Inside This Issue

The Stories

Earnings expectations for most energy-related firms are far less demanding than they were in late April, when oil approach $90 a barrel and the S&P 500 hit new recovery highs. For better or worse, second-quarter earnings season will be a major catalyst for the energy patch. See Earnings Season.

In the run-up to second-quarter earnings season, expect macro issues to be the primary driver of stocks prices in the energy sector. See The Bigger Picture.

There are winners and losers in every market. Here are two short plays for aggressive investors seeking to hedge their portfolios. See Hedging Our Bets.

We were stopped out of Range Resources Corp (NYSE: RRC) during last Friday’s selloff, but the company’s fundamentals remain attractive. See Stock Update.

The Stocks

Seadrill (NYSE: SDRL)–Buy @ 29
Peabody Energy Corp (NYSE: BTU)–Buy @ 52, Stop @ 32
Baker Hughes (NYSE: BHI)–Buy @ 55 with one put option for every 100 shares
Schlumberger (NYSE: SLB)–Buy @ 85
Weatherford International—Buy @ 26
Diamond Offshore (NYSE: DO)–Sell Short above 60
First Solar (NSDQ: FSLR)–Sell Short above 110
Range Resources Corp (NYSE: RRC)–Buy @ 60

Earnings Season

The Portfolio tables on the website include a column highlighting the expected earnings release date for every recommendation. As you can see, earnings season for the energy patch begins around July 21 and extends into mid-August.

This earnings season should be a particularly important catalyst for the group, as it will shift investors’ attention from the latest macroeconomic headlines to the performance of individual companies. This earnings season also will offer more color on how the Macondo oil spill and drilling moratorium will affect production and spending.

Expectations for most energy companies have increased over the past year.But downside revisions to global economic growth, coupled with the problems in the Gulf of Mexico, have prompted analysts to lower earnings estimates for many energy firms. This trend should continue in the near term. On the plus side, these revisions will make it easier for companies to beat earnings estimates.

The degree to which analysts have pared forecasts varies widely, depending on the subsector. Earnings estimates for integrated oil companies have endured a rollercoaster ride, falling early in the year, rising in March and April and then tumbling sharply after May 1. Here’s a look at the consensus estimates for Exxon Mobil Corp’s (NYSE: XOM) 2010 earnings.

Source: Bloomberg

Outfits exposed to deepwater drilling in the US Gulf of Mexico have suffered severe earnings downgrades in recent weeks. These moves hardly come as a surprise; the moratorium has impacted profit outlooks for deepwater contract drillers with heavy exposure to the Gulf. As I’ve explained in recent issues, if enforced, the moratorium would result in a mass exodus of rigs and personnel, forcing companies to find contracts in other regions. Rig contractors would have to slash day-rates to attract interest in these rigs. This scenario has already played out for several operators.

Noble Corp (NYSE: NE), a deepwater contract driller rated Hold in the Energy Watch List, is one firm that already has begun to renegotiate contracts covering its rigs in the Gulf. Here’s a look at consensus earnings estimates for Noble this year.

Source: Bloomberg

As you can see, consensus expectations for Noble’s earnings have plummeted since the Obama administration announced its blanket ban on all drilling activity in Gulf waters deeper than 500 feet. Although the moratorium is slated to last only six months, there’s a high probability that the ban will extend beyond this period. Contract drillers have the most to lose in that scenario.

The one exception to that rule is Gushers Portfolio recommendation Seadrill (NYSE: SDRL), a contract driller with only one rig in the Gulf and a fleet of recently built rigs operating under longer-term contracts.

Shares of Seadrill have sold off in sympathy with the other drillers, though the situation in the Gulf will have only a modest impact on the firm’s earnings. Based on a quarterly payout of $0.60 per share, the stock now yields 12.6 percent, and this payout likely will increase to north of $0.70 by early 2011. This weakness presents an ideal opportunity to build a position in Seadrill; buy the stock up to 29.

Another subsector worth watching is coal, particularly coal-mining firms with exposure to Asia and Australian market. Despite credit concerns in Europe and fears of a global economic slowdown, earnings estimates for many coal-mining concerns have increased this year.

When the Australian government officially unveiled its resource super profits tax (RSPT) in the spring, the announcement put a lid on the group’s earnings estimates.

