In This Issue

The Stories

I always pay particularly close attention to initial public offerings (IPO) of new MLPs because these newly listed names usually raise distributions quickly to attract investors. Here’s my take on the latest IPOs. See MLP IPOs.

By virtue of their diversified product lines and geographic footprints, the big services firms represent the best way to profit from the end of easy oil. But smaller, specialized players in the services and equipment space also stand to benefit as producers increasingly target technically complex and hard-to-produce fields. See Are You Being Served?

Asian demand for Australian coa remains robust; here’s a dividend-paying stock that offers exposure to this trend. See Coal Plays.

I revisit the investment thesis behind one of the top performers in the model Portfolios this year. See Exploration and Production.

Our newest feature, the Fresh Money Buys list, tells you which energy names to buy now. See Fresh Money Buys.

The Stocks

Chesapeake Midstream Partners LP (NYSE: CHKM)–Buy in Energy Watch List
Niska Gas Storage Partners LLC (NYSE: NKA)–Hold in Energy Watch List
PAA Natural Gas Storage LP (NYSE: PNG)–Hold in Energy Watch List
Lamprell (LSE: LAM, OTC: LMPRF)–Buy in Energy Watch List
TETRA Technologies (NYSE: TTI)–Buy in Energy Watch List
Bristow Group (NYSE: BRS)–Buy in Energy Watch List
Bucyrus International (NSDQ: BUCY)–Buy < 77
Peabody Energy Corp (NYSE: BTU)–Buy < 52
Penn Virginia Resource Partners LP (NYSE: PVR)–Buy < 24
Natural Resource Partners LP (NYSE: NRP)–Buy < 27
Macmahon Holdings (Australia: MAH)–Buy < AUD0.75

MLP IPOs

The master limited partnerships (MLP) in the model Portfolios are among this publications most successful and longest-standing recommendations. Given their long tenure, it’s no surprise I’ve written about this asset class extensively over the years; readers seeking an overview of some of the unique benefits of MLPs should consult the April 14, 2010, issue of The Energy Letter, Master Limited Partnerships and Taxation.

Most MLPs are involved in the midstream energy business, which includes storing, transporting and processing natural gas and oil–businesses that generate reliable cash flows, much of which flows through to unitholders in the form of quarterly distributions (the MLP equivalent of dividends). Right now the average MLP yields 6 to 6.5 percent, though some names boast yields that exceed 10 percent.

And although MLPs trade on popular US exchanges, they aren’t corporations and are exempt from US corporate income tax. Instead MLPs pass through distributions to its unitholders, each of whom pays taxes on his or her share of the partnership’s profits. But profits aren’t all MLPs pass through to investors; unitholders also enjoy considerable tax shields. Noncash accounting charges such as depreciation shield a large portion (often 80 to 100 percent) of the distributions from taxation. In other words, you can defer taxes on most of your accumulated distributions until you decide to sell the MLP.

These tax advantages will not expire if Congress allows the tax cuts implemented by George W. Bush to sunset.

In the previous issue of The Energy Strategist, I outlined all of my current MLP recommendations. But I cover dozens of additional names in my Energy Watch List. In addition, I always pay particularly close attention to initial public offerings (IPO) of new MLPs because these newly listed names usually raise distributions quickly to attract investors. Still under many investors’ radar screens, the IPOs can be a lucrative hunting ground for those seeking high yields.

Here’s a look at the prospects for the three largest new MLP IPOs so far this year.

Chesapeake Midstream Partners LP (NYSE: CHKM)

Key Takeaways:

• Chesapeake Energy Corp (NYSE: CHK), the MLP’s general partner, is one of the largest independent exploration and production companies in the US and boasts a wealth of assets suitable for drop-down transactions.
• Chesapeake Midstream’s gathering contracts are structured so that it has little to no exposure to natural gas and other commodity prices.
• The MLP’s Mid-Continent gathering system should benefit from increased drilling in fields rich in oil and natural gas liquids.
• Chesapeake Midstream has a slightly lower-than-average yield but offers superior growth prospects and below-average business risks.

Chesapeake Midstream Partners LP is the most anticipated MLP IPO in recent memory, primarily because the MLP’s general partner (GP), Chesapeake Energy Corp, is one of the largest independent exploration and production (E&P) firms operating in US unconventional natural gas and oil fields. CEO Aubrey McClendon has talked about taking a midstream gas MLP public for years, so investors have awaited this IPO for some time.

The 2008-09 financial crisis temporarily shelved plans for an IPO of Chesapeake Energy’s midstream division, but improved credit conditions and solid demand for MLPs prompted the company to file its first registration statement for Chesapeake Midstream in February.

McClendon and his team appear to have picked an opportune time for the IPO; the units commanded prices at the top end of the projected range, suggesting strong demand from institutional investors. And since the IPO at $21, the units have climbed to $25, indicating that the secondary market is also interested in the new MLP.

Fundamentals support the market’s enthusiastic reception of Chesapeake Midstream; the new IPO offers lower-than-average business risk and superior growth potential.

 A Strong, Growth-Oriented GP

The GP manages the day-to-day operations of an MLP’s assets and makes key decisions on acquisitions and organic expansion projects. Investing in an MLP whose GP doesn’t have unitholders’ best interests in mind often entails its fair share of pain. Fees paid to the GP called incentive distribution rights (IDR) underscore point: High IDRs can make it tougher for the MLP to raise capital for future growth prospects.

