Editor’s Note: A few days ago, I received a call from a longtime subscriber asking if Roger Conrad and I plan to host a dinner at this year’s World MoneyShow Orlando, which takes place Feb. 9-12, 2011, at The Gaylord Palms Hotel & Convention Center. This call got me thinking: It’s been two years since we hosted such an event at the show, and frankly, I miss those dinners.

Roger Conrad, Ben Shepherd and I decided to book a table for the evening of Thursday, Feb. 10 in The Gaylord Palms’ Old Hickory Steakhouse. For those of you who are familiar with the hotel from years past, Old Hickory is restaurant that resembles a tree house and is located near the lobby. The steakhouse serves some choice cuts of meat, and we felt it was a more appropriate venue than the restaurant that looks like a pirate ship.

For those interested in joining us, the dinner costs $299 per person and includes wine, drinks and a four-course meal. This will be a small event, so seats are limited. To book your place at the table, call Customer Service at 1-800-832-2330 and ask for Special Offer O01595.

Small Ball

When most investors think of energy stocks, mega-caps such as Chevron Corp (NYSE: XOM) and Schlumberger (NYSE: SLB) usually come to mind. These giants should form the cornerstone of an investor’s portfolio, and both feature prominently in our model Portfolios. But during bull markets for energy, small- and mid-cap stocks often post some of the biggest gains.

Over the years, small and midsize names have been some of our biggest winners; for example, Seadrill (NYSE: SDRL) and Linn Energy LLC, once well into mid-cap territory, have attained large-cap status.

In this issue we delve into a list of companies with market capitalizations of $3 billion or less that are on our radar. The two best prospects are new additions to the model Portfolios; we will continue to follow the others in the Energy Watch List.

In This Issue

The Stories

Rising demand for fuel and higher oil prices ensure that the latest additions to the model Portfolios will offer plenty of upside for 2011. See Two for Growth.

This master limited partnership debuted on the New York Stock Exchange in December 2010. Our early read suggests it could be a winner for aggressive investors. See One for Income.

Recent market action has prompted us to update our ratings for four Portfolio holdings. See Taking Stock.

Want to know which stocks to buy now? Check out the updated Fresh Money Buys list. See Fresh Money Buys.

The Stocks

World Fuel Services Corp (NYSE: INT)–Buy < 40
Oasis Petroleum (NYSE: OAS)–Buy < 31
QR Energy LP (NYSE: QRE)–Buy in Energy Watch List
Valero Energy Corp (NYSE: VLO)–Hold (Sell 50% of Position, Set Stop @ 22.50)
ExxonMobil Corp (NYSE: XOM)–Hold (Sell 50% of Position, Set Stop @ 72)
Nordic American Tanker Shipping (NYSE: NAT)–Hold
Knightsbridge Tankers (NSDQ: VLCCF)–Buy < 27.50

Two for Growth

World Fuel Services Corp (NYSE: INT) markets fuel and related logistical services to a wide range of customers in the land, sea and air transportation businesses. The company doesn’t produce, refine or transport the fuel itself, serving instead as a middleman that arranges the purchase, storage, shipping and sale of fuel through third-party operators.

World Fuel Services buys fuel in bulk from suppliers, ensures consistent quality, and manages the delivery of that fuel to its customers. For example, the firm might purchase bunker fuel for a cruise ship operator and arrange the delivery of that fuel to various ports where the cruise ships will refuel during their voyages.

In addition, the company extends credit to customers to facilitate purchases and helps clients hedge against higher fuel costs.

Source: World Fuel Services Corp

Although World Fuel Services’ aviation and marine business segments account for the bulk of the company’s revenue, management has expanded the firm’s land operations, primarily through acquisitions. Each of its three divisions boasts a top-notch customer base that includes industry leaders such as Royal Caribbean Cruises (NYSE: RCN), tanker operator Frontline (NYSE: FRO), Virgin America airline and FedEx Corp (NYSE: FDX).

Don’t dismiss World Fuel Services’ business model as mundane and boring. Not only do companies worldwide regard fuel-related logistics as essential to their success, but there’s also plenty of scope for the firm to grow its business in coming years. World Fuel Services benefits from three key trends: a focus on cost savings, rising global demand for fuel and ongoing consolidation within the fuel logistics industry.