However, estimates didn’t fall, as many analysts held that the negative public reaction to the tax–coupled with heavy lobbying by Australian mining firms–would result in a watered-down version of the tax. As I explained in the previous issue, I felt the government would wait until after the next election to change the tax plan; then-Prime Minister Kevin Rudd lobbied heavily for the tax and would appear weak if he changed course.

The Labour Party’s unexpected decision to replace Rudd with Julia Gillard, the country’s first female prime minister, represents a remarkable fall from grace for Rudd; only a few months ago he appeared a shoe-in to win another general election. Apparently, the party felt that Rudd’s unwavering advocacy for the RSPT and use of public monies to fund an ad campaign supporting the tax had alienated too many voters.

In one of her first moves as prime minister, Gillard suspended Rudd’s controversial marketing campaign and announced that the administration would review the RSPT proposal.

Talks with the big mining companies yielded a compromise in early July: The tax rate now tops out at 30 percent, as opposed to 40 percent, and the levy only applies to coal and iron-ore mining. More important, the RSPT only comes into effect when a mining firm’s returns exceed 12 percent–a far cry from the original 6 percent.

Facing a less-onerous tax burden, some mining outfits have resumed projects that were halted when the RSPT was first announced.

This is an outright victory for the mining industry and Portfolio recommendation Peabody Energy Corp (NYSE: BTU).


Source: Bloomberg

As you can see, consensus estimates of Peabody Energy’s earnings have improved despite the headlines. Although the tax proposal wouldn’t have gone into effect for several years, Peabody and other outfits considered mothballing planned expansion projects until there was greater clarity on tax proposals. The recent compromise emboldened analysts to again raise their forecasts for Peabody’s 2010 earnings. Buy Peabody Energy Corp up to 52 with a stop at 32.

Higher earnings estimates for Peabody aside, the expectations for most energy-related firms are far less demanding than they were in late April, when oil approach $90 a barrel and the S&P 500 hit new recovery highs.

Sentiment is far more bearish these days; don’t be surprised if stocks respond positively when earnings beat expectations by a modest margin. A significant relief rally could be in the cards if comments from industry management teams remain relatively upbeat. For better or worse, second-quarter earnings season will be an even more important and market-moving event than usual.

The Big Picture

Until earnings season gets underway, the market will have little concrete news flow to digest other than a smattering of economic reports. Accordingly, the same broad macroeconomic themes and headlines that have dominated the tape since late April should continue to drive stock prices.

I’ve written about these big-picture themes extensively in the past few issues of The Energy Strategist and look forward to the day we can focus once again on stock- and sector-specific growth stories. At the same time, the big-picture headlines have produced some wild swings in the market; to ignore these trends would be irresponsible. 

In a Flash Alert issued on June 8 I called for a summer rally above the S&P 500’s 200-day moving average; within two weeks, the market pushed through that key technical level, rallying to an intraday high near 1,130. Two weeks later, the broader market sold off more than 100 points, closing below its 2010 lows.

The broader market should react positively if earnings reports don’t disappoint, particularly now that expectations are lower. That being said, any rally is unlikely to push the S&P 500 beyond its June highs; I expect the broader market to remain range-bound until autumn. Over this period investors should expect dramatic, short-term swings in both directions.

I’m more constructive on the final months of 2010. The big-picture themes that have weighed on energy-related stocks this year are fears of a double dip recession, the risk of a second credit crunch and the fallout from the Macondo oil spill in the Gulf of Mexico. Conditions in credit markets appear to be easing, and I still hold that the chances of a double-dip recession are remote.

The Macondo oil spill is a negative for certain energy-related industries–for example, the deepwater drillers I discussed earlier. But a prolonged moratorium is bullish for energy commodities; an extended ban will restrict supply even as global oil demand recovers.

Over the longer term, new regulations governing deepwater drilling operations should benefit oil-services and subsea-equipment firms; new guidelines will necessitate the purchase of new equipment such as subsea blowout preventers (BOP) and the use of advanced techniques to complete wells. 

In the past few issues I’ve outlined a two-part strategy for playing this market.