Here are a few questions to ask when evaluating an MLP’s GP.

• Is the GP wholly owned by a private-equity firm? Private-equity firms often hold GP assets for a relatively short time and may look to sell at an opportune time.
• Is the GP an operating company with assets suitable for drop-down transactions? In drop-down deals the GP sells assets such as pipelines or gas-processing facilities directly to the MLP. Drop-downs are usually highly accretive to cash flow and allow the MLP to immediately boost its distribution payouts.
• What is the IDR structure and in which tier is the MLP? As noted earlier, IDRs are a fee paid by the limited partners (LP) in an MLP (for the most part, that’s us) to the GP. IDRs are usually related to the size of the distributions paid to LP unitholders; the GP’s take typically rises as distributions increase. Such a structure incentivizes the GP to grow the business, but high IDR payments early in an MLP’s life can stunt its growth.
• What is the GP’s ownership stake in the MLP? GPs often own a significant proportion of the MLP’s limited partnership interests when the MLP is first listed. Over time, the GP usually sells off its LP stake to raise capital. That being said, GPs that retain a significant stake in the LP are usually more sensitive to unitholders’ interests.
• Is the GP in a position to help the MLP when credit markets weaken? This was a key question to ask in 2008-09. Some GPs shored up the finances of the MLPs they sponsored by temporarily suspending IDR payments, providing direct loans or offering some sort of guarantee that the distribution wouldn’t be cut.
• How experienced is GP’s management team? This is the most basic question investors can ask of any company. An experienced management team like the ones in place at Enterprise Products Partners LP (NYSE: EPD), Kinder Morgan Energy Partners LP (NYSE: KMP) and Linn Energy LLC (NSDQ: LINE) is preferable.

On all of these points, Chesapeake Midstream and its GP score well.

Chesapeake Midstream owns nearly 3,000 miles of gathering pipelines in two key regions: the Barnett Shale around Fort Worth, Texas and an area collectively known as the Mid-Continent that includes the Permian Basin, Anadarko and Granite Wash plays.

These assets are small diameter pipelines that connect individual gas (or oil) wells to processing facilities and, ultimately, the interstate pipeline network. In addition to gas gathering, Chesapeake Midstream also provides ancillary services such as compression and treating. The latter process involves removing carbon dioxide from raw natural gas.

Chesapeake Energy drills actively in all of these regions. The company has spent north of $1.5 billion on midstream energy assets over the past few years because it needs gathering, treating and compression capacity to transport the gas, natural gas liquids (NGL) and oil it produces. Because these assets are integral to Chesapeake Energy’s operations, the GP is incentivized to ensure that Chesapeake Midstream remains healthy.

Chesapeake Energy’s motivation for spinning off these midstream assets is clear. First, holding these assets in an MLP structure is far more tax efficient. Second, the IPO brought Chesapeake Energy a substantial influx of capital, funds the firm can use to grow production. Meanwhile, capital raised by Chesapeake Midstream can be used to build out additional infrastructure to support Chesapeake Energy’s drilling operations.

Drop-down transactions should drive distribution growth at Chesapeake Midstream over the next few years. The MLP’s portfolio doesn’t include Chesapeake Energy’s extensive midstream assets in the Marcellus Shale of Appalachia, the Haynesville Shale of Louisiana and East Texas, and the Fayetteville Shale in Arkansas, among other regions. The gathering system owned by Chesapeake Midstream serves about 3,500 natural gas wells that produce about 1.532 billion cubic feet of gas equivalent per day, but Chesapeake has stakes in over 40,000 wells whose daily output amounts to 2.6 billion cubic feet of gas.

And this growth forecast isn’t idle speculation. Management anticipates as many as two drop-down transactions of $250 to $500 million worth of assets in each year going forward. 

With around $750 million available on its credit facility and the potential to raise low-cost cash in the debt markets, Chesapeake Midstream should have no trouble financing deals of that size. And as part of the partnership agreements, Chesapeake Midstream has the right of first refusal on any midstream assets that Chesapeake Energy chooses to sell.

Some analysts have expressed concern about Chesapeake Energy’s debt load and subpar credit rating, questioning whether depressed natural gas prices (see Short-Term Outlook for Natural Gas and Pugh Clauses and Shale-Gas Activity) will constrain the GP’s ability to secure financing.

These fears are largely unfounded.

Chesapeake Energy has set a goal of working its way back to an investment-grade credit rating. Actions speak louder than words, but the bond markets appear to be putting faith in the company.

Source: Bloomberg

This graph tracks the price of Chesapeake Energy 6 7/8% due Nov. 15, 2020 (CUSIP: 165167BUO). As you can see, these bonds have appreciated steadily to the point that the current yield stands at roughly 6 percent, about 330 basis points (3.3 percent) above the current yield on a 10-year US Treasury note. A year ago this spread was more than 480 basis points. Falling spreads to Treasuries is a sign of improving sentiment. Although the Chesapeake Energy’s bonds still don’t command a yield spread that’s typical of investment-grade credits, the trend is heading in the right direction–even if natural gas prices aren’t cooperating.

In addition, Chesapeake Energy has partnered with major international oil companies on many of its key fields, a move that significantly reduces the out-of-pocket investment required to develop the plays.

