the market. Continued evidence that fiscally troubled EU countries are implementing austerity plans could provide an upside catalyst.

I expect the resistance levels at 1,040 and 1,050 to hold amid a broader rally this summer. Global stock markets are oversold, and a steady stream of negative news has failed to push markets below February’s lows–a sign that there’s already a great deal of negativity priced into stocks.

Crude Oil

I also expect oil prices to hold their May lows in the mid-USD60s. As I noted in last week’s issue of The Energy Letter, tanker flows to China and the Far East suggest that demand remains strong despite the government’s efforts to cool the red-hot economy.

Meanwhile, mounting evidence suggests that US oil demand is accelerating.


Source: Energy Information Administration

This graph tracks the year-over-year change in US demand for oil and oil products. These figures are based on the four-week moving average of demand to smooth out short-term spikes caused by unusual events.

As you can see, the year-over-year change in US petroleum demand is at 6.7 percent, the highest growth rate since 2006. Demand growth has clearly accelerated since the beginning of 2010.

According to data from the US Energy Information Administration (EIA), average retail gasoline prices topped out at $2.958 per gallon in the week of May 10, 2010, just a few weeks after oil prices hit their 2010 highs. In the week ended May 31, 2010, gasoline prices had already dropped nearly 20 cents per gallon. With crude prices still in the $70s per barrel, retail gasoline prices could decline further. Such a drop would coincide with a seasonal uptick in demand over the summer, fueling an uptick in US oil demand.

Bottom line: I doubt oil prices will reach new highs until there’s a clear sign that US crude oil and gasoline inventories are falling from glutted levels. At the same time, crude prices have ample support around $65 a barrel. Crude oil might retest last summer’s lows of just under $60 a barrel, but that worst-case scenario appears unlikely; US demand is accelerating, and forecasts call for a difficult hurricane season.

Natural Gas

Natural gas prices have remained resilient in the face of weakness in stocks, oil and industrial metals prices. The commodity has also shrugged off the fact that US gas in storage stands 16.3 percent above the five-year average.

I expect gas prices to be well supported through August based on three key trends: an uptick in US industrial demand, strong electricity demand driven by hot summer weather and the threat of an active hurricane season.

Although weather predictions are subject to significant error, the National Oceanic and Atmospheric Administration (NOAA) projects that 14 to 23 named storms will hit Atlantic this year including eight to 14 hurricanes and three to seven major hurricanes. This prediction is based on two major trends: Warmer-than-normal sea surface temperatures across most of the tropical Atlantic and the dissipation of the El Nino current in the Pacific.

El Nino conditions in the Pacific tend to inhibit hurricane formation in the Atlantic and produce average to below-average summer temperatures in the US.

Major hurricanes in the Gulf of Mexico disrupt both oil and natural gas production, but the impact on the latter industry tends to be more pronounced. The threat of hurricanes should support gas prices at least into August and September, the peak of hurricane season.

And the market has yet to recognize the big jump in US industrial gas that has occurred in recent months.

Source: Energy Information Administration

US industrial gas demand is released by the EIA with a two-month lag; the most recent data covers March. However, based on this data it appears that industrial demand is back at or above levels last seen in early 2006 and 2007. This reading is consistent with increasing manufacturing activity in the US.

Without a surge in demand or supply interruption this summer, US gas storage could approach full capacity by September or October. In that event, prices on near-month gas futures would drop sharply. But that’s a worry for a few months in the future, not today. At the same time, above-average storage levels will probably cap any major advances in natural gas prices to around above the $6 per million British thermal units.

Drilling Activity

US natural gas drilling activity has surprised a lot of analysts this year. Despite depressed gas prices, the gas-directed rig count is up from around 750 rigs at the beginning of the year to closer to 1,000 today.

I explained this apparent anomaly in the April 28 issue of The Energy Letter, Why Some Natural Gas is Worth $7.28, but here’s a quick summary.

Producers are increasingly targeting natural gas in the Marcellus Shale of Appalachia and the Eagle Ford Shale of South Texas, both of which contain a significant amount of natural gas liquids (NGL).