1. Buy safe-haven sectors. The list of safe havens includes income-oriented stocks such as Seadrill, energy-focused master limited partnerships (MLP) and the tankers recommended in the most recent issue. In addition, I continue to see upside for refiner Valero Energy Corp (NYSE: VLO), non-US oil producers and explorers such as Afren (LSE: AFR) and onshore US oil and gas producers such as EOG Resources (NYSE: EOG) and Range Resources Corp (NYSE: RRC).
2. Use hedges and downside protection to stabilize your portfolio amid a volatile market. One example of this is the put option insurance I recommend on service giant Baker Hughes (NYSE: BHI). I will also review some outright short-sale recommendations in this issue.

This two-part strategy allows us to accumulate well-placed stocks at attractive valuations while the markets are down. Investors who buy the income-oriented names now can lock in yields that were unheard of just three months ago. Meanwhile, the hedges will stabilize your portfolio when investors panic and the markets dive.

Before delving into a few new hedges, let’s review the most recent data on the three main big-picture risks that continue to drive market sentiment.

Credit Crunch

In the previous issue, I enumerated several signs that credit conditions have improved both in Europe and the US. These improvements have continued over the past two weeks, and the risk of a second credit crunch has receded.

One of the most important investing lessons I’ve learned: It’s tough to formulate a relevant and accurate outlook if you don’t monitor a consistent set of indicators. In the last issue of TES, I examined three basic indicators of credit market health–the TED Spread, yield spreads on sovereign debt and US corporate bond issuance–and concluded that the EU credit crisis was easing and the risk of contagion appeared low.

To underscore this point, let’s look at where these three indicators are today, starting with the TED Spread.

Source: Bloomberg

The TED Spread is a basic measure of conditions in the interbank lending market. A higher spread indicates that banks are cautious to lend to one another–a sign of stress in the financial system.

As you can see, the TED Spread spiked between late April and early June, though its June high was just less than 50 basis points–well below the 400-plus spreads witnessed at the height of the 2008 financial crisis. Over the past month the TED Spread has receded, and the indicator remained relatively stable during last week’s selloff.

The next graph depicts the spread between the interest rates on 10-year Spanish and Italian government bonds and the yield on 10-year German bunds.

Source: Bloomberg

Spain and Italy are the two largest eurozone countries that are considered at risk of a sovereign default. Germany is Europe’s safe-haven market; when investors are scared they buy bunds, or German government bonds. Suffice it to say, higher spreads reflect higher risks.

Spreads on Spanish government debt remain wide by any historical metric, though they’re slightly off their highs. Italy, however, is a much larger economy, and spreads on 10-year Italian government bonds appear to have topped out.

Last issue I noted that US corporations issued just $35 billion in bonds in May–roughly one-third the average issuance in the first four months of the year. Some commentators interpreted this weakness as a sign that companies were unable to access credit markets or simply found rates less attractive.

I also observed that June was shaping up to be a much better month for bond issuance; this positive trend continued, and US companies issued more than $69 billion worth of bonds last month–roughly double what they issued in May, and a solid showing for what’s normally a quiet month.

All told, most of the credit-market indicators I follow suggest that fears are easing. Although investors remain nervous about sovereign debt issued by Spain and a handful of other countries, the contagion over which some pundits agonized never took root: The EU sovereign debt crisis hasn’t infected the interbank or US corporate-bond market to a meaningful degree.

These credit problems remain concentrated in peripheral EU economies. Recent data on European bank lending indicates that credit availability has returned to pre-crisis levels. Consider Deloitte’s recent survey of 125 Chief Financial Officers (CFO) at major British firms. The study found that CFOs rate credit as more available than at any time since the third quarter of 2007, around the peak of the credit bubble.

MLPs continue to benefit from normalizing credit market conditions. These outfits usually rely on a combination of debt and equity capital to fund major new infrastructure projects–the lifeblood of distribution growth. When conditions deteriorate in debt markets, investors fret over these firms’ ability to fund growth.

In 2008 MLPs posted their worst-ever returns, while 2009 was the best year in Alerian MLP Index’s history. The main driver of this performance wasn’t commodity prices or the economy; MLPs have only modest economic and commodity exposure. In fact, many MLPs continued to boost their distributions through the recession that stretched from 2008 into early 2009. That being said, the credit crunch did hit the group, though the recent improvement in credit markets has buoyed MLPs once again.

I highlighted my favorite MLPs in the last issue of TES and reiterate my buy recommendations on all of them.