Chesapeake Energy’s acreage in the Barnett Shale is far and away the single most important source of volumes for Chesapeake Midstream. These properties are developed as part of a joint venture (JV) with Total (NYSE: TOT). Under the terms of the deal, Chesapeake Energy sold Total a 25 percent stake in its Barnett Shale interests in exchange for $800 million cash and an agreement that Total will fund $1.45 billion worth of future drilling and completion expenses in the field. In other words, Chesapeake got cash and what amounts to a free ride on most of expenses through 2012.

Given the backing of a giant like France-based Total, worries about Chesapeake’s ability to fund drilling in the Barnett Shale are vastly overblown.

Finally, Chesapeake Energy has maintained a 41.5 percent ownership stake in Chesapeake Midstream, further aligning the GP’s interests with unitholders.

Asset Risk and Commodity Exposure

The natural gas gathering and processing business tends to entail significant exposure to commodity prices. Typically, gathering is sensitive to drilling activity; the more wells being drilled in an area, the greater the demand for new well hook-ups. Gatherers often earn a fee for hooking up new wells to their systems and are remunerated based on the amount of gas transported. Robust drilling activity translates into strong results

Frenzied drilling in key US shale plays despite low gas prices reflects superior economics in certain plays and the urgent need to secure leaseholds through production. But activity in these fields should pull back a bit in coming months. Aubrey McClendon noted in Chesapeake Energy’s second-quarter conference call that the firm would focus on drilling in liquids-rich plays until the price of gas recovers to more than $6 per million British thermal units.

All of these developments at the GP level won’t affect on Chesapeake Midstream’s ability to pay distributions. Roughly three-quarters of the MLP’s cash flows will come from its gathering operations in the Barnett Shale. These volumes are covered under long-term gathering agreements signed with the Chesapeake Energy-Total JV. Here are some of the key terms.

1. A fixed fee for every 1,000 cubic feet of gas gathered and treated from the Barnett Shale acreage. At the beginning of every year, this fee automatically increases 2 to 2.5 percent.
2. The JV has agreed to dedicate all gas produced from existing and future wells in the Barnett Shale to Chesapeake Midstream.
3. The JV has agreed to minimum volume commitments through mid-2019, and these commitments increase by 3 percent every year. In other words, the MLP will receive a certain contractually guaranteed minimum whether or not the gathering system is used. Not only will this minimum increase, but the volume-based fee will rise each year.

The remaining 25 percent of cash flow come from Chesapeake Energy’s Mid-Continent operations. This gathering agreement resembles the one covering the Barnett Shale, with one notable exception: No minimum volume is set.

This omission is less of an issue in the Mid-Continent, an NGL- and oil-rich region where Chesapeake Energy likely will increase its output to take advantage of superior economics.

Distribution Growth Potential

Chesapeake Midstream has yet to announce its first quarterly distribution. But the MLP indicated that it would pay distributions equal to about $0.3375 per unit per quarter ($1.35 per year). This is the minimum quarterly payout set forth in the registration statement.

The first payment would be prorated because the MLP will be publicly traded for only two months in the third quarter. Expect the partial third-quarter distribution to be around $0.225 per unit. Based on the current price and an annualized payout of $1.35, units of Chesapeake Midstream yield roughly 5.5 percent. Note that most brokers’ websites and sites like Yahoo! Finance won’t display the correct yield until the MLP declares a full quarterly distribution.

To forecast potential distribution growth, let’s examine the MLP’s IDR Tier structure, listed below:

• Tier 1: 98 percent to MLP holders and 2 percent to the GP, up to $1.55 per unit;
• Tier 2: 85 percent to MLP holders and 15 percent to the GP, between $1.55 and $1.69;
• Tier 3: 75 percent to MLP holders and 25 percent to the GP, between $1.69 and $2.03; and
• Tier 4: 50 percent to MLP and 50 percent to the GP, above $2.03.

To start, Chesapeake Midstream will be in the Tier 1 threshold, meaning that 98 percent of any distribution goes to the holders of the LP units. This scaled structure, which requires less growth in total cash flows to boost the payout to unitholders, often enables new MLPs to grow their payouts at a faster rate than mature rivals it takes less growth in total cash flows to produce a rise in the payout to LP unitholders.

And the GP is incentivized to grow distributions as quickly and sustainably possible; the higher the distributions paid to unitholders, the higher the percentage received by the GP.

An example will flesh this idea out more clearly. Williams Partners LP (NYSE: WPZ) offered a similar value proposition when it went public in 2005. The GP, Williams Companies (NYSE: WMB), owned a large number of assets appropriate for drop-down transactions. The MLP hit the top end of its Tier 1 payout in two quarters, exceeded its Tier 2 payout in a year and hit its Tier 3 payout just two years after the IPO.

Although it’s by no means a sure thing, Chesapeake Midstream could enjoy a similar growth rate, assuming that the GP drops down about $500 million in assets each year. If Chesapeake Energy sticks to its word, the MLP could pay out $0.3875 per quarter by mid-2011 and $0.4225 per quarter in early 201–an annualized growth rate of roughly 15 percent.

Chesapeake Midstream likely will end 2010 with an annualized yield of about 5.5 percent, less than the 6.2 percent average of the benchmark Alerian MLP Index. However, a lower-than-average yield is justified by fee-based gathering contracts that limit exposure to commodity prices. The potential for the distribution to grow at a double-digit rate also mitigates a lower yield.