Because NGL prices broadly track the price of crude oil and demand for NGLs has picked up as the economy recovers, much of this so-called gas drilling is actually NGL drilling.

Accordingly, I expect the US onshore rig count to remain flat through the summer. Strong NGLs pricing and demand will support the gas-directed count, while the oil-directed rig count should see more upside as producers target promising onshore oil plays such as the Bakken and Niobrara Shale. Check out the graph below for a closer look.

Source: Bloomberg

This graph tracks the US onshore oil-directed rig count. Note that onshore oil drilling activity in the US stands at its highest levels in 20 years. Activity onshore is far stronger than it was when oil prices peaked in summer 2008–proof that US onshore unconventional oil plays are world-class and have the potential to yield significant production growth.

And further upside could be in store for onshore drilling activity, as the fallout from the oil spill in the Gulf of Mexico prompts producers to shift spending from deepwater plays to unconventional deposits on land.

And drilling activity is picking up overseas. First-quarter earnings reports from the major services firms indicated that spending on new oil and gas developments outside the US is on the rise. It also appears that profit margins for the services companies troughed in the first quarter and should see upside in the second half of 2010 and through 2011.

Most international drilling activity targets oil, so the outlook for average oil prices is a key consideration. Oil prices have ample support in the mid $60s per barrel, and I expect crude to head higher late this year because of recovering demand, falling spare capacity in OPEC and potential non-OPEC supply disruptions related to the oil spill in the US Gulf of Mexico. As long as prices don’t spend too much time below $70 a barrel, most international projects will remain on track.

Coal

Outside the US, the main driver for coal stocks will be news about Australia’s proposed super tax on mining firms, which, if approved, would go into effect in 2012. Under the legislation, the Australian government would levy a 40 percent tax on mining companies’ “windfall” profits, or any profits above a 5.3 percent return on assets.

This is a low return to be considered a “windfall,” and combined with other Australian taxes the change could force some mining firms to pay a tax of almost 60 percent on their profits–represents the highest tax rate of any major producing country.

What comes of this tax proposal depends on Australia’s election cycle. The center-left government led by Prime Minister Kevin Rudd is selling this tax as a populist move to ensure that Australia gets its “fair share” of miners’ profits. Some of the funds raised by the tax would be invested in Australia’s pension system; others would offset a reduction in the corporate tax rate.

But the plan appears to have backfired. Rudd’s government is now running behind the center-right opposition in the polls, and the prime minister’s popularity has declined at a rapid pace in recent weeks. The Australian mining industry has mounted an aggressive campaign against the tax, an effective ploy in a country where as much as one-third of total corporate profits come from mining.

With elections likely in October, the government appears to be digging in its heels, launching a taxpayer-funded advertising campaign to support the proposal. This fight is getting ugly.

The government may not be unwilling to back down from the proposal for fear such a move would be regarded as weakness. The Prime Minister has recently said that key elements of the tax proposal won’t be open to negotiation. But regardless of what happens come election time, the industry likely will have room to negotiate or influence the particulars.

These modifications might involve, for example, hiking the return-on-assets threshold used to determine what constitutes a “windfall” profit. I doubt the government truly wants to risk a mass exodus of investment dollars from Australia to lower-tax locales such as Canada. And keep in mind that the tax wouldn’t go into effect until 2012–there’s plenty of time to strike a compromise.

The center-right party will make this a campaign issue. If they’re elected in October this proposal would likely be scrapped entirely or modified extensively.

One way or the other, I expect the tax proposal to be watered down. But the mere mention of the tax has already caused some damage: Mine expansion projects have been put under review or postponed, and the proposed takeover of MacArthur Coal (Australia: MCC) by Gushers recommendation Peabody Energy (NYSE: BTU) appears to have collapsed after the mining giant lowered its bid.

The major Australian mining stocks are already pricing in a significant hit from the tax, providing upside if the tax proposal is scrapped or watered down. Nonetheless, this will remain a key source of volatility and headline risk for miners leveraged to Australian coal through the upcoming election.

