It’s become a tradition to devote the first issue of the new year to the outlook for the upcoming 12 months. These forecasts focus on five areas of interest to energy-focused investors: the global economy, the broader stock market, oil prices, natural gas prices and coal prices.

But you can’t look forward without looking back. The first issue of the year always begins with a review of my outlook for the preceding 12 months, an analysis of prognostications came to fruition and those that failed to materialize. Being a perfect forecaster isn’t a prerequisite for success in the market. But investors who refuse to honestly evaluate their past mistakes are doomed to failure. There’s nothing worse than an investor who clings to a pet theory or stock just because he or she can’t admit to making an error.  

Investors shouldn’t regard any forecast as carved in stone. We will always adjust our outlook as the facts change or new information comes available. In addition, investors must be prescient and nimble enough to take advantage of emerging and situational opportunities. The BP (NYSE: BP) oil spill in the Gulf of Mexico is a perfect example; investors who heeded our subsequent call to buy Seadrill (NYSE: SDRL) and other names leveraged to deepwater drilling enjoyed substantial gains.

Regard this issue as a road map to the future, a basic outlook and strategy to keep in mind during the year ahead.

In This Issue

The Stories

You can’t look forward without looking back. Here’s a quick review of The Energy Staretgist’s 2010 outlook for the economy and broader market. See Economy and Broader Market: 2010 Review.

With the US economic recovery gaining strength and key emerging markets still in growth mode, investors’ confidence continues to improve. See Economy and Broader Market: 2011 Outlook.

The Energy Strategist reviews the year that was for oil, natural gas and coal.

The Stocks

Schlumberger (NYSE: SLB)–Buy < 85
Weatherford International (NYSE: WFT)–Buy < 26
Core Laboratories (NYSE: CLB)–Buy < 95
Petroleum Geo-Services (OTC: PGSVY)–Buy < USD16
Cameron International (NYSE: CAM)–Buy < 50
Dresser Rand (NYSE: DRC)–Buy < 40
Seadrill (NYSE: SDRL)–Buy < 35
Diamond Offshore Drilling (NYSE: DO)–Sell Short > 60
Afren (LSE: AFR)–Buy < GBP1.50
Occidental Petroleum Corp (NYSE: OXY)–Buy < 95
Suncor Energy (TSX: SU, NYSE: SU)–Buy < USD43
Chesapeake Energy Corp Preferred D (NYSE: CHK D)–Buy < 100
EOG Resources (NYSE: EOG)–Buy < 115
Range Resources Corp (NYSE: RRC)–Hold
Petrohawk Energy Corp (NYSE: HK)–Hold
Peabody Energy Corp (NYSE: BTU)–Buy < 65
Joy Global (NasdaqGS: JOYG)–Buy <85
International Coal (NYSE: ICO)–Buy < 8
Penn Virginia Resource Partners LP (NYSE: PVR)–Buy < 29
Natural Resource Partners LP (NYSE: NRP)–Buy < 30

Economy and Broader Market: 2010 in Review

It’s impossible to formulate a rational outlook for energy markets and related stocks without outlining a road map for the economy and broader market. At times in 2010, macroeconomic events and trends were the primary drivers of energy commodities and related stocks.

Here’s a recap of my 2010 forecast for the economy and broader market, an outlook I laid out in the Jan. 6, 2010, issue The Crystal Ball:

• That with the Great Recession ending in summer 2009, the US economy would lumber through a subpar cyclical recovery but skirt a double-dip recession;
• That the global economy would pick up significantly in 2010, led by emerging markets;
• That the S&P 500 would end the year between 1,250 and 1,300, up about 12 to 17 percent from its 2009 close;
• That the energy sector would turn in a strong performance; and
• That the market could suffer a “lengthy” correction over the course of the year as “investors fret over the durability of the economic recovery.”

Although the major elements of my 2010 economic and market forecast were spot-on, some of my energy-related prognostications failed to materialize. But I’m just as willing to analyze my bad calls on natural gas (more on that later)as I am to pat myself on the back for good calls. After all, the markets are cruel to investors who are too stubborn to acknowledge their errors and change course.

The National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee is the official arbiter of the start and end dates for US recessions. In late September 2010, the NBER announced that the Great Recession had ended in June 2009. Calling the end of the recession before the NBER’s official announcement might not seem all that important in retrospect, but at the end of 2009 many economists still claimed that the nascent recovery was merely a brief pause in a prolonged downturn.