A Double-Dipper?

The main concern facing global markets has shifted from the EU credit crunch to signs of slowing growth and fear of a double-dip recession. US economic data points released over the past few weeks have been weaker than expected and estimates for economic growth in developed markets for this year and next have moderated.

In the first issue of 2010, The Crystal Ball, I summarized my outlook for the economy as follows: “The US recession ended last summer, and the economy will enjoy a weak, cyclical recovery in 2010.”

The recent spate of soft economic data is consistent with this outlook. The 2007-09 recession rivals the 1982 and the 1973-74 downturns as the most severe in post-War history, but the recovery has also been far weaker than the rebounds after the aforementioned contractions.

This weaker-than-normal recovery is a symptom of lingering economic headwinds. The list of impediments to growth includes a stretched US consumer who’s now focused on paying down debt rather than spending. Other risks include expiring stimulus measures, rising taxes and uncertainties regarding new regulations–namely, the financial reform bill and US health care legislation. 

The US economy is now growing at roughly its long-term trend rate. However, one normally would expect the economy to be growing at a faster rate in the quarters immediately following a recession. As a result of this sub-par recovery, US unemployment will remain elevated through at least 2012–yet another reason consumer spending won’t grow as quickly as it has in previous recoveries.

But there’s a big difference between a subpar recovery and an outright contraction; investors must be careful not to confuse the two. Although much has been made of the recent string of disappointing economic data, the numbers haven’t indicated that a contraction is in the cards. A perfect example is the oft-cited Conference Board Consumer Confidence Index.


Source: Bloomberg

The media has a tendency to sensationalize economic releases. The Consumer Confidence Index fell short of consensus expectations in June, falling roughly 10 points from the May reading. Though disappointing, this drop wasn’t out of the ordinary; the index has remained in the same range for over a year. The most recent reading appears to have reversed a slight upside breakout that occurred in April and May.

It goes without saying that the employment situation is a major driver of consumer confidence. The June jobs report was weaker than the consensus forecast, but the “whisper forecasts” called for an even weaker number–from that standpoint, the market’s reaction was relatively subdued. Generally, the small gain in payrolls is consistent with my forecast for a weak cyclical recovery.

It’s also important not to focus solely on the headline employment numbers. Although payrolls growth is weak, private incomes and salaries are rising at a more than 4 percent annualized pace. Consumers will focus on paying down debt and saving money in the near term, but this rate of income and wage growth suggests that consumer spending won’t collapse.

And then there’s Institute for Supply Management’s Purchasing Managers Index (PMI) for manufacturing, which measures the strength of US manufacturing. The index is structured so that readings over 50 indicate expansion, while readings under 50 indicate contraction. The most recent reading was 56.7, down from 59.7 in May and considerably less than the consensus estimate of 59. But check out this graph.

Source: Bloomberg

Although the most recent PMI reading disappointed, the index had been at a historically elevated level and still sits well above its long-term average. And the manufacturing sector continues to expand at a decent pace. In short, just because PMI has turned lower from a high level does not mean that it’s destined to return to lows put in during the recession. Indicators usually flatten out as a recovery progresses.

And while US economic data has disappointed in recent weeks, the news from Europe has been surprisingly positive. One useful indicator of EU economic health is the eurozone manufacturing PMI.

Source: Bloomberg

This indicator is interpreted in the same manner as US PMI: Readings above 50 indicate expansion; readings less than 50 indicate contraction. The eurozone PMI slipped a bit in June but remains at a historically high level and implies the strongest rate of economic growth for the area since the end of 2006. Europe’s manufacturing base, particularly in Germany and other core economies, may get a boost from the weaker euro.

Some pundits made a big deal about the schism between the US and Europe at the G-20 Summit. The basic reasoning is that European leaders are focused on reining in spending, while the Obama administration is pushing for additional stimulus.

Reduced government spending will weigh on European economic growth next year, though the strictest austerity measures will occur in peripheral economies such as Greece and Portugal.

It’s also worth mentioning that the early read on Germany’s proposed budget is that the government plans to on spending cutbacks rather than tax increases–a positive for markets.

Another positive from Europe’s renewed commitment to fiscal discipline: These moves appear to have stabilized the euro’s fall against the US dollar. The euro’s weakness in May had contributed to concerns about the currency’s stability.