The two Portfolio recommendations with the most exposure to the tax proposal are coal mining giant Peabody Energy (NYSE: BTU) and mining equipment maker Bucyrus International (NasdaqGS: BUCY). Strong demand for coal and steel in Asia will support metallurgical coal pricing and profits for both firms. The recent selloff is overdone and offers a buying opportunity.

As for the US coal mining sector, still-strong global steel demand should support metallurgical coal prices this year. But the real headwind for US coal mining firms has been in the thermal coal markets; weaker demand from electricity during the recession resulted in excessive coal inventories at many US power plants.

This headwind appears to be easing. The most recent data from the EIA indicates that power plants have 168.9 million short tons of coal, down from 190 million in December 2009. It’s normal for coal stockpiles to fall early in the year because of a seasonal uptick in electricity demand, but this represents an above-average decline.

As of February, coal stocks were still at above-average levels, but a drop-off in production and rising demand are normalizing conditions. Comments from the mining firms during the first quarter confirmed this general trend. Although shares of US-centric mining firms suffered alongside most other energy stocks, this improving trend is worth watching for the balance of the year.

And warm summer weather will drive demand for electricity (and, by extension, coal) higher.

Uranium

Uranium prices remain stuck in the low $40s per pound. Earlier this year the Dept of Energy (DOE) put a lid on spot uranium prices by selling uranium out of its stockpiles. With that supply out of the way, uranium prices could rise in the second half of the year. Uranium prices appear well-supported around $40 a pound, and I expect that to remain the case as long as economic conditions remain solid.

Over the longer term, the nuclear renaissance story remains intact. A few years ago, few would have predicted that new nuclear reactors would be built in the US. And construction is underway on dozens of new plants around the globe.

According to data from the World Nuclear Association, there are 438 operating nuclear reactors worldwide with a total capacity of 374,127 megawatts (MW). An additional 54 reactors were in some stage of production as of May 1, 2010, with a total capacity of 56,145 MW. And reactors with an additional 161,999 MW worth of capacity are in some stage of planning. China and Russia are the current leaders in terms of nuclear capacity under construction, but the US, Japan and other developed nations also plan a significant build-out in coming years.

On the uranium supply front, Canadian giant Cameco Corp (Toronto: CCO, NYSE: CCJ) appears to be making progress on its flooded Cigar Lake mine, a site that will add to supply over the longer term. At the same time, Australia’s proposed super tax on miners has imperiled BHP Billiton’s (NYSE: BHP) massive Olympic Dam expansion. If the project were nixed, future uranium production would be constrained.

Uranium and nuclear power remain attractive themes for long-term investors. I will consider aggressive investments in the group if spot uranium prices begin to rise from their recent doldrums this summer. I’ll revisit my favorite plays in future issue.

The Macondo Disaster

I devoted the entire May 5 issue, Opportunity amid Crisis, to an analysis of the circumstances of and repercussions from the blowout of BP’s Macondo well in the Gulf of Mexico and the subsequent oil spill. I offered an update to that analysis in Tuesday’s Flash Alert, Politics and the Gulf of Mexico.

I won’t cloud the discussion with another lengthy discourse. Suffice it to say that risks surrounding any company with significant exposure to or association with the deepwater Gulf of Mexico have increased. In a few cases, there are real risks in terms of liability to the spill or a significant impact to underlying business conditions resulting from the expanded drilling moratorium I outlined in the aforementioned Flash Alert.

But for many companies these concerns are mostly headline risks. President Obama has attracted significant criticism for his handling of the Gulf spill. The President’s approval ratings, already under pressure after the health care reform debate, have taken a beating in recent weeks.

This is a major political concern for Obama particularly given the fact that midterm elections are looming, and the Democratic Party is at risk of losing a number of seats in Congress. These political realities have prompted the administration to step up its rhetoric against BP, other companies involved with the Macondo well and the deepwater drilling industry in general. 

Besides political rhetoric, ongoing efforts to stanch the oil flowing from the Macondo well also pose a headline risk to stocks leveraged to US deepwater activity. Last week BP estimated that its “top-kill” operation had a 60 to 70 percent chance of bringing the well under control.