Consider the importance of fuel prices to a commercial airline or shipping firm–even a slight change in fuel costs can dramatically impact a transportation company’s profitability. Meanwhile, the complexity of supplying a global operation and limiting exposure to volatile energy prices is a formidable challenge that requires significant resources.

World Fuel Services is up to the challenge. With years of experience buying and supplying fuel in 200 countries and territories, the company grasps the intricacies of local markets, the availability of regional refining capacity and supply-demand conditions in various parts of the world. This accumulated knowledge is aggregated in a computer system that aids in decision-making and enables the firm to identify and take advantage of local or regional price differentials. In addition, World Fuel Services’ extensive customer base enables it to obtain bulk discounts and demand the best prices from suppliers.

Keeping energy prices in check is a constant struggle for the transportation industry. By purchasing fuel at the lowest prices possible and passing some of these savings through to customers, World Fuel Services enables transportation outfits to cut costs and simplify their business. The company generates a profit by marking up the price of the fuel it resells and charging for ancillary services.

Although World Fuel Services targets businesses with exposure to commodity prices, the company is somewhat protected from the vagaries of the energy market. Sales may rise and fall with commodity prices, but profits depend on the spread between the price it pays for the fuel and the amount it charges its customers. In most instances, World Fuel Services immediately sells the fuel it purchases to customers, limiting its exposure to shifts in commodity prices. When the company holds or stores fuel for future delivery, hedges mitigate any shift in energy prices.

World Fuel Services’ recent earnings history is a testament to this resilience.

Over the past few years, companies exposed to energy prices have endured an unparalleled stress test. Oil and fuel prices soared through mid-2008 but suddenly collapsed at the height of the financial crisis. From the first quarter of 2009 onward, oil prices have climbed.

Any energy-related company that managed to remain profitable on both the upswing and downswing of this cycle has proved the resilience of its business model. Neither a producer nor a consumer, World Fuel Services is insulated against volatile energy markets.

The proof is in the earnings. The firm managed to grow its earnings per share (EPS) when oil prices increased from 2004 to mid-2008 and when prices collapsed in late 2008 and early 2009.

World Fuel Services’ EPS actually shot up by 154 percent in the third quarter of 2008 and 80 percent in the fourth quarter, largely because of the company’s credit business.

At the height of the financial crisis, banks stopped issuing letters of credit that containership operators and dry-bulk shippers use to finance their cargoes. Low-risk in nature, these short-term credit instruments are based on the value of the goods or commodities being shipped. Banks also stopped offering short-term credit that covered shippers’ refueling and other operating costs.

With a pristine balance sheet, World Fuel Services stepped into the breach, allowing airlines, shipping firms and other customers to purchase fuel on credit. As one of the few lenders in a market with little access to credit, the company posted unusually large profits in the back half of 2008.

World Fuel Services has the scope to further expand its credit services if opportunities arise; the company has plenty of cash on its balance sheet as well as a $475 million credit facility that allows it to borrow money at the ultra-low rate of 1 percent above LIBOR. Moreover, the loan portfolio continues to perform, with bad debt expense generally amounting to less than 1 percent of gross profit.

Although shifts in commodity prices don’t necessarily impact World Fuel Services’ business, rising demand for fuel provides a substantial tailwind: Profits increase with every additional gallon of fuel that the company sells.

As I explained in Road Map for 2011, the world economy continues to recover from the vicious 2007-09 recession. Economic growth has been modest in much of the developed world, though data suggest that conditions improved in late 2010 and early 2011. Emerging economies continue to expand dramatically, bolstering global growth but raising concerns about inflation.

Economic growth spurs rising demand for energy commodities. According to the International Energy Agency’s (IEA) Jan. 18, 2011, Oil Market Report, global oil demand grew by 2.7 million barrels per day (bpd) in 2010 to a record 87.7 million bpd. Some of the strongest growth occurred in the second half of 2010. Demand for oil grew at the fastest rate since 2004, when oil demand increased by roughly 3 million bpd. The IEA’s 2011 forecast calls for global demand to reach 89.1 million bpd in 2011, an increase of 1.5 million bpd.