Chesapeake Midstream Partners LP is a buy in my Energy Watch List. 

Niska Gas Storage Partners LLC (NYSE: NKA)

• Niska is one of the largest owners and operators of natural gas-storage assets in North America.
• The MLP derives a large portion of its revenues from fees that are insensitive to gas prices. But the MLP’s proprietary operations do have considerable market risk.
• Gas storage fundamentals appear to be deteriorating, potentially putting Niska’s growth at risk.

Chesapeake Midstream’s market cap is more than double the size of Niska Gas Storage Partners LLC, an MLP that went public on May 11, 2010, at $20.50 per unit. The fledgling MLP has struggled, and its units trade for less than its IPO price despite a 12.5 percent rally in the benchmark Alerian MLP Index.

Niska controls 185.5 billion cubic feet (bcf) of natural gas-storage in the US and Canada, making the MLP one of the largest independent owners of these assets in North America. The majority of these facilities are located near major pipeline hubs, and gas in these facilities can be marketed to a large number of potential buyers.

Demand for natural gas storage has grown in recent years, driven by several long-term trends. One of the most important is the winter-summer spread in gas prices. Strong winter heating demand tends to drive high gas consumption in the winter months; prices are typically higher during the winter than during the summer or the fall and spring shoulder seasons.

As a result of seasonal demand patterns, US natural gas in storage tends to fall during the winter months because demand exceeds production; gas in storage rises from April to October as production exceeds demand. Gas storage is a sort of buffer between seasonal demand and supply.

These seasonal patterns offer profits for companies that buy gas at cheap prices in midsummer, store these volumes for a few months and sell it at sky-high rates in January. The bigger the difference between average summer and winter prices, the better the profits. Large winter-summer differentials and extreme volatility in gas prices tend to increase the value of gas storage.

Storage Contracts

Niska operates its storage facilities under three basic types of arrangements: long-term contracts, short-term contracts and proprietary management.

Long-term firm (LTF) storage contracts are multiyear deals between Niska and a third party that seeks the right to inject gas into storage and withdraw portions of this volume multiple times per year. Typically, these storage contracts specify the amount of gas and a maximum number of “cycles,” or the injection and subsequent withdrawal of gas from storage.

Capacity reservation fees guarantee a certain amount of storage for a customer and account for 90 percent of the revenue Niska earns in LTF deals. Note that clients pay these fees regardless of whether they use the storafe and how many times the gas is cycled.

In addition, Niska levies an additional charge based on the volume of gas that is stored, injected and withdrawn, but these variable fees offset fluctuating costs. The real cash flow comes from the dependable, low-risk reservation fee. On average, Niska uses about 70 percent of its capacity and generates about 50 percent of revenues from LTF deals. LTF contracts currently in force have an average of just over three years remaining.

Short-term firm (STF) contracts generally have an effective period of less than one year. The main difference between STF and LTF deals is customer flexibility; under an STF deal, the customer is required to inject gas on a certain date or specified dates and withdraw that gas on predetermined dates. The customer cannot inject and withdraw gas on an as-needed basis. The customer pays a preset fee for this service, usually based on gas price differentials at the time the contract is signed.

For example, say a customer enters an STF deal today and plans to withdraw the stored gas in February 2011. Natural gas currently trades at $3.95 per million British thermal units (MBTU), while futures expiring in February suggest prices of roughly $4.40 per MBTU. The fee charged under an STF deal would be based on this spread. Because STF contracts are renegotiated frequently and depend on prevailing spreads, there’s more risk in STF than LTF deals.  Typically, STF deals account for less than 20 percent of Niska’s revenue.

The remainder of Niska’s revenue comes from “proprietary optimization” deals. That is, Niska uses excess storage capacity for its own operations. Niska doesn’t trade gas directly but uses its storage capacity to capture various low-risk arbitrage opportunities.

Greater pricing volatility volatility, regional variations in gas prices and higher summer-winter spreads increase the number of these proprietary opportunities. This business can provide Niska with plenty of upside in strong markets but also introduces some volatility to cash flows.

All told, Niska’s business has a fee-based component but significant exposure to volatility in natural gas prices. Investors should demand a higher-than-average yield to compensate for this added business risk.

Growth Opportunities

Niska’s general partner is Niska Sponsor Holdings, a firm that’s 95-percent owned by Carlyle/Riverstone, an energy-focused private-equity fund. Generally speaking, an operating company with plentiful assets to drop down to an MLP is preferable to a private-equity concern as a GP. But the involvement of a private-equity GP isn’t necessarily a deal-breaker. In this case, the GP has significant operating experience with gas storage and other midstream energy assets.

Even better, the GP is pursuing a new gas storage development in western Canada and has permission to build a new facility in Louisiana; either of these assets would be suitable drop-downs for the MLP.

There’s also significant potential for organic expansion. At Niska’s storage hub in Alberta, Canada the company will add about 9 bcf of capacity by early next year and a total of 18 bcf by early 2014. The company is also awaiting approval to expand its storage facilities in California over the next three years.

Distribution Growth Opportunities

Niska paid a distribution of 0.173 in August, a partial quarterly payout because the MLP went public midway through the second quarter. The firm should disburse a full quarterly distribution of $0.35 in November, equivalent to an annualized yield of around 7.4 percent.