The big drop in BP’s shares on Tuesday largely reflected the market’s disappointment that the top-kill didn’t work. The company did itself few favors by giving such a high probability of success last week.

Now BP is trying to siphon off more of the oil flowing from the well; the company could implement this strategy by the end of the week. The market’s expectations are lower, but another failure could send BP’s stock lower still.

The two relief wells BP is drilling represent the ultimate solution but won’t be completed until August. But progress on these two wells could be delayed, and it might take several attempts before BP is able to intersect the damaged well.

Again, shares of BP and other companies related to the spill face plenty of potential headline risk.

I haven’t changed my view that the deepwater-levered stocks I recommend have suffered inordinately from the Macondo spill and headline risk. However, fundamentals won’t shield the stocks from panic-driven selloffs. And the emergence of industry- and sector-specific exchange-traded funds mean that when bad news affects one well drilled by one company, even stocks with no exposure to the Gulf of Mexico can take a hit.

My general strategy involves avoiding unhedged exposure to stocks that likely face liability for the spill. At the same time, the broader selloff is an opportunity to buy stocks that have only modest business risk related to the Gulf drilling moratorium.

Here’s a rundown by industry group.

Producers

BP is the operator of the Macondo field and has a 65 percent economic stake. Wildcatters Portfolio holding Anadarko Petroleum Corp (NYSE: APC) holds a 25 percent stake in the well, while Japan’s Mitsui (NasdaqGS: MITSY) owns a 10 percent interest.

BP and, to a lesser extent, the other producers directly related to Macondo will have the highest exposure to the cost of clean-up and liabilities related to the spill. BP alone has lost about $60 to $70 billion in market value since the spill occurred.

It’s impossible to know how much the spill will ultimately cost. However, even assuming the most pessimistic assumptions, $60 billion is a massive overreaction. BP boasts a large cash position, generates a lot of cash through its global operations, and could take on a great deal of additional debt to fund the cost of the spill–bankruptcy is a remote risk.

And if its stock continues to trade at depressed valuations, BP might become an attractive acquisition candidate–particularly after the market has a better grasp on the spill’s ultimate cost.

BP’s management mismanaged expectations about the potential for their top-kill operation, and the political vitriol to which the company has been subjected has done little boost investors’ confidence in the stock.

The announcement that the US has opened criminal and civil investigations into BP was hardly a surprise but still precipitated a selloff; sensationalist headlines, panic and emotion are driving the stock, not fundamentals.

Nevertheless, the risks of out-of-control market volatility are too high to justify adding BP to the model Portfolios, though I do rate the stock a “Buy” in my How They Rate coverage universe. If you’re a long-term investor with a great deal of patience, an investment in BP could pay off.   

Wildcatters Portfolio recommendation Anadarko Petroleum Corp faces the same headwinds buffeting BP; the stock plummeted on June 1, touching our recommended stop early in the day.

With $3.7 billion in cash on the books, significant insurance coverage and the ability to raise additional funds, Anadarko is financially strong. And the market value Anadarko has lost since the spill simply doesn’t reflect reality–the stock is pricing in a $50 to $60 billion price tag for the spill.

But most operating agreements dictate that each partner is responsible for its share of the spill’s ultimate. Under such a contract, Anadarko would owe 25 percent of the final tab. And these deals often contain an exemption clause in the event of negligence or misconduct on the part of the operator; if BP’s negligence caused the spill, Anadarko might be able to claw back some or all of the cost.

It’s way too early to know if legal remedies will provide Anadarko any relief; any award would be a long time coming because of lengthy court proceedings. But based upon what we know about the spill, there’s a good chance Anadarko won’t owe the full 25 percent. Meanwhile, Anadarko’s fundamentals remain strong. Its deepwater assets in West Africa are particularly promising and could make the company a takeover target as the dust settles on Macondo.

If the costs of Macondo become clearer or Anadarko is able to get relief from BP in the courts, the stock could easily return to the mid-60s.

Despite Anadarko’s strong fundamentals, I hesitate to re-enter the stock with the news flow so uncertain and volatility so high. It would be impossible to set a stop to limit our downside losses because headline risk makes Anadarko’s shares uncharacteristically volatile.