Much of this growth will occur in emerging economies where gross domestic product continues to expand at a rapid rate. A global operator with a presence in just about every imaginable market, World Fuel Services should benefit from rising demand for transportation fuels, particularly in Asia.

In addition to pure volume growth, World Fuel Services’ client list continues to expand because of volatility in energy markets. Rather than navigate these vagaries on their own, airlines and shipping firms continue to outsource some of their fuel procurement operations to World Fuel Services in an effort to contain costs.

Industry consolidation is another key component of World Fuel Services’ growth story. The company operates in a fragmented industry that’s constellated by regional operators, many of which can’t compete with World Fuel Services’ international scope.

The company has traditionally competed with big oil companies that handle fuel marketing and procurement for some major customers. But many of the majors continue to divest their downstream operations (i.e., refining and marketing) to redirect capital spending toward exploration and production.

As the integrated oil companies exit the downstream business, World Fuel Services has ample opportunity to win business and drive consolidation. The firm has a long history of deal-making, and has stepped up the pace of its acquisitions, buying Hiller, a Florida-based distributor of aviation fuel, and Danish outfit Nordic Camp Supply, which procures fuels for NATO, US and other European armed forces operating in Afghanistan.

Despite being one of the industry’s biggest independent players, World Fuel Services controls less than 10 percent of the market for bunker fuel. Its share of the aviation and land markets is even smaller, providing plenty of scope for growth. The company’s global operations make it the best-positioned consolidator.

Shares of World Fuel Services have enjoyed quite a run, reflecting the company’s strong fundamentals and recent acquisitions. But the stock still trades at just 15 times the consensus 2011 earnings estimate–historically, the firm has grown earnings at an annualized rate of about 20 percent. Excepting short-term pullbacks, the stock could eclipse $50 over the next six to nine months.

World Fuel Services Corp, a new addition to the growth-oriented Wildcatters Portfolio, rates a buy under 40. Subscribers worried about a potential correction should consider staggering their purchase, buying some of their intended position now and fleshing out their investment after any decline of 5 to 10 percent.

Oasis Petroleum (NYSE: OAS) went public in June 2010, the height of investors’ concern about the EU credit mess, the oil spill in the Gulf of Mexico and a potential US double-dip recession. Against this gloomy backdrop, the stock has roughly doubled in price since its closing price on the day of its initial public offering (IPO).

The market’s enthusiasm for this IPO stems from its operations in the Bakken Shale, an oil-producing region of North Dakota and Montana that’s arguably the most exciting US onshore oil field. (See the Oct. 20, 2010, issue Rough Guide to Shale Oil.) For the most part, oil produced from the Bakken is of an extraordinarily high grade, equivalent in quality or better than West Texas Intermediate (WTI), the US benchmark.  Many wells in the Bakken generate decent rates of return even with oil in the $50 per barrel; at current oil prices, returns on investment can exceed 100 percent.

The Bakken is an unconventional field just like the Barnett, Haynesville and Marcellus Shale. What makes an oil or natural gas play unconventional? Conventional reservoir rocks such as sandstone feature are highly porous and permeable, boasting many pores capable of holding hydrocarbons as well as fissures and interconnections through which the oil or gas can travel. When a producer drills a well in a conventional field, oil and gas flow through the reservoir rock and into the well, powered mainly by geologic pressure.

Shale fields and other unconventional plays contain plenty of hydrocarbons but lack channels through which oil or gas can travel. Even in shale fields where there’s plenty of geologic pressure, the hydrocarbons are essentially locked in place.

Producers have developed and refined two major technologies in recent years to unlock the natural gas and oil trapped in shale deposits: horizontal drilling and hydraulic fracturing.

A horizontal well branches off laterally from an initial vertical drill hole, exposing more of the productive layer to the well. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, sand coated with ceramic material or ceramic material–ensures that these passages remain open.

Over the past several years, US producers have perfected these techniques in a number of prolific shale gas plays. More and more of these operators are applying the same techniques to a handful of established and emerging shale oil plays.