In 2010 the US economic recovery proved lackluster, especially considering the severity of the 2007-09 downturn.

In terms of postwar recessions, the 1973-74 and 1981-82 downturns most closely resemble the 2007-09 economic crisis in terms of severity and duration. In the year after the 1973-74 contraction, US economic growth averaged 6.2 percent. When the economic recovery began in 1982, US gross domestic product (GDP) expanded by 7.8 percent.

However, the US economy expanded at an average annualized rate of just 3 percent in the 12 months following the official end of the Great Recession.   

A double-dip recession occurs when an economy begins to contract within 12 to 18 months of exiting a recession. Only two postwar downturns fit this definition, the two US recessions in the early 1980s. For the US economy to slip into a double-dip recession, GDP would need to have contracted in the back half of 2010.

Although the government has yet to release its advanced estimate of fourth-quarter GDP, a number of indicators suggest that the US economy picked up steam heading into year-end–foreclosing the possibility of a double dip. My insistence that the US would dodge a double-dip recession was controversial when I issued my 2010 outlook and attracted even more criticism in midsummer when the US economy hit a soft patch. But this prediction ultimately panned out.

Closing out 2010 at 1,257.64, the S&P 500 finished within my forecasted range. Based solely on price appreciation, the index was up 12.8 percent; with dividends reinvested, the S&P 500 gained about 15 percent. As I predicted at the outset of last year, the S&P 500 Energy Index outperformed the broader market by about 5 percent, rising 20.5 percent with dividends reinvested. The widely watched Philadelphia Oil Services Index, one of my favorite groups, did even better, returning 27 percent on the year.

My call for a lengthy correction amid worries about global economic growth also came to fruition (mostly). From its April high to its July low, the S&P 500 gave up about 18 percent, as weak US and European economic data fanned fears of a double-dip recession. This selloff was a bit more severe than the 10 to 15 percent pullback I’d envisaged.  

In addition, I failed to highlight the European sovereign credit markets as a potential risk for the global economy.

Economy and Broader Market: 2011 Forecast

I remain bullish about the prospects for the economy and markets in 2011.

A spate of data released over the past few months suggests that US economic growth is accelerating. I expect US GDP to grow by about 3 percent in 2011, a slight improvement from a 2.8 percent expansion in 2010. 

Emerging markets will continue to enjoy robust growth in 2011, with China and India leading the way. Although these countries will continues to tighten their monetary policies in an effort to slow inflation and prevent their economies from overheating, Asian emerging markets should grow GDP by at least 8 percent in 2011. That’s down slightly from the previous year, but still strong by any historical standard.

Against this backdrop, the S&P 500 should rally to between 1,400 and 1,500 by year-end, a 15 percent gain. This bullish outlook doesn’t preclude the occasional 5 to 10 percent correction; bouts of profit-taking are only natural or renewed concerns about the fiscal health of Portugal and Spain could temporarily shake investors’ confidence. Regard such pullbacks as a buying opportunity, particularly for my favorite energy stocks. This sector should outpace the broader market and rank among the S&P 500’s top performers in 2011.

Economists love obscure statistics and indicators of economic performance. Despite my training and educational background, I prefer to focus on a handful of indicators that have proved their worth over many years. Information overload isn’t conducive to making investment decisions, nor is digging up obscure indicators to justify a broken-clock strategy that’s permanently bullish or bearish.

One of my favorite indicators is the Conference Board’s Index of Leading Economic Indicators (LEI). The LEI comprises 10 key economic indicators that tend to turn before the economy as a whole shifts course. The list includes housing starts, consumer expectations, jobless claims and the performance of the US stock market.  

These indicators tend to weaken months before the economy slips into recession and improve before the economy begins to grow. The LEI has proved itself a reliable barometer of the business cycle over the years.

Source: Bloomberg

This graph tracks shows the year-over-year change in the LEI from the late 1960s to the present. When the year-over-year change in the LEI shifts into negative territory, a recession is usually in the cards. As you can see, this indicator predicted the recessions in the 1970s and early ‘80s as well as the mild downturns in the early ‘90s and 2001. We noted in the Jan. 23, 2008, issue Strengthening Headwinds that movements in the LEI indicated a recession was imminent.