This quarterly distribution is still in Niska’s first tier of IDRs; the GP currently receives about 2 percent of the MLP’s cash distributable cash flow. Tier 2 of the IDR structure begins at $0.4025, a logical target for the quarterly payout in early 2012. Based on this level, Niska would yield around 8.4 percent.

At this stage in its life and in this environment, it’s unclear whether the MLP is a good risk. Although robust output from shale-gas plays suggests elevated demand for storage, the surfeit of production has pushed down prices along the future curve. In fact, the difference between summer and winter prices–a key driver of Niska’s margins–is relatively tight. An extraordinarily hot summer bolstered gas prices, further compressing this spread. Meanwhile, because prices have dropped, the dollar size of these spreads is smaller than it was a few years ago.

Although Niska yields about 1 percent more than the average MLP in the Alerian Index, it doesn’t compensate for these risks.  We’re assuming coverage of Niska Gas Storage Partners LLC in our Energy Watch List as a hold.

PAA Natural Gas Storage LP (NYSE: PNG)

• PAA owns two natural gas storage facilities, one in Louisiana and one in Michigan.
• Unlike Niska, PAA has almost no exposure to natural gas prices and storage fundamentals.
• PAA’s yield is lower than average, and its growth prospects may be hampered by weakening natural gas fundamentals.

PAA Natural Gas Storage LP owns two natural gas storage facilities, one in Louisiana and one near Detroit. Despite its apparent similarity to Niska Gas Storage Partners, the two MLPs aren’t carbon copies of one another; the main difference is that PAA derives a much larger percentage of its total revenue from simple fees that are unrelated to gas storage economics.

In fact, roughly 99 percent of PAA’s total revenue stems from fee-based businesses. The single most important source of revenue is what PAA calls “firm storage services,” a combination of LTF and STF contract. In both cases, however, most of the fees PAA collects are capacity reservation fees that are paid whether or not the capacity is used.

The MLP has decided to start a marketing division that would take advantage of some of the same arbitrage opportunities that Niska exploits, but this business would be much smaller and designed to utilize capacity not immediately committed under long-term deals. PAA has repeatedly reaffirmed that it will commit most of its capacity under long-term deals, including any new storage it adds.

PAA plans to expand its capacity at both of its storage facilities. The company’s Pine Prairie facility in Louisiana has 24 bcf of total storage capacity, up from 14 bcf at the beginning of 2010. PAA has plans to add another 21 bcf of capacity to Pine Prairie by mid-2012, and if it can get the necessary permits, management may expand the facility to as much as 150 bcf over the long term. The company’s Bluewater facility in Michigan has a capacity of around 26 bcf and PAA. 

PAA Natural Gas Storage also wins points because its GP is Plains All American Pipeline LP (NYSE: PAA), an oil-focused MLP with an excellent operational record. In fact, the GP is already supporting the MLP; Plains All-American owns units in PAA Natural Gas Storage and is foregoing some of its distributions on these units to support cash flows.

With decent organic growth prospects, a fee-based business model and a strong GP, PAA Natural Gas Storage is less risky than Niska despite exposure to the same business lines.

But PAA likely will pay a distribution of $0.3375 per unit in the third quarter, equivalent to an annualized yield of about 5.5 percent; the price of the MLP already reflects its low business risk and strong GP.

Given the potential near-term negatives for storage economics outlined earlier, investor sentiment towards PAA Natural gas is likely to remain tepid at best. We’re adding PAA Natural Gas Storage LP to the Energy Watch List as a hold.

Are You Being Served?

In the Aug. 4, 2010, issue, Oil Services: In the Sweet Spot, I reviewed second-quarter results from Schlumberger (NYSE: SLB), Baker Hughes (NYSE: BHI) and Weatherford International (NYSE: WFT), three of the industry’s biggest operators.

Commentary from this triumvirate of CEOs suggests that activity in key international markets should accelerate in the back half of 2010 and into 2011. E&P firms are ramping up spending now that oil prices appear to have returned to sustainable levels, a welcome development after the anomalous lows recorded during the credit crunch.

By virtue of their diversified product lines and geographic footprints, the big services firms represent the best way to profit from the end of easy oil. But smaller, specialized players in the services and equipment space also stand to benefit as producers increasingly target technically complex and hard-to-produce fields.

Earnings posted by names leveraged to offshore activity have lagged peers with onshore operations, but business should improve over the next few years as E&P outfits ramp up spending. A potential uptick in mergers and acquisitions offer additional upside for small- and mid-cap services and equipment outfits.

Here are three specialty firms that offer exposure to a near-term recovery in offshore spending and attractive long-term growth trends.

Lamprell (LSE: LAM, OTC: LMPRF)

• Replenished backlog, robust pipeline of bids offers potential upside catalysts.
• Management continues to diversify business line.
• Reputation for excellence leads to repeat customers.
• Business should pick up as the international market for jackups improves, particularly in the Middle East.

Lamprell, a leader in producing and refurbishing specialized offshore vessels, suffered a 42.6 percent decline in revenue in 2009 and omitted its interim dividend–hardly inspiring results. But the global credit crunch and weak oil prices reduced activity for many offshore service and equipment providers and prompted a wave of project delays and cancellations.

Lamprell’s management made all the right moves during these trying times, cutting costs aggressively, expanding into new markets and focusing on replenishing its order backlog and building its pipeline of bids.  