Producers have found that long horizontal wells–“long laterals” in industry parlance–and huge multistage fracturing jobs maximize output from shale deposits. For example, in the Bakken producers routinely drill laterals that exceed 10,000 feet in length, a distance of nearly two miles. Plenty of producers do fracturing jobs in more than 30 stages, and a few are contemplating fracturing projects of 42 stages or more. As technology and drilling techniques evolve, output and efficiency continue to improve.

Oasis Petroleum own roughly 300,000 acres of leasehold in the Williston Basin of Montana and North Dakota. This is the only region where the company operates, so the stock is one of the few pure plays on the Bakken. Oil accounted for more than 93 percent of the company’s output in the third quarter of 2010, an attractive production profile at a time when oil prices should continue to climb and natural gas prices remain depressed.

In the third quarter, Oasis Petroleum had 17 wells enter production, drilled eight wells that are awaiting completion and wasin the process of sinking four other wells. Management expects the company to have drilled 44 wells in 2010–the firm will announce the exact number when it reports fourth-quarter results in February.

Oasis Petroleum has farmed out stakes in some of its wells but still retains an average working interest of more than 75 percent in the wells it had drilled. The firm also operates 85 percent of its wells.

The company continues drill aggressively. In 2010 Oasis Petroleum spent $243 million, the majority of which went to its drilling program. This year management expects to spend about $440 million to drill 69 wells and retain an average working interest of about 68 percent.

The company has seven rigs working on its leasehold and has agreements that allow it to fracture at least five wells per month. Halliburton (NYSE: HAL) and other major services companies have noted a shortage of fracturing capacity in shale oil fields; having secured fracturing services in advance, Oasis should meet its drilling and production targets.

The company has found that 10,000-foot horizontal wells with 28 fracturing stages yield superior returns and estimated ultimate reserves. The company’s 2011 capital budget calls for costs of $6.8 to $7.2 million per well, up from an average of $6.6 million in the first half of 2010. Much of this increase stems from a tight market for fracturing and other services, but management noted in its third-quarter conference call that service costs appeared to be moderating.

Oasis Petroleum’s acreage is located in the West Williston and East Nesson areas, as depicted in the map below.

Source: Oasis Petroleum

The company plans to devote 80 percent of its 2011 budget to drilling in West Williston, a region on the periphery of the Bakken’s core that accounts for more than half the company’s net acreage and output. Six of the company’s seven contracted rigs operate in this area.

The company reported that wells in its West Williston leasehold flow at an average rate of 567 to 969 barrels of oil equivalent per day (boepd) during the first seven days of production. Over 60 days, the production rate averages 359 to 613 boepd. Management estimates the amount of recoverable oil at 400,000 to 700,000 barrels per well.

This gibes with the experience of Continental Resources (NYSE: CLR), the leading acreage holder in the Bakken. Although some of the Continental’s wells in the play’s core produced at an initial rate of more than 4,000 boepd, management noted that that average 30-day production rate of its wells was about 623 boepd–in line with Oasis Petroleum’s findings in West Williston. Similarly, Continental Resources estimates that its average well contains recoverable reserves of about 518,000 barrels of oil equivalent from each well drilled.

Based on an average 60-day production rate of 30,000 barrels, Oasis Petroleum’s wells would generate about $2.4 million worth of oil–assuming prices of $80 per barrel. Even if the company’s wells cost $7.2 million to drill–the high end of expectations–these wells quickly cover their costs and offer attractive rates of return. In the third-quarter conference call, management observed that early results suggest that at least a portion of its West Williston wells would be profitable with oil at $45 to $50 per barrel.

With average 60 day production rates of 329 to 529 boepd and estimated ultimate reserves of 350,000 to 600,000 barrels, returns on Oasis Petroleum’s wells in East Nesson aren’t quite as impressive but still represent a worthwhile endeavor. In 2011 the company plans to spend $51.4 million in the Nesson play.

Oasis has successfully ramped up production over the past few years, a trend that should continue.

Source: Oasis Petroleum

In the third quarter of 2010, Oasis Petroleum produced an average of 5,507 boepd, up by nearly 150 percent compared to the third quarter of 2009. The company is also in a good position to at least double its output over the coming 12 months.