With the LEI currently up 6.2 percent from year-ago levels, it’s unlikely that the US economy will slip into recession over the next nine months. 

That’s not to suggest that the year-over-year change in the LEI is infallible; a slight dip into negative territory in the mid-90s turned out to be a false alarm. Nevertheless, the indicator’s solid track record gives it more credibility than the flavor-of-the-month statistics to which some commentators refer.

I also keep an eye on sequential month-over-month shifts in the LEI to identify periods when economic growth picks up or slows down.

Source: Bloomberg

This graph tracks monthly changes in the LEI from mid-2008 to the present, providing a clear glimpse of three distinct stages in the economic cycle: the severe contraction that accelerated in mid-2008, slowed in early 2009 and reversed in 2009-10.

Also note the soft patch between late spring and early summer 2008, when slowing economic growth precipitated an18 percent correction in the S&P 500. US economic growth has since picked up steam, with the LEI rising by 1.1 percent in November–the biggest monthly improvement since March 2010. Better still, nine of the 10 underlying indicators that constitute the LEI were positive in November, suggesting that the recovery has broadened in scope.

Another reliable indicator is the Institute for Supply Management’s US Purchasing Managers Index (PMI), a monthly data point that provides a snapshot of activity in both the manufacturing and non-manufacturing (service) sectors of the economy. PMI data is also available for a number of key foreign markets.

The PMI is based on a monthly survey of managers in several different industries. Readings above 50 indicate expansion; levels below 50 indicate contraction. The manufacturing version comes out on the first business day of each month and often moves the market.

Source: Bloomberg

Some commentators argue that this indicator has lost its relevance in the US because manufacturing is no longer as big a component of GDP as it was 30 years ago. But the graph above speaks volumes: Manufacturing PMI data and US GDP are closely correlated, with PMI data tending to lead economic trends by a few months.

The December PMI reading for the manufacturing segment came out on Jan. 3, 2011, providing one of the first snapshots of US economic activity in the final month of 2010. Manufacturing PMI jumped to 57 in December 2010, the index’s highest level since May and well above the summer low of 54.4. Movements in this indicator also suggest that the US economy weakened slightly over the summer but recovered its positive momentum in the fall.

Meanwhile, the PMI for the non-manufacturing segments of the US economy stands at 57.1, near its highest level since the recession ended.

The extension of the George W. Bush-era tax cuts should provide an additional boost to the US economy and stock market. Prior to the compromise between Republican leaders and President Obama, many feared that the tax cuts would expire because of Congressional gridlock. Such an outcome would have been disastrous for the US economy.

Allowing tax cuts for individuals earning more than $250,000 per year to expire likewise would have endangered the recovery. Not only do wealthier Americans account for as much as 40 percent of consumer spending, but these individuals also account for a disproportionate share of investments in stocks and other financial assets.

The compromise also included a payroll tax cut for 2011 that effectively replaces the Making Work Pay tax credit that was part of the 2009 stimulus package, though the deduction is larger and applies to more Americans. The new payroll tax cut and the extension of other credits should add 0.5 to 1 percent to US GDP growth in 2011.

It’s impossible to develop a credible economic outlook without factoring in key emerging markets. The press has played up China’s decision to hike interest rates, but this decision hardly comes as a surprise; Beijing has long emphasized that it will pursue policies that curb inflation and prevent the local economy from overheating. But that doesn’t mean that Chinese authorities have wavered in their commitment to sustainable growth.

Check out this graph of the PMI for China’s manufacturing sector.

Source: Bloomberg

The Chinese economy hit a wall in late 2008, temporarily stymied by the global financial crisis. But within a few months China’s manufacturing PMI surpassed 50 once again. This recovery stemmed from an easing in the global financial crisis and a massive stimulus program implemented by the Chinese government in late 2008 and early 2009.

Chinese PMI peaked in early 2010, suggesting that Beijing successfully slowed economic growth to a more sustainable rate of roughly 8 percent per year. As you can see, the PMI continues to hover near the levels that persisted in 2006-07. This soft landing is a positive development for global economic growth.

Embracing Risk

Over the past year S&P 500 companies have consistently beat analysts’ earnings forecasts, while the majority also trumped expectations for revenue growth in the last few quarters. This strength stems from aggressive cost-cutting during the downturn, growing exposure to emerging markets and the ongoing cyclical recovery in the US.