If one simply reads the headlines about economic data, it’s easy to be convinced a recession is around the corner. But the actual data suggests a slowdown, not a contraction.

Investor sentiment tends to err to extremes. Investors were too optimistic about the economic recovery in March and April, when many economists raised their growth forecasts. Now investors appear overly bearish about the the prospects for global growth.

The Macondo Disaster

I’ve written extensively about the oil spill in the Gulf of Mexico over the past two issues;  I’ll confine my comments to an update on the latest developments.

BP (NYSE: BP) appears to be following the classic strategy of under-promising and over-delivering. Comments from the company and government officials suggest that the first relief well–a well that will permanently plug the leaking well–is ahead of schedule. I suspect that BP will manage to stanch the leak by the end of July or in early August, slightly ahead of forecast. And once the well is plugged, it will be easier for investors to assess the damage and clean-up costs.

Many speculate that BP will be acquired or partner with another firm to offset the heavy clean-up costs. Although I expect BP to survive, it’s too risky to add to the model Portfolios.

I continue to prefer Anadarko Petroleum Corp (NYSE: APC) because of its discoveries offshore West Africa. But the firm’s 25 percent interest in the Macondo exposes the stock to a great deal of headline risk.

Last month Anadarko issued a series of press releases confirming the text of the operating agreement governing its relationship with BP on the Macondo field. Here’s an excerpt:

Under the terms of the joint operating agreement (JOA) related to the Mississippi Canyon block 252 lease, BP, as operator, owed duties to its co-owners including Anadarko to perform the drilling of the well in a good and workmanlike manner and to comply with all applicable laws and regulations. The JOA also provides that BP is responsible to its co-owners for damages caused by its gross negligence or willful misconduct.

Anadarko’s efforts to prove that BP’s gross negligence caused the spill are hardly surprising; this would reduce or even eliminate the firm’s liability for the disaster. However, it will take some time for this issue to be resolved; until that happens, the spill will be a black cloud over Anadarko’s stock. This uncertainty prevents me from adding Anadarko Petroluem Corp to the model Portfolios.

Beyond the two producers directly impacted by the spill, the more important issue is the duration of the drilling ban. As I was penning the previous issue, a federal judge ruled that the moratorium was too broad. The Obama administration has appealed the ruling and has stated that it will issue a new moratorium that may allow some drilling activity on existing fields.

But the court ruling isn’t likely to change the basic situation in the Gulf; new exploration wells will probably be prohibited, so the impact on the energy industry will be undiminished.

As I noted earlier in this report, firms operating in the Gulf are already making moves which suggest they the moratorium could remain more or less in effect for far longer than six months.

Noble Corp’s Noble Clyde Boudreaux is a deepwater semisubmersible rig capable of drilling in waters up to 10,000 feet deep. The rig was contracted to Noble Energy (NYSE: NBL) to drill in the US Gulf of Mexico for a day-rate of about $600,000 through November 2011. Note that Noble Corp is a contract driller and Noble Energy is a producer; despite having similar names, the two companies aren’t related.

Noble Energy likely threatened to enforce its force majeure contract with Noble Corp; this clause gives operators an out if forces beyond their control halt drilling in the Gulf for a prolonged period. Obviously, the producer doesn’t want to pay a guaranteed $600,000 per day to the driller if it can’t use the rig.

But Noble Corp and Noble Energy reached a compromise. Under the terms of the deal, the rig will sit idle in the Gulf until December at a reduced rate of $145,000 per day; and this period can be extended if both parties agree to do so after December. In addition, both parties have agreed to negotiate a new contract at a day-rate of around $397,000 per day once the moratorium expires.

This deal is interesting for a number of reasons. First, it’s obvious that Noble Corp never would have entered into such an agreement if management thought that the firm could negotiate a new contract somewhere else in the world at a better day-rate. If all 33 rigs affected by the moratorium leave the Gulf, it would create a supply glut that would take at least a few years to resolve. Noble Corp’s management understands this challenge, instead opting to negotiate a lower day-rate than to take its chances elsewhere.

Second, this announcement indicates the scope of the financial and economic impact of the US drilling moratorium. Noble Corp will take a big hit on its day-rate for a prolonged period, and once the moratorium is lifted, the new contract will be at a much lower rate than before the spill.