Oasis Petroleum is in good financial shape, with no net debt, a $120 million revolving line of credit and about $270 million in cash. Management expects that its drilling results should enable warrant an increase to its credit line in early 2011. The company will need that cash, as the $200 million or so of cash flow it will generate in 2011 won’t fully cover its planned $440 million in spending.

That Oasis Petroleum is outspending its cash flow isn’t a major concern. Unlike many shale gas operators, the company isn’t drilling to secure leaseholds; most gas producers are at best only modestly profitable with gas prices at current levels.

And every well that Oasis Petroleum drills demonstrates the quality of its acreage and allows it to increase its production and proven reserve estimates. Strong internal drilling results and solid well performance fin neighboring acreage should serve as an upside catalyst for the stock. Most of the region’s major producers are likely to outline additional well results as they report earnings over the next few months.

Shares of Oasis Petroleum have enjoyed quite a run since the IPO, raising questions about valuation.  The company’s current enterprise value–the total market capitalization, plus net debt–is about $2.41 billion, and the firm should produce 7,600 boepd in the fourth quarter.

Brigham Exploration owns similar assets, grew its third-quarter output by an almost identical 144 percent year over year, and is expected to produce about 8,100 barrels of oil per day in the fourth quarter. However, Brigham’s enterprise value comes in at $3.31 billion. On a comparative basis, Oasis Petroleum appears cheap.

The stock trades at about 10.5 times 2011 earnings before interest, tax, depreciation and amortization (EBITDA), while shares of Brigham Exploration trade at 11.6 times forward EBITDA. Meanwhile, Continental Resources trades at 10.4 times 2011 EBITDA, reflecting the company’s size and maturity; it takes a lot more earnings growth to move the needle for larger companies. Bottom line: Shares of Oasis Petroleum don’t appear overvalued.

The stock should also benefit from two upside catalysts: rising oil prices and a slew of drilling results due out over the next few months. As I noted in Road Map for 2011, oil should overcome the occasional pullback to eclipse $100 per barrel in the first quarter and touch $120 per barrel later this year.

Disappointing drilling results or a 10 percent correction in oil prices could touch off a short-term selloff in the stock, but investors should increase their exposure to oil-leveraged producers on dips.

Oasis Petroleum rates a buy under 31 in the Gushers Portfolio. Consider establishing an initial position and adding shares on any pullback.

One for Yield

QR Energy LP (NYSE: QRE) debuted as a publicly traded master limited partnership (MLP) on Dec. 17, 2010. We’ve written about MLPs extensively in previous issues, many of which appear in the model Portfolios.

MLPs don’t pay any tax at the corporate level–a huge advantage in a country with the second-highest corporate taxes. As partnerships, MLPs pass through the majority of their income to investors in the form of regular distributions; the average MLP currently yields about 6 percent. Each investor is responsible for paying tax on his or her share of distributions received. But MLP distributions are highly tax-advantaged and offer a significant tax shield for investors.

Because of depreciation allowance, 80 to 90 percent of the distribution you receive from a typical MLP is considered a return of capital by the Internal Revenue Service. You don’t pay taxes immediately on this portion of the distribution.

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

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

QR Energy owns upstream assets from which it produces oil and natural gas. Oil and natural gas liquids account for about 70 percent of the outfit’s reserves (29.7 million barrels of oil equivalent) and production (5,184 barrels of oil equivalent per day).

Operations in the Permian Basin, a mature oil-producing region in west Texas and New Mexico, account for 60 percent of QR Energy’s reserves and nearly half its output. In recent years, producers have achieved well results in certain parts of the Permian by drilling horizontally or using hydraulic fracturing techniques.

The Permian is also a hot area for upstream-focused MLPs, including Wildcatters Portfolio recommendation Linn Energy.

In addition to the Permian, QR Energy has operations in the Mid-Continent region (Oklahoma and northern Texas) and the Ark-La-Tex region straddling the borders of Texas, Arkansas and Louisiana. All of these areas appeal to upstream MLPs because the fields are mature and the underlying geology is well-understood. Also, these areas boast modest decline rates and offer predictable output, attractive attributes for an MLP.