I’m investigating the potential to use options on Anadarko to allow us to re-enter the stock while limiting downside risk. I explain the basics of options in a special report, “The ABCs of Options to Hedge Risk.” However, the options currently price in extreme volatility; I recommend standing aside from Anadarko until the stock stabilizes and we have a bit more clarity.

For now I will track Anadarko as a buy in How They Rate and will outline any future recommendations via a Flash Alert.  

Drillers

Tuesday’s Flash Alert offered a complete rundown of contract drillers’ exposure to the moratorium on drilling in the Deepwater Gulf of Mexico.

As I explained in Opportunity amid Crisis, Transocean (NYSE: RIG) should have minimal liability exposure to the Macondo spill. But Transocean’s fleet of older rigs and exposure to the Gulf of Mexico pose challenges. I prefer Seadrill (NYSE: SDRL), the only deepwater contract driller featured in the model Portfolios.

Seadrill has only one rig in the Gulf affected by the moratorium, and this new rig should be able to find work elsewhere. The company also has strong contract coverage for existing rigs, insulating the firm against near-term rate pressures as competitors relocate rigs from the deepwater Gulf of Mexico to other markets.

Shares of Seadrill sold off a bit in sympathy with the rest of the industry, providing an attractive buying opportunity. Now paying $0.60 per quarter, Seadrill yields more than 12 percent–and the company has the scope to boost its payout further in coming months. Seadrill remains a buy under 29, though I am suspending my recommended stop to guard against potential volatility.

If equities rally this summer, I may look to short or take out a put option play in Diamond Offshore (NYSE: DO) to hedge against exposure to the Macondo well disaster and drilling moratorium in the Gulf of Mexico. But the time isn’t ripe for such a hedge.

Subsea Equipment

Cameron International Corp (NYSE: CAM) manufactured the blowout preventer (BOP) that malfunctioned on the Macondo well. The BOP is designed to automatically seal a well in the event of an emergency.

The device’s failure isn’t a liability risk for Cameron International; the BOP was built in 2001, and Transocean, the contract driller, is responsible for its ongoing maintenance. And reports suggest that Transocean may have modified at least one of the components on the BOP.

Nevertheless, shares of Cameron International sold off yesterday, touching our recommended stop loss. Liability risk probably wasn’t the culprit for the stock’s sharp decline; shares of most companies that manufacture subsea equipment for deepwater wells were also hit hard. Both FMC Technologies (NYSE: FTI) and Dril-Quip (NYSE: DRQ) gave up more ground than Cameron International, though neither name was involved with the Macondo well.

The market reflects fears that the expanded drilling moratorium in the Gulf of Mexico will make for slower business. For example, all three companies manufacture subsea trees, the network of valves and equipment used to control production from a deepwater well. If no new wells are drilled in the Gulf for several months, demand for trees and other such equipment stagnates.

But deepwater drilling will continue elsewhere, particularly in deepwater Brazil and offshore West Africa. The Gulf of Mexico is only one part of the business.

Second, the most likely outcome of the Gulf mess is that the government will allow deepwater drilling but will enforce stringent new regulations, including stepped up well inspections and modern BOPs to guard against blowouts. This spells more business for the likes of Cameron International.

This will be a high margin business for Cameron and could result in an uptick in ongoing maintenance revenues if drillers contract with BOP manufacturers to handle ongoing maintenance and safety inspections.

Despite these long-term tailwinds, the market is completely blinded by the Gulf drilling moratorium. I recommend standing aside from Cameron International Corp for now but will likely jump back into the stock at the first sign of stability. The stock rates a buy in How They Rate.

Services

I also discussed the Big Four international services firms in yesterday’s Flash Alert: Schlumberger (NYSE: SLB), Weatherford International (NYSE: WFT), Baker Hughes (NYSE: BHI) and Halliburton (NYSE: HAL).