Not all contracts will be renegotiated in this manner. Some operators have chosen to invoke force majeure clauses, and contract drillers will challenge these moves in court. Deepwater drillers with exposure to the Gulf will suffer from lower day-rates.

What’s particularly frustrating is the common perception is that Gulf drilling can be turned on and off like a light switch. Once rigs and personnel leave the Gulf, returning all this equipment and know-how to the region will not be an easy matter.

And the government likely will be issue much stricter regulations governing the equipment and safety procedures in the Gulf; meeting these new requirements will involve considerable time and investment.

Smaller, independent companies could effectively be locked out of the Gulf because of rising compliance and insurance costs. In the worst-case scenario, only big players such as Chevron (NYSE: CVX) and Petrobras (NYSE: PBR) would be able to drill in the region.

These concerns add up to less non-OPEC oil supply and higher energy prices.  

My basic outlook remains the same. Services companies such as Baker Hughes, Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT) suffer a bit from the moratorium on drilling in the Gulf, but their long-term growth stories remain attractive. Of our three Portfolio recommendations, Baker Hughes has the most exposure to the deepwater Gulf, while Weatherford International will suffer the least from the oil spill.

That being said, operations in the deepwater Gulf represent a relatively small portion of revenues for firms that boast a diversified geographic footprint. Any impact is already priced into these stocks. Buy Baker Hughes under 55 with one October 2010 put option for every 100 shares. Schlumberger is a buy up to 85; Weatherford International is a buy up to 26.

Hedging Our Bets

Given my outlook for the economy and credit markets, I remain bullish on oil prices and the energy sector in general.

Several subscribers asked about natural gas and related stocks during our inaugural online chat last month. Drilling activity will remain solid in the Haynesville Shale and Marcellus Shale because these unconventional plays are cheap to produce. Contrary to popular misconception, many of the best unconventional fields involve lower production costs than conventional plays. 

In addition, as I explained at some length in the April 28, 2010, issue of The Energy Letter, many of the best unconventional plays are rich in natural gas liquids (NGL). Natural gas is composed primarily of methane but also includes a long list of other hydrocarbons such as propane, butane and ethane.

Collectively, these other hydrocarbons are known as NGLs; the value of a barrel of NGLs tends to track the price of crude oil far more closely than that of natural gas. Because NGL prices are relatively high, NGL production can increase the value of producers’ output significantly. This is a major reason why drilling activity remains strong in Appalachia’s Marcellus Shale and the Eagle Ford Shale of south Texas, despite weak gas prices.  

As for dry gas (methane), warm summer weather, resurging industrial demand and an early start to what’s expected to be an active hurricane season bodes well for prices. These factors should put a floor under the price of gas for the remainder of the summer. That being said, I don’t expect gas prices to soar; the US has ample inventories.

For these reasons, I prefer gas producers such as Petrohawk Energy Corp (NYSE: HK) and Range Resources Corp and gas-levered services names such as Nabors Industries (NYSE: NBR) and Baker Hughes to buying the commodity itself or an exchange-traded fund (ETF) like United States Natural Gas Fund (NYSE: UNG).

The producers with access to the best plays can make money at current gas prices, and services firms benefit from strengthening drilling activity. I don’t recommend UNG, but if you own the ETF, I would recommend using a summer rally in gas as an opportunity to sell.

But despite my positive long-term outlook, there are some fundamental challenges in the near term. In particular, I expect lingering concerns about the economy and Europe to keep the markets range-bound over the balance of the summer. To protect the model Portfolio against bouts of selling, it’s a good idea to identify and short a few sectors that look vulnerable at current prices.

Two such groups are alternative energy and select deepwater contract drillers–the stocks most directly affected by the spill in the Gulf of Mexico. The main issue is that the drilling moratorium has already prompted several operators to declare force majeure, allowing them to cancel existing long-term rig contracts. In a typical deepwater drilling contract, the producer agrees to pay a certain day-rate–a daily fee to lease the rig and crew–to the contract driller.

Drilling contractors have two basic options: They can try to renegotiate rig contracts with producers or accept force majeure and see new contracts in international markets. Neither option is particularly attractive. An influx of deepwater rigs from the Gulf of Mexico will overwhelm demand elsewhere; contractors moving rigs out of the Gulf are unlikely to earn day-rates anywhere near what they were before.