Like all upstream MLPs, QR Energy has exposure to oil and natural gas prices; prospective investors should understand the MLP’s hedge book and potential production growth before adding the stock to their portfolios.

QR Energy’s prospectus states that management intends to keep 65 to 85 percent of its total oil and gas production hedged three to five years into the future. At present, the MLP has hedged 80 percent of its 2011 production, 71 percent of its 2012 production, 68 percent of its 2013 production, 65 percent of its 2014 production and 47 percent of its 2015 production.

These large hedge positions shelter QR Energy from near-term volatility in oil and gas prices, though the MLP has more exposure to commodity prices than Linn Energy, which has hedged nearly all of its production for years into the future.

QR Energy’s most likely growth strategy is to acquire new producing oil or gas fields, potentially through drop-down transactions from its parent and GP, which is controlled by Quantum Resource Fund.

In a drop-down transaction, the MLP’s GP sells some of its assets to the MLP, usually at a price that ensures the deal is immediately accretive to DCF and allows the limited partner to boost distributions. Many MLPs, including portfolio recommendation Teekay LNG Partners LP (NYSE: TGP), have used drop-down transactions as a major avenue of growth.

QR Energy’s GP is controlled by a private-equity firm that owns reserves totaling 56.4 million barrels of oil equivalent–almost double the MLP’s current reserve base. These properties would be a good fit for QR Energy’s portfolio, and the fund intends to drop down some of these assets to the MLP. The fund has an incentive to foster QR Energy’s growth because it owns more than 47 percent of the outstanding units and receives a management incentive fee that increases as the MLP’s cash flow and distribution grow.

QR Energy has targeted a minimum quarterly distribution of $0.4125, equal to $1.65 on an annualized basis. Assuming that the MLP pays its minimum distributions, its units currently yield more than 8.2 percent.

Management expects the MLP to generate enough DCF to cover its distribution 1.07 to 1.08 times. These estimates assume that the MLP’s production will decline 3 percent, oil prices will average $80 per barrel, and natural gas prices will average $4 per million British thermal units.

With oil prices already above $90 per barrel, management’s forecast for this commodity appears conservative. Moreover, QR Energy has already hedged 78 percent of its 2011 oil production at about $85 per barrel, so the company could still achieve an average price of $80 per barrel even if crude prices tumbled considerably.

Management’s price forecast price realization for natural gas also appears conservative; 84 percent of the MLP’s 2011 output is hedged at an average price of $7.26 per million British thermal units.

Forecasted cash flows aren’t particularly sensitive to commodity prices, thanks to the large 2011 hedge book. That being said, a significant production miss (on the order of 10 percent) would endanger the MLP’s distribution coverage ratio.

QR Energy is a high-risk play because of its commodity exposure and an unproven operating history. But it does offer a considerable yield premium to the average upstream MLP and benefits from strong exposure to crude oil. Appropriate for aggressive investors, QR Energy LP rates a buy in the Energy Watch List.

Taking Stock

Optimism about the US economy and fuel demand has been a tailwind for US refiner and Gushers Portfolio recommendation Valero Energy Corp (NYSE: VLO). The stock is up roughly 47 percent since it joined the Gushers Portfolio in the Feb. 17, 2010, issue A New Dark Age for Refiners.

Fears of a double-dip recession meant that we held the stock longer than we’d initially anticipated, but our original investment thesis ultimately panned out. The cyclical rebound in the US economy bolstered demand for refined products, while Valero Energy benefited as competitors shuttered older plants and delayed planned investments.

But with the stock trading well above our price target, it’s time to evaluate whether this trade offers future upside. The 3-2-1 crack spread–a measure of profitability for refiners–currently stands at $15.80 per barrel. Crack spreads exhibit a pronounced seasonality, with refining margins typically improving in the first half of each year and falling over the summer.

The crack spread is much higher now than it was a year ago–or, for that matter, early 2008 and 2009. This strength stems from an uptick in US demand for refined products over the holiday season and increased exports of distillate fuel–diesel and heating oil–to Europe and elsewhere. (See the Jan. 4, 2011, issue of The Energy Letter, Forget $5 Gasoline: Demand for Diesel is Driving Oil Prices.) Crack spreads should continue to expand in the first quarter, reflecting tighter inventories.