All of these stocks garner just 5 to 10 percent of their revenues from the deepwater Gulf of Mexico. A prolonged drilling moratorium will produce a sizeable near-term earnings hit because the services firms will need to keep some on the payroll for when the moratorium is lifted, but those employees won’t be generating much revenue. And there are the costs associated with moving equipment out of the Gulf.

Nonetheless, the selloff in these names is way out of proportion to the earnings hit. The only services firm with potential direct liability is Halliburton, which likely will avoid a big bill because it will be tough to prove the firm was at fault in the spill. I discussed this at length in Opportunity amid Crisis.

The services firm with the least exposure to offshore and deepwater revenues among the Big Four is Weatherford International.

The stock has been weak in sympathy with the rest of the group, but I expect the firm’s next earnings call in July to act as a catalyst; Weatherford’s fundamentals are recovering from last year’s missteps, and the company’s heavy onshore exposure will differentiate it from the rest of the sector.  Buy Weatherford International up to 26.

Schlumberger’s diversified international exposure will insulate the firm’s earnings from a slowdown in the deepwater Gulf of Mexico. The oil-services giant owns the most-advanced technology and is a market leader that I consider a long-term holding. Buy Schlumberger up to 85.

Baker Hughes doesn’t have direct exposure to Macondo but has more exposure to the deepwater Gulf than the other service majors.

As a result the firm’s earnings likely will suffer a larger hit because of the moratorium, though the distinction is likely to be minor. I like Baker’s exposure to onshore oil and gas reserves in the US and its acquisition of BJ Services.

BJ is a leading player in hydraulic fracturing, a key service involved in producing oil and gas from unconventional fields. Such fields lack permeability, making it tough for oil and gas to flow through the reservoir and into a well. Hydraulic fracturing involves pumping liquid into the field to crack the reservoir rock and facilitate the flow of oil and gas.

Baker was the third stock to hit our recommended stop loss during the selloff on June 1. Unlike Anadarko and Cameron, however, I recommend that investors buy back into Baker Hughes. Instead of recommending a stop loss I am recommending you buy put insurance to hedge any downside over the next several months.

Buy Baker Hughes and purchase one $35 October 2010 put-option contract for each 100 shares of Baker. The cost of these puts is around $3.70 each, or $370 per contract. I will track the value of this position assuming that readers buy the put insurance.

I explained how put insurance works in the special report “The ABCs of Options to Hedge Risk.” In this case, you’re paying $370 per 100 shares–roughly 10 percent–to limit your downside in Baker to 35 per share. Your upside is unlimited, though if the stock rallies above 50 you’ll lose the entire $370 insurance policy you purchased.

Although these options are rather expensive right now, the puts give us more than four months of downside protection and peace of mind. Buying the puts is preferable to setting a stop because in volatile markets stops tend to get hit at the most inopportune times.

Safe Havens

Some sectors offer a welcome safe haven for investors this summer. These stocks have little or no exposure to either the Macondo spill itself or to a prolonged moratorium on deepwater drilling in the Gulf of Mexico. I also expect some institutional money allocated to the deepwater theme to be shifted within the energy sector to groups with less headline risk.

Here’s a general overview of some of my favorite safe-haven themes.

Non-US Oil Producers and Explorers

Given the near-constant news coverage, a casual observer of the energy markets could be forgiven for thinking that the deepwater Gulf of Mexico is the world’s only oil-producing region. Fortunately, that’s not the case. Although new regulations and a potentially lengthy moratorium on drilling will delay for new discoveries in the Gulf, exploration continues in the world’s other main deepwater exploration markets.

And offshore isn’t the only region that’s capable of generating production growth. In the April 7 issue The Search for More Oil, I outlined a long list of small producers targeting regions like Africa, offshore Greenland, India and Vietnam. All are due to show strong growth in oil production over the next 12 to 18 months, and all have upside from exploration wells currently being drilled.

Top plays that fit into this category are Canadian oil sands producer Suncor Energy (NYSE: SU), a stock that’s posted gains in recent sessions. Investors appear to be betting that the oil sands remain among the only North American plays that can generate real production growth on a scale that could rival the deepwater Gulf.

Gushers recommendation Afren (London: AFR) has the scope to generate real growth from its onshore and offshore fields in Africa, primarily in Nigeria.

In mid-May the company noted that production remains stable and that development of the key Ebok field is on track–first oil production should come onstream in October. This field represents a big source of production growth for Afren and an upside catalyst for the stock.

Amid a sharp correction in oil prices and the negative press surrounding Macondo, Afren is trading around 100 pence per share (GBP 1), less than 10 percent off its 52-week highs. Although a drop in the value of the British pound against the US dollar means that the return in dollar terms is lower that’s still an impressive showing. Afren rates a buy under GBP1.15.

Finally, Brazilian national oil company Petrobras (NYSE: PBR A) has some exposure to fields in the Gulf, but Macondo isn’t one of them. And the main driver of the firm’s production growth and stock performance has been and will remain deepwater fields offshore Brazil. Petrobras remains a buy in the Wildcatters Portfolio under 37.

US Onshore Producers and Services

Oil and natural gas prices look to be well-supported this summer, and US onshore rig counts are soaring. The deepwater drilling moratorium in the Gulf of Mexico may prompt firms to reallocate spending from offshore to onshore operations.

And most of the world’s major integrated oil companies have established some sort of meaningful presence in US gas and or oil shale plays. The latest to join the fray was Royal Dutch Shell (NYSE: RDS.A), which acquired a private producer in the Marcellus for $4.7 billion.

Wildcatter Portfolio Holding EOG Resources (NYSE: EOG) offers exposure to oil and natural gas liquids (NGL) deposits in the Bakken Shale in North Dakota, the oil-rich part of the Barnett Shale and recently announced discoveries in the Niobrara Shale in the Rockies and the Eagle Ford Shale in South Texas. EOG Resources rates a buy under 115.

Oil-heavy producer Occidental Petroleum Corp (NYSE: OXY) announced a significant new oil discovery in California that promises to show significant production growth in coming years. In addition, the company boasts significant international oil assets. Occidental Petroleum Corp is a buy under 95.

Range Resources Corp (NYSE: RRC) is a leading producer in the NGLs-rich Marcellus shale, and its experience in the region makes it a cost leader. Buy Wildcatters Portfolio holding Range Resources Corp under 60.

Gushers portfolio holding Petrohawk Energy Corp (NYSE: HK) is a leader in the Haynesville Shale, a dry gas that contains no NGLs. However, these wells are so prolific the play is economic even at rock-bottom gas prices.

In addition, Petrohawk has put together a significant position in the liquids- and oil-rich Eagle Ford Shale of South Texas. Gushers recommendation Petrohawk Energy Corp is a buy under 30.

On the services side, my favorite plays include land-based contract driller Nabors Industries (NYSE: NBR), a company that owns a fleet of powerful land rigs needed to drill America’s unconventional oil and gas reserves. The surging US rig count spells strong demand for the firm’s rigs. Buy Nabors Industries under 28.

Tenaris (NYSE: TS) manufactures oil country tubular goods (OCTG) such as pipes and drill casing. The company sells advanced pipes to the deepwater market, so it has a bit of exposure to the Gulf.

But advanced OCTG equipment is also needed in unconventional oil and gas reserves; Tenaris should benefit from the rising US rig count. Buy Tenaris under 47.

Refiners

As I noted in yesterday’s Flash Alert, refiner lower oil prices reduce refiners’ input costs. And US oil demand is growing at an accelerating pace.

This is all great news for Gushers recommendation Valero Energy (NYSE: VLO), a buy under 20.

Master Limited Partnerships

Most of the MLPs I recommend are involved in the midstream energy business and own pipelines, gas storage facilities and oil terminals. These assets generate steady cash flows regardless of commodity prices and the state of the economy. This is what allows most MLPs to pay high and rising distributions–the average MLP now yields around 7 percent–and that payout is tax-advantaged.

Some MLPs have exposure commodity and economic risks. Processing is one such business; however, margins in processing typically benefit from high oil prices relative to gas–commodity sensitivity is attractive right now.

And the gathering business–hooking up individual wells to the pipeline network–benefits from strong drilling activity.