Analysts’ earnings estimates for the S&P 500 have increased of late, but these forecasts remain on the low side for energy and other sectors. As the market grows more confident in the recovery’s sustainability, the index could trade at 15 to 16 times earnings. With the S&P 500 expected to generate full-year earnings per share of $95 in 2011, the index should finish the year between 1,400 and 1,500.

Recent developments in the market for US Treasury notes also bode well for equities.

Source: Bloomberg

This graph tracks the yield on a 10-year US Treasury note from 2007 to present and depicts two instances when uncertainty prompted investors to stash money in this traditional safe haven. As you can see, Treasury yields plummeted at the height of the financial crisis, when panicked investors shifted capital to US government bonds from riskier asset classes.

Concerns about the fiscal health of Greece and other EU nations touched off another flight to quality in spring 2010. Speculation that the Federal Reserve would embark on a second round of quantitative easing (QE2) provided additional fuel for the rally. Nevertheless, the yield on the 10-year Treasury note bottomed in October, about a month before the Fed formally announced QE2. Since then, US government bonds have sold off sharply–despite the Fed’s purchases–pushing up yields by roughly 100 basis points

Some commentators argue that rising Treasury yields reflects investors’ concerns about the US government’s rising deficit, noting that the country’s weak fiscal position could prompt its creditors to demand higher interest rates on US government debt. Rising rates would prove disastrous given the excessive debt loads that households and federal, state and local governments are carrying.

But this longer-term concern isn’t behind the recent weakness in the market for US Treasury notes. Not only did the S&P 500 rally to a new 52-week high before year-end, but the financial sector also led the index higher, gaining 10.6 percent in December.

If investors were concerned about the US government’s fiscal health, they wouldn’t allocate capital to domestic bank stocks. The price of 10-year Treasury notes have declined because growing confidence in the economy is prompting investors to pull money from Treasuries and other safe havens and deploy this cash in the stock market.

Some commentators have questioned the effectiveness of QE2, pointing out that interest rates spiked shortly after the Fed began buying government bonds. There are plenty of reasons to question the need for another round of quantitative easing, but the idea that QE2 is designed solely to push down US interest rates is wrongheaded. In a Nov. 24, 2010, editorial published in the Washington Post, Fed Chairman Ben Bernanke wrote:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

QE2 was partly designed to spur investors into selling US Treasuries and buying stocks. The Fed is clearly trying to push up inflation expectations to avoid the risk of deflation, and there’s no easier way to lose money than ultra-low yields coupled with rising inflation. Meanwhile, rising stock prices stimulate spending by making individuals feel wealthier.

An uptick in inflation and unattractive bond yields should combine with investors’ increasing confidence in the economic recovery to support US stocks.

Upside and Downside Risks

The biggest upside risk to my US economic and market forecast is that consumer spending, which accounts for about two-thirds of US GDP, will return with a vengeance.

Elevated debt levels and high unemployment should ensure that Americans continue to save more and spend less. That being said, consumer spending picked up in the back half of 2010, and last year’s holiday shopping season was the best in several years. If households ramp up spending in 2011, US economic growth could trump expectations.

Europe’s sovereign debt problems represent the biggest downside risk to my 2011 outlook. However, rising credit risk in a handful of peripheral EU economies is unlikely to spawn a global or regional credit crunch.

Even at the height of the EU sovereign debt crisis in May and June, the spillover into markets such as the US corporate debt and interbank lending markets was modest.

Source: Bloomberg

This graph depicts the difference between the average yield on 10-year bonds of US industrial companies rated BBB by Standard & Poor’s and the yield on 10-Year US Treasury notes. When this spread spikes, as it did in late 2008 and early 2009, investors are demanding a higher return on corporate bonds to compensate for rising default risk.

This yield spread ticked up slightly in the May and July but has since reversed course. US corporate credit markets remain robust–even companies with inferior credit ratings can borrow at record-low interest rates. The feared credit contagion barely caused a hiccup in US corporate bond markets.

And although spreads in the interbank lending market rose a bit in May and July, these rates barely budged when Ireland’s fiscal problems came to a head.

At this point, the challenges facing the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) have been on investors’ radar screens since early 2010–the shock value has worn off. Moreover, the EU has set up a fund to bail out weaker nations and appears committed to doing whatever it takes to preserve the integrity of the euro.