That being said, the run-up in shares of Valero Energy and other refiners already reflects this improvement, and the demand story is becoming better understood and appreciated by the investing public.

There’s an old saw on Wall Street that investors should sell when they can, not when they have to. Heed this advice. We’re downgrading Valero Energy Corp a hold. Investors should sell half their position and place a stop order to sell the stock at 22.25. This strategy locks in some attractive gains but provides exposure to additional upside, should the stock continue its upward trajectory. If the stock tumbles, the stop order will ensure a 27 percent gain on our remaining position.

Investors looking for an alternative play should consider World Fuel Services, a stock that also benefits from rising global fuel demand and the cyclical economic recovery but has more near-term upside catalysts.

We added ExxonMobil Corp (NYSE: XOM) to the Proven Reserves Portfolio in the July 21, 2010, issue Energy Value Plays for two key reasons: It’s a great stock to own in times of market volatility, and sentiment surrounding ExxonMobil’s purchase of XTO Energy was far too bearish at the time. The latter point was a key component of my buy thesis:

XTO Energy was a Wildcatters Portfolio recommendation when ExxonMobil announced the deal in late 2009. Under the terms of the transaction, XTO’s shareholders received 0.7098 shares of ExxonMobil for each XTO share held. The Super Oil also took on about 10.4 billion in net debt owed by XTO.

At the time of the announcement in December the full value was $41.37 billion, though the decline in ExxonMobil’s share price between the announcement and consummation date lowered the full value to $34.9 billion–a large acquisition deal by any measure.

Investors appear concerned that ExxonMobil might have paid too much for XTO, while some have expressed concerns that the new assets increase the profile of natural gas in Super Oil’s production mix.

The market has vastly overreacted to both concerns, furnishing savvy investors with an excellent opportunity to buy ExxonMobil’s shares.

And there’s plenty to like about XTO Energy’s business model. The acquired firm is a US-focused natural gas producer with a long history of operating in the Barnett and Haynesville Shale, among other unconventional natural gas plays.

Moreover, XTO and ExxonMobil share similar strategies; both firms built a reputation for driving down costs in new fields through efficiency gains.

XTO also brings a lot of know-how to the table, a valuable asset as ExxonMobil seeks to exploit the significant unconventional acreage its amassed both in the US and internationally. At present, shale-gas production is primarily a North American phenomenon, though ExxonMobil and other producers are eyeing similar deposits overseas.

Granted, the deal increases the ExxonMobil’s exposure to natural gas, but as my rundown of upstream projects suggests, the company was already headed in that direction before the tie-up with XTO. This strategic shift reflects the company’s long-term outlook for energy markets; management expects demand for natural gas to accelerate at a much faster rate than the market for any other energy commodity between now and 2030.

As I noted in the introduction, this view isn’t that far-fetched when you consider the impressive demand growth in China and India. The market is paying too much attention to the near-term outlook for gas in North America; I expect gas prices to return to $6 per million British thermal units over the next one to two years.

In addition, I don’t agree that Exxon overpaid. Although Exxon issued new shares for XTO holders, the deal doesn’t represent much of a financial burden for a company of Exxon’s size.

And with gas prices depressed in late 2009 and sentiment weak, ExxonMobil wasn’t exactly buying into the industry at the height of euphoria–the deal is a value play on a business that will be of increasing strategic performance down the line.

This shortsightedness affords investors an opportunity to pick up a long-term value creator at a cheap price.

ExxonMobil is still a good long-term play; subscribers that have owned it for many years should consider holding for the long haul. But sentiment is no longer as bearish as it was last summer, and the stock trades at the high end of its normal valuation premium to its fellow Super Oils. We continue to prefer Proven Reserves Portfolio holding Chevron Corp (NYSE: CVX) because of its superior production growth potential over the next few years.

We took advantage of a golden opportunity to buy ExxonMobil Corp, but there are better opportunities elsewhere in the market. Sell half your position for a 35 percent profit and raise your stop to 72 to lock in profits on the remainder of the position. This downgrade doesn’t reflect any specific fundamental problems; this is a tactical move. ExxonMobil