The firm has leveraged its expertise and reputation for completing projects on time and on budget to win engineering and construction contracts in the wind-power industry. In February 2010 Fred Olsen Windcarrier awarded Lamprell with a contract worth USD320 to construct two liftboats designed to install offshore wind turbines. Like the jackup rigs used in shallow water, these units have extendable legs that transform the vessel into a stable work platform when activated.

Thus far in 2010 wind-power contracts have accounted for a little more than half of Lamprell’s new backlog, and management has noted that this market should offer additional opportunities in coming years.

In January the UK called for the construction of 32 gigawatts of offshore wind energy; 14 wind farms are active or under construction in the region, while 25 are in various stages of planning.

 Management estimates that Europe will require 29 new installation and maintenance vessels to meet ambitious plans to expand offshore wind-power generation and expects to win more business in this niche market.

These green energy endeavors provided a needed boost in a difficult down-cycle, though Lamprell should continue to benefit from persistent weakness in the market for older, shallow-water rigs.

Intent on cutting costs, many contract drillers have opted to “cold stack” these units, or temporarily remove them from the market. This process often involves maintenance and refurbishing, Lamprell’s traditional strength. To take advantage of these opportunities, the company has expanded its ability to refurbish jackups offsite.

Meanwhile, management noted that it will continue to pursue opportunities to construct advanced, shallow-water rigs for national oil companies, the only operators that have expressed interest in expanding their fleets. In July the firm recently signed a contract with the National Drilling Company, Abu-Dhabi to build two LeTourneau S116E jackup drilling rigs for USD317.

Shares of Lamprell should benefit from several upside catalysts over the near term and long term.

Management has managed to more than double the firm’s backlog this year, assuaging concerns about the firm’s earnings visibility and overly aggressive proposals, while a robust bid pipeline of USD3.1 billion worth of projects should provide additional contract wins this year. These proposals are summarized below.

With an order book of attractive projects, management can afford to be more selective about the work it takes on, a luxury at the nadir of the down-cycle. Less price competition from Korean shipyards, which migrated into some of the company’s business lines when the ship-building industry tanked, should also offer upside.

Over the long term, the firm’s proven ability to complete complex engineering and construction projects on time and on budget should enable it to win business as offshore activity picks up in the firm’s core markets of Asia and the Middle East.

And although the Macondo disaster won’t have a direct impact on the firm’s operations–the majority of which involve shallow-water equipment–the incident has prompted many of the big, integrated oil firms to jettison older offshore rigs in favor of newer models. This broad trend, coupled with the long-term outlook for seaborne drilling activity, should benefit Lamprell.  

Meanwhile, the company continues to invest in future growth, preparing a new facility in the United Arab Emirates that will allow the firm to refurbish and construct semi-submersibles, refurbish drillships and build jackets, decks and topsides for deepwater applications. Adding exposure to deepwater markets should prove a huge upside catalyst, especially in the wake of new regulations spurred by the Macondo oil spill.

With a newly reinstated dividend and plenty of potential near-term catalysts, Lamprell is a buy in my Energy Watch List.

Please be advised that stocks trading in London are quoted in pence (1/100 of a pound) per share, not pounds per share; a stock quoted as trading at 100 doesn’t trade for GBP100 ($150) but GBP1 ($1.50).

TETRA Technologies (NYSE: TTI)

• Plug and abandonment business should pick up in the Gulf of Mexico, as new regulations and stricter enforcement prompt operators to replace aging platforms and offshore infrastructure.
• Platform removal and well abandonment businesses offer superior margins to infrastructure construction.
• TETRA is a leader in completion fluids, with plenty of opportunity to expand into international markets.
• Demand for well testing will benefit from frenzied drilling in US shale plays, while the firm’s production enhancement technologies will do well in an era when output from many mature fields is in decline.

Founded in 1981, TETRA Technologies has gradually expanded its business to include an assortment of services and products involved in well completion, production enhancement and well decommissioning. In 2009 US operations accounted for 80 percent of the company’s revenue, while international business (primarily in Latin America, Mexico and Brazil) represented 20 percent of sales.

This strategic focus on late-stage services meshes well with the firm’s geographic footprint. Not only does the Gulf of Mexico contain many older offshore structures, but the hurricane-prone region offers plenty of opportunity for platform removal and abandonment operations–Hurricane Ike, for example, was a huge boon for business.

Demand for decommissioning and abandonment services remains relatively stable domestically–management estimates that roughly 3,200 platforms and associated wells in the Gulf are potential candidates–and should pick up as producers in the region focus on modernizing their equipment in the wake of the Macondo disaster.

In the near term, the Obama administration’s drilling moratorium in the Gulf of Mexico and permitting delays for plug and abandonment activities have produced cost pressures. But this business line’s longer-term fundamentals remain intact. And with over 3,300 structures outside the Gulf facing decommissioning, management plans to take advantage of growth opportunities overseas.

TETRA’s completion services division faces similar headwinds in the Gulf of Mexico, though management aims to sell heavy completion fluids to Petrobras (NYSE: PBR) and grow its onshore operations in North America’s hottest shale-gas plays, the Haynesville Shale in Louisiana and east Texas, the Marcellus Shale in Appalachia and the Eagle Ford Shale in South Texas. These moves will help offset weakness in the Gulf while the ban on deepwater drilling remains in effect.