The other alternative is a negotiated settlement.

As I noted earlier, Seadrill is the company least impacted by the moratorium because it has only one rig in the Gulf of Mexico. Even better, Seadrill’s fleet of rigs are state of the art, highly capable and just a few years old on average. The most likely outcome of the BP spill is that the US government ultimately opens the Gulf for drilling once again but with much stricter regulations.

One of the drillers that stands to lose the most from these developments: Diamond Offshore (NYSE: DO).

This table shows how much exposure the major drillers have to a six-month moratorium on deepwater drilling in the Gulf. Diamond Offshore doesn’t have the most exposure in terms of revenue, but its exposure is roughly three times that of Seadrill.

The reason I recommend shorting Diamond Offshore is twofold: The firm has an older fleet, and a high dividend yield means that the stock usually commands a premium.

Because of their age, some of Diamonds’ rigs aren’t capable of drilling in the deepest waters and are unlikely to secure contracts abroad. And once the ban is lifted, new regulations could force Diamond has to upgrade many of its rigs. Operators may also prefer to hire newer rigs as an added layer of safety.

Shares of Diamond traditionally have traded at a premium to because the firm pays out much of its free cash flow in the form of a dividend. But Seadrill offers a higher yield, and that payout is more visible now that the firm has shifted its primary listing to the New York Stock Exchange. I expect yield-oriented investors to reduce their stake in Diamond and re-allocate cash to Seadrill.

Meanwhile, Diamond Offshore likely will take a significant hit from the moratorium and could be forced to reduce its payout. This would be a huge problem; companies that cut their dividends quickly lose favor with yield-oriented investors.

I recommend that aggressive investors sell Diamond Offshore short above 60. As with all short positions, I will track this recommendation in the Gushers Portfolio.

Solar power will be a major loser as EU members rein in spending. This alternative energy is extremely expensive compared to coal or natural gas. Worse yet, it’s impractical because output from solar-power facilities varies wildly with light conditions; as there’s no way to store power on the grid, variable output from solar plants is a major challenge. Utilities must install back-up power plants–usually gas-fired facilities–to feed in power when output from solar plants falls. In other word, solar power isn’t even a good way of reducing reliance on fossil fuels.

About a year ago, I attended an energy conference in Washington, DC and listened to a speech from Secretary of Energy Stephen Chu. Even Chu, a big proponent of solar and other alternative energy sourced, admitted that it could be more than a century before solar becomes an important power source. I am a long-term investor, but I don’t have a century to wait. I suspect most subscribers are in the same boat.

Because solar power is impractical and extremely expensive, government subsidies are the main reason the industry has thrived. European countries have promoted solar power and other alternative energies aggressively through feed-in tariffs that guarantee higher prices for alternatives.

Spain was the world’s fastest-growing solar market in 2008, thanks to generous subsidies. But Spain and other EU countries are now re-evaluating their energy policies in light of the need to reduce their budget deficits. And Germany’s feed-in tariff for solar power fell to a lower rate as of July 1.

The Obama administration is a proponent of green energy. In fact, the US Dept of Energy recently approved $2 billion in loan guarantees for US solar power projects.

But the US budget situation is also deteriorating, and funding for alternatives will suffer as the $787 billion stimulus plan expires. Democrats may manage to pass additional subsidies for alternative energies as part of an energy bill, but such an outcome is unlikely this year. If Republicans pick up seats in Congress during midterm elections, it will be even more difficult to pass such an energy bill.

First Solar (NSDQ: FSLR) holds long-term appeal and appears as a recommendation in my Alternative Energy Field Bet. The company’s thin-film solar technology is cheaper than polysilicon, giving the firm a leg-up on competitors. However, I’ve recommended that investors avoid most alternative energy stocks for over a year and a half, and the short-term headwinds for First Solar are significant.

Aggressive investors should short First Solar above 110.

Stock Update

Amid last week’s selloff, we were stopped out of gas producer Range Resources Corp. I continue to like Range because of its low cost and NGL-rich asset base in the Marcellus Shale. And fears stricter regulations for gas drilling in the region are massively overblown; the Marcellus Shale brings too much revenue to Pennsylvania.