A number of European nations, including Greece, the UK, Ireland, Italy and Spain, have addressed yawning budget deficits by introducing fiscal austerity measures. Although these economies will suffer in the near term, these moves should improve their fiscal situation over the next three to five years.

Better still, many of these austerity plans have included heavy spending cuts, not tax increases; historically, spending cuts have proved more effective in reducing deficits without sacrificing economic growth.

We haven’t heard the last of Europe’s sovereign credit woes–attention will likely turn to Portugal and Spain in 2011–but this weakness is unlikely to sink the global recovery. However, another sovereign debt scare could catalyze a 5 percent correction in the broader market, much like the one that occurred in November 2010.

Oil: 2010 Review

My 2010 outlook called for crude oil to eclipse $100 per barrel in 2010, reflecting improving demand and tightening supplies. I noted that the economic recovery in the US and other developed markets would make up for some of the demand destruction that occurred during the financial crisis and global downturn, but attributed most of uptick in oil demand to China and other rapidly growing emerging markets.

This prediction fell short of reality: The price of West Texas Intermediate crude reached $92 to $93 per barrel at the end of 2010, while Brent crude finished the year at $95 to $96 per barrel.

Nevertheless, my forecast deserves at least partial credit for being directionally correct. At the time I made this prediction, the futures curve implied that oil would end the year at about $84 to $85 per barrel. Meanwhile, the consensus forecast called for oil prices to remain relatively unchanged.

On the supply side, my argument focused on the end of easy (and cheap) oil–one of my top investment themes for 2010.

The end of easy oil has been a long-standing theme in this publication and remains arguably the most powerful driver in the sector, though the unprecedented drop-off in demand that occurred during the credit crisis and resultant economic dislocation obscured this long-term trend. But with the global economy and credit markets on the mend, this theme should return to the front burner.

Supply concerns are at the heart of the end of easy oil. Non-OPEC oil production will, at best, remain steady in coming years. That’s assuming additional production from oil sands, deepwater fields and other unconventional sources offsets declining output from mature onshore and shallow-water fields.

In other words, production from easy- and cheap-to-produce large onshore fields with less-complicated geology will be replaced by output from expensive-to-produce plays. That translates into rising marginal costs for crude oil production and elevated oil prices to incentivize the massive investment needed to ramp up production.

To profit from this trend, investors should focus on the services and equipment firms that own the technology needed to produce more complex fields. Oil producers that stand to increase their output meaningfully will also offer superior upside.

Names leveraged to spending on deepwater exploration and production took a hit after the BP (NYSE: BP) oil spill, but investors who took advantage of this selloff reaped the rewards in 2010.

Oil: 2011 Outlook

Oil should exceed $100 per barrel in the first quarter of 2011 and reach $120 per barrel at some point during the year. Oil prices will average more than $95 per barrel in 2011.

Once again, my forecast is above consensus expectations. The current futures market curve indicates that oil will trade at $94 per barrel at the end of 2011. Analysts surveyed by Bloomberg expect oil prices to average $91 per barrel in the fourth quarter of 2011 and $87 per barrel on the year.

I’ve explained the rationale behind my bullish outlook in a number of recent articles. The Nov. 19, 2010, installment of The Energy Letter, Eight Reasons to Buy Oil-Related Stocks, provides a comprehensive overview of my case, while Riding the Services Cycle and Here Comes the Spending discuss specific stocks.

Here’s a basic summary of my outlook and how to play it.

Oil demand is rising rapidly. In the third quarter of 2010, global oil demand hit an all-time quarterly high of 88.6 million barrels per day. That represents year-over-year growth of 3.8 percent, the fastest pace since 2004. The rate of demand growth will likely slow in 2011 but should come in at 1.5 to 2 percent, or about 1.5 million barrels of oil per day.

Emerging markets will remain the most important drivers of oil consumption. Consider this graph of passenger car sales in China.

Source: Bloomberg

Sales of passenger cars in China hit a record high of 1.34 million vehicles per month at the end of 2010. Despite the slowdown in economic growth since early 2010 and the government’s efforts to tighten monetary policy, Chinese demand for cars continues to boom. Similar trends are underway in India and other emerging markets. These rapidly growing economies will continue to push global oil demand higher.

Global airline traffic underscores this trend.

Source: Bloomberg

Though off its recent high, global airline traffic is increasing at an annual rate of more than 8 percent–well above growth rates witnessed during the energy bull market of 2004-08. Rising passenger volumes, led by increases in emerging markets, have been a major factor behind booming demand for jet fuel.

That brings me to the question of supply. OPEC is the world’s key swing supplier of oil, and its members have maintained their discipline despite oil prices in the $90s. Check out the graph below.

Source: Bloomberg

The official target production limit for the OPEC-11 has been 24.845 million barrels of oil per day since early 2009. But many OPEC producers cheat and produce more oil than their official quotas. For example, OPEC produced 26.8 million barrels per day in December, roughly 2 million barrels per day above the official target.

The incentive to cheat grows as oil prices rise. If a barrel of crude goes for $90, it’s a lot more tempting to produce extra oil than if oil prices are in the $50s. That’s why OPEC-11 oil production increased steadily in the back half of 2009 and into early 2010, even though the cartel’s official quota remained unchanged.

Since mid-2010, OPEC-11 production has declined slightly, suggesting that the cartel is comfortable with prevailing oil prices. The group is unlikely to increase the official production target anytime soon. But non-OPEC supply growth falls short of rising demand for crude oil.

Oil inventories are filling the gap between production and consumption. That’s why oil inventories in the US and other key markets have declined. Although inventories of oil and gasoline are still above the seasonal average in many developed markets, users will continue to draw down these supplies.

If demand keeps rising and OPEC declines to supply additional oil, the pace of inventory drawdowns will accelerate, potentially catalyzing a major spike in oil prices.

My top oil-related plays for 2011 include services and equipment firms that help producers discover and develop new fields. Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT) offer broad exposure to increased spending on exploration and production. Buy Schlumberger under 85 and Weatherford International under 26. Niche service providers Core Laboratories (NYSE: CLB) and Petroleum Geo-Services (OTC: PGSVY) are poised for a strong 2011. Core Laboratories is a buy under 95, while Petroleum Geo-Services is a buy under USD16.

My favorite oil equipment names include Cameron International (NYSE: CAM), a buy under 50, and Dresser-Rand, a buy under 40.

Investors seeking growth and income should consider deepwater contract driller Seadrill (NYSE: SDRL). The company’s fleet of new rigs features the latest equipment, providing a huge competitive advantage. Yielding almost 8 percent and with the scope to boost its payout significantly, Seadrill is the only deepwater driller in the model Portfolios. Buy Seadrill under 35.

In contrast, Diamond Offshore Drilling (NYSE: DO) has one of the oldest deepwater fleets, a group of rigs that won’t be able to earn attractive rates in coming years. The company recently announced that it has ordered a new rig, the first step in an extremely expensive and time-consuming strategy of updating its fleet.

Selling Diamond Offshore Drilling short provides a bit of insurance against any broader pullback or correction that might occur over the next 12 months. This short position is for investors looking to hedge a portfolio with significant exposure to energy stocks. If you fit into this category, short Diamond Offshore Drilling above 60.

Producers that have the opportunity to increase their oil output also stand to benefit from higher crude prices. My top picks in this category include Africa-focused Afren (LSE: AFR), a buy under GBP1.50, and Occidental Petroleum Corp (NYSE: OXY), a US-based outfit with a promising oil find in California. Oil sands operator Suncor Energy (TSX: SU, NYSE: SU) is also a buy under USD43.

Natural Gas: 2010 Review

I won’t mince words: I was wrong about natural gas prices in 2010.

In early 2010, I wrote: “I’m not calling for natural gas prices to soar above $10 per million British thermal units; gas prices should average about $7 per million British thermal units, a healthy level that will make producers with high-quality assets profitable and encourage an increase in drilling and service-related activity.”

My rationale rested on four key points: an upsurge in industrial demand, strong seasonal gas demand during the cold winter of 2009-10, a growing political push behind natural gas and flat or falling natural gas production.

My first two points held up. US industrial gas demand soared 7.5 percent from year-ago levels in the first 10 months of 2010, largely because of depressed prices. With the US economy likely to grow about 3 percent in 2011, I expect industrial demand for natural gas to post further gains in 2011. The weather was also on my side. An extraordinarily cold winder and a sweltering summer increased demand at gas-fired power plants in 2010.

But demand is only half of the equation. Last year’s forecast failed to take into account the extent to which gas production would grow in a weak pricing environment.


Source: Bloomberg

Since early 2010, US natural gas production has soared to record levels, largely because of drilling activity in the nation’s shale gas fields.

Source: Bloomberg

This graph shows the US natural gas rig count, which measures the total number of land-based drilling rigs in the US actively drilling for gas. As you can see, the rig count soared through May 2010 despite depressed natural gas prices. Even with gas prices near a multiyear low, the rig count had declined only slightly at the end of 2010.

There are four primary reasons why the gas-directed rig count continued rise despite weak gas prices and excess production:

1. High-value liquids. Some producers targeted plays rich in wet gas, or gas that contains significant quantities of natural gas liquids (NGL) such as ethane, propane and butane. A barrel of NGLs is typically worth about 55 to 65 percent of a barrel of oil, providing superior economics. I discussed this phenomenon at length in the April 28, 2010, issue of The Energy Letter, Why Some Natural Gas is Worth $7.28.
2. Leasehold contracts. Many leasing contracts contain clauses that force companies to produce gas from their leaseholds within a specific time frame or forfeit these claims. These terms prevent producers from sitting on leased land until gas prices are attractive. Producers continue to drill even though the economics of gas production have deteriorated.
3. Experience. Producers have become more efficient at extracting natural gas from shale, lowering the cost of production and break-even prices.
4. Hedges. Many producers hedge at least a small percentage of their output, limiting exposure to spot or near-month gas prices. Hedges improve profitability.

For these reasons, supply growth overwhelmed demand, keeping a lid on US natural gas prices throughout 2010.

Although my 2010 natural gas forecast wasn’t accurate, the news isn’t all bad. For one, I’m a big believer in a quote from John Maynard Keynes: “When the facts change, I change my mind.” As it became clear that supplies were rising much faster than I had originally anticipated, I revised my forecasts accordingly and explained the reasons behind the surge in production.

Second, I was right about one trend: The US rig count continued to shift away from rigs that drill vertical wells to directional ones capable of drilling horizontal wells. Historically, land rigs have been regarded as low-tech compared to their offshore cousins, but drilling lengthy horizontal well segments through shale requires a great deal of precision and horsepower.

That a larger proportion of US rigs boast these advanced capabilities reflects the rising importance of shale gas plays to US production.

A good deal more work goes into drilling a horizontal well in a shale field than drilling a traditional vertical well in a conventional reservoir. For example, producing shale reservoirs requires the use of hydraulic fracturing–pumping liquid and sand into a field under immense pressure to improve permeability. Some of the most advanced wells drilled in unconventional gas plays employ fracturing in a series of carefully planned stages.

And there are several other technologies and services that are required to drill unconventional wells.

The higher proportoon of directional rigs suggests that more activity is being directed toward unconventional fields–and that spells more business for services firms with exposure to gas-levered services.

As a result of this trend, I recommended three services and drilling picks with gas exposure: Baker Hughes (NYSE: BHI), Nabors Industries (NYSE: NBR) and Tenaris (NYSE: TS). These three picks were up an average of 22.4 percent in 2010.

On the other hand, shares of Range Resources Corp (NYSE: RRC) and Petrohawk Energy Corp (NYSE: HK)–the two shale gas producers in the model Portfolios–both lost ground in 2010.

Natural Gas: 2011 Outlook

The natural gas supply outlook is unlikely to improve in the first half of 2011; prices should remain below $5 per million British thermal units.

Several producers have commented that their acreage in the Haynesville Shale and other plays will be held by production by midyear. That means these companies will no longer need to drill just to hold their leases and will be able to shift their rigs to oil plays or gas fields that are rich in NGLs. A number of producers also noted that there are fewer hedges covering gas production in the back half of 2011.

These two factors suggest that the US natural gas rig count could decline significantly in the back half of the year, particularly in dry-gas basins such as the Haynesville and higher-cost plays such as the Barnett Shale. Drilling activity should continue apace in the liquids-rich portions of Pennsylvania’s Marcellus Shale and the Eagle Ford Shale in south Texas.

Although gas prices won’t have much upside in 2011, a decline in the rig count would improve sentiment surrounding US producers. It won’t take much of a shift to send the stocks higher; analysts and investors are almost uniformly bearish on the group. But that’s a potential story for the end of the year

The long-term outlook is better. Natural gas is the cleanest fossil fuel and will be a major part of any successful attempt to reduce America’s dependence on foreign energy supplies. Gas is also a crucial part of any legitimate effort to reduce carbon dioxide emissions.

Investors seeking exposure to shale gas producers should focus on Chesapeake Energy Corp Preferred D (NYSE: CHK D). Chesapeake Energy Corp (NYSE: CHK) is the largest independent gas driller in the US and the preferred shares are convertible; if the common stock rallies, the preferred shares will have some upside. But the preferred shares currently yield over 5 percent, so you can be patient with Chesapeake and still earn a return on your investment. Buy Chesapeake Energy Corp Preferred D under 100.

EOG Resources (NYSE: EOG) is another solid play. The company boasts leading acreage positions in the top US shale plays, including the oil rich Bakken Shale and the Eagle Ford. (See Rough Guide to Shale Oil.) EOG’s growing liquids and oil production will offset continued weakness in gas prices. Buy EOG Resources under 115.

Several of the master limited partnerships (MLP) in the model Portfolios offer exposure to rising demand for natural gas infrastructure such as pipelines and storage facilities. Pipeline owners are paid based on the volumes of gas they handle, not the price of that gas.

MLPs have been among the model Portfolios’ best-performing plays over the past year and offer tax-advantaged yields of 6 to 9 percent. Enterprise Products Partners LP (NYSE: EPD) and Kinder Morgan Energy Partners LP (NYSE: KMP) both offer direct exposure to this trend.

In light of the recent rally in both stocks and my cautious outlook for gas prices, producers Range Resources Corp and Petrohawk Energy Corp are now a hold.

Coal: 2010 Review

I ranked coal among my top three investing themes for 2010. Here’s what I wrote: “The US will see a gradual normalization in inventories of steam coal; US miners with heavy exposure to metallurgical (met) coal should fare best. But the Land Down Under remains my favorite coal-producing regions. Australia will be the world’s dominant exporter of both met and steam coal for the foreseeable future.”

My two top recommendations were coal mining equipment maker Bucyrus International and mining giant Peabody Energy Corp (NYSE: BTU). I preferred the latter because of its Australian operations and exposure to Asian demand. Shares of Peabody Energy gained 42 percent in 2010, while Bucyrus International was up 60 percent in 2010.

Coal: 2011 Outlook

This year should bring more of the same. I discussed the domestic and international coal markets at length in the Nov. 17, 2010 issue Buy Coal-Related Stocks This Holiday Season and added International Coal (NYSE: ICO) to the Gushers Portfolio in a Flash Alert issued on Dec. 20, 2010.

Coal-related stocks are some of my top picks for 2011. Peabody Energy Corp is a buy under 65, while mining equipment supplier Joy Global (NasdaqGS: JOYG) is a buy under 85.

International Coal’s fast-rising met coal production makes it an attractive play and a likely takeover target. Flooding in Australia has limited the country’s exports of met coal, further tightening the market. Buy International Coal under 8.

Income investors should consider coal-focused MLPs Penn Virginia Resource Partners LP (NYSE: PVR), a buy under 29, and Natural Resource Partners LP (NYSE: NRP), a buy under 30.

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 the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays 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 compiled a list of 15 Fresh Money Buys that includes 13 names and two hedges.

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 aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset exposure to energy stocks.

Also note that stocks that exceed my buy target for more than two consecutive issues will either be removed from the list or the buy target will be increased. Here’s the list, followed by a short update on company-specific developments.

Source: Bloomberg, The Energy Strategist

See You at the Summit

Advertisers would have you believe that what happens in Vegas stays in Vegas. That also goes for the presentations and one-on-one conversations that occur at KCI Investing’s 2011 Wealth Summit at the luxurious Mandarin Oriental in the new CityCenter arts complex.

Guests will have the opportunity to listen to some of the investing community’s brightest minds share their top ideas and trades. Don’t miss out on this unique opportunity to hear Elliott Gue, Roger Conrad, Yiannis Mostrous and Benjamin Shepherd share their latest insights on the markets and economy.

Special guests include Jim Fink, senior editor of Investing Daily, who will discuss the ins and outs of options, and executives from Linn Energy LLC and Vermilion Energy. This year’s conference focuses on the unprecedented growth of Asian economies and the game-changing investment strategies you need to protect and grow your portfolio in the 21st century.

The two-day event gets underway on April 1, 2011. Get smart on April Fools’ Day. Pre-register for the Wealth Summit at InvestingSummit.com.