Fluids are the crown jewel of TETRA’s completion services segment, and its high-end products compete effectively against offerings from Schlumberger, Baker Hughes and Halliburton (NYSE: HAL). Completion fluids are typically solids-free brines injected into a well to prepare it for eventual production.

Although this business held up well in the first half of the year thanks to a backlog of drilled but uncompleted wells, the fluids business will suffer substantially in the back half of the year because of the drilling ban.

The production and enhancement division is also well positioned for long-term growth despite prevailing weakness.

TETRA boasts the largest fleet of onshore flowback testing in the US, 80 percent of which is deployed in North American shale plays, as well as a sizable presence in key international markets.

Meanwhile, the company’s over 3,600 wellhead compressors, a technology designed to increase production from mature fields, should benefit over the long term from the high number of older fields in North America and around the world. Operations in Mexico have suffered because of security concerns and reductions to Pemex’s budget, but this is a short-term hiccup in a business for which there is a fundamental need.

Despite ongoing weakness from the drilling moratorium in the Gulf, TETRA Technologies is well-positioned for future growth in the majority of its business lines. TETRA Technologies is a buy in my Energy Watch List.

Bristow Group (NYSE: BRS)

• The world’s leading provider of helicopter services to the oil and gas industry, Bristow stands to benefit substantially from increased activity in deepwater exploration and production.
• Helicopter services are required throughout a deepwater well’s lifetime, from exploration to abandonment.
• No.1 or No. 2 operator in key growth markets.

The world’s leading provider of helicopter services to the oil and gas industry, Bristow Group boasts 583 aircraft and is the No. 1 or No. 2 operator in a number of key international markets.

The Big Three oil-services firms have noted that activity in international deepwater fields should continue to pick up into 2011, while the roughly 65 floating rigs expected to be delivered from the second quarter of 2010 to the end of 2012 bode well for Bristow’s fleet utilization and margins.

Long-term growth in deepwater activity should provide a nice tailwind for Bristow: The typical deepwater worksite is 100 to 200 miles offshore and houses a crew of 150, compared to the average shallow-water facility that’s 20 miles offshore and includes a crew of 20. And the firm shuttles these crews to and from the installation on a weekly, biweekly or monthly basis.

Over the past several years management has positioned the company to capitalize on this uptick in deepwater activity. Fleet upgrades and sales of older aircraft have lowered the average age to twelve years, while the large and medium-sized helicopters that are becoming the industry standard comprise roughly 69 percent of Bristow’s fleet.

And with strong positions in Brazil, West Africa and Australia, the firm boasts exposure to markets where activity is expected to increase substantially in coming years. Plus, Bristow’s close relationship with its clients provides entrée into emerging markets worldwide.

With the Gulf of Mexico accounting for just 11 percent of its revenue, Bristow’s earnings should be largely unaffected by the drilling moratorium in the Gulf of Mexico. Poised to take off as deepwater spending and activity increases, Bristow Group rates a buy in my Energy Watch List.

Coal Plays

In the Aug. 18, 2010, issue, A Tale of Two Industries, I explained why coal is my favorite group for the remainder of 2010. I also explained the key differences in the outlook for US and Asian coal markets.

 In just over a month, the five coal plays mentioned in that issue are up more than 8 percent, compared to 4.4 percent for the S&P 500 and 2.5 percent for the S&P 500 Energy Index.

I continue to recommend buying coal-mining equipment manufacturer Bucyrus International (NSDQ: BUCY) under 77 and global coal mining behemoth Peabody Energy Corp (NYSE: BTU) under 52. My two coal-focused MLPs, Penn Virginia Resource Partners LP (NYSE: PVR) and Natural Resource Partners LP (NYSE: NRP) rate buys under 24 and 27, respectively.

As I noted in the Sept. 21 Flash Alert, A New Deal, I regard Penn-Virginia Resource Partners decision to buy Penn-Virginia GP Holdings (NYSE: PVG) as favorable for both firms. 

Investors looking to gain exposure to Penn-Virginia Resource Partners should consider buying Penn-Virginia GP Holdings right now; once the merger is finalized, you’ll receive 0.98 units of the LP for each unit of the GP. At present, this approach enables investors to pick up Penn-Virginia Resources Partners at a discount.

In this issue, I take a look at an unusual coal play that’s well-placed to benefit from strong growth in Asian demand. I am also adding the stock to Gushers Portfolio, a collection of stocks for aggressive investors seeking growth.

Macmahon Holdings (Australia: MAH, OTC: MCHHF)

• Handles mining and construction projects in Australia.
• Mining contracts involve providing ongoing services such as drilling and blasting as well as waste management and equipment maintenance, normally under multiyear deals.
• The largest single category of construction projects is related to building rail links, a business related to mining activity.
• Macmahon’s order book is growing once again as the Australian mining industry recovers from the commodity price shock of 2008-09 and the resource tax shock of earlier this year.

Macmahon Holdings is an Australian contract mining and construction firm that provides key services to the mining industry, including drilling, blasting, waste management and ongoing maintenance of mines. The company focuses on the coal and iron ore industries, though it’s involved in other mining operations.

For example, Macmahon has a contract with Gushers Portfolio recommendation Peabody Energy to provide services for the company’s Eaglefield, an open-pit mine that produces both high-quality metallurgical coal and steam coal. The deal is worth $500 million, and the contract runs from October 2003 to September 2013.

Macmahon handles all drilling and blasting services, provides an on-site equipment maintenance depot and removes of overburden and interburden, or the dirt, rocks and other waste materials around the coal deposit. 

In addition to its resources business, Macmahon also handles major construction projects. A little over half of these undertakings involve rail-related infrastructure, the key means of transporting coal and other commodities from Australian mines to ports for export.

An example of a recent project is a $90 million rail expansion project connecting Goonyella, a key hub of coal mining activity in Central Queensland, to the Abbott Point export terminal near Bowen, Australia. Macmahon also handles various civil engineering projects, including building bridges and water and wastewater facilities in Australia, Asia and Africa.

Needless to say, Macmahon’s fortunes are leveraged to the health of the resource industry. The announcement of a proposed “resources super profits tax” prompted several planned projects to be delayed or canceled.

As I outlined in the Sept. 1, 2010, issue, Politics and Energy, I had expected the Australian Labor Party to lose the general election and the center-right Liberal Party to form a new coalition government. I was wrong. Through a weak alliance of the Green Party and some independent rural members of Parliament, the Labor Part and Prime Minister Julia Gillard narrowly retained their grip on power. The coalition is tenuous, and many believe that the government will need to call another election within 12 months.

Although this coalition means that the controversial tax is unlikely to be scrapped altogether, Gillard’s compromise proposal is far less onerous. Scrapping the tax entirely would be the ideal outcome for the coal mining industry, but Gillard’s version won’t stop new investments in mining projects. This is good news for Macmahon.

Macmahon showed rapid improvement in order trends in its fiscal year ended June 2010. In June 2009 the company’s backlog of unfinished contracts stood at about AUD1.41 billion, and over the course of the next 12 months, the firm completed about AUD1.25 billion in deals.

But, the company added a total of more than AUD1.9 billion in new contracts and extensions to existing contracts, with the majority of those orders coming in the second half of the fiscal year. At $2.2 billion, the order book is actually larger than it was in 2007 and 2008, before the global financial crisis and commodity price collapse prompted many miners to delay or cancel projects.

 The firm was able to renew all five mining contracts that expired in the fiscal year, a sign of strong ongoing relationships with Peabody Energy, BHP Billiton (NYSE: BHP) and other luminaries

And even though the firm has a market capitalization of just AUD500 million (USD480 million) and the stock trades at less than AUD1 per share, it’s no fly-by-night company with weak financials. Macmahon has no net debt and generates significant free cash flow from its existing contracts.

It’s an aggressive play, but I am adding Macmahon Holdings to the Gushers Portfolio as a buy under AUD0.75. I recommend buying the stock directly from the Australian exchange. In addition to its attractive fundamentals, Macmahon also pays a dividend and yields north of 4 percent.

When I added Peabody Energy to the Gushers Portfolio in 2009, I considered the stock to be relatively risky; coal prices remained depressed, and the sector was extremely volatile. But with the recovery gaining steam, I am shifting the recommendation from Gushers Portfolio to the growth-oriented Wildcatters Portfolio. I remain bullish on Peabody and recommend buying the stock under 52; this move solely reflects reduced risk.

Exploration and Production

I highlighted a long list of international crude oil-focused E&P companies in the April 7, 2010, issue, The Search for More Oil. One of the best performers in the group is Gushers Portfolio recommendation Afren (LSE: AFR), a company with outstanding leverage to growth in African oil production. Here’s an update.

Afren (London: AFR)

• Afren’s Okoro Setu project in Nigeria is showing flat production, but the firm plans to expand output by drilling two new wells in the fourth quarter.
• The key Ebok development is on track for first production in the fourth quarter.
• Okwok and OML 115 are two additional fields in appraisal and exploration, respectively; more well results are due over the next three months.

Nigeria accounts for the majority of Afren’s oil production, and the outfit’s most important expansion projects are located in the nation. The company’s Okoro Setu Project produced 17,841 barrels of oil per day in the first half of the year, and Afren has identified two new locations that it plans to drill by year-end that will boost production from this older field.

The company’s most important expansion project is Ebok. As of mid-July, Afren had partially drilled all five production wells and a water-injection well to maintain underground pressures and maximize output. In addition, one well that Afren had intended for water injection encountered about a 100-foot oil column, so the firm has decided to treat the well as a producer instead.

In addition, Afren is preparing the offshore production unit and related infrastructure to handle oil from Ebok. All told, the project looks to be on target for first oil in the final quarter of this year. This is in-line with expectations I outlined back in the April 7 issue.

Looking a bit further into the future, the company’s Okwok and OML 115 fields also hold significant promise, and Afren is undertaking some additional appraisal work in both plays since my last update. In Okwok the company began drilling another appraisal well–a well designed to help delineate the reservoir’s size–in late August that should be wrapped up by the end of September. OML 115 is about 2 kilometers from Ebok and has some of the same geologic structures; an exploration well is scheduled for the fourth quarter, another potential news catalyst for the stock.

Afren is poised to show significant growth in oil output over the next few years and remains a buy under GBP115 ($1.80) on the London exchange.

Fresh Money Buy List

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

I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve selected a list of 15 Fresh Money Buy list, including 13 names and two hedges, all taken directly from the model Portfolios.

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

Source: The Energy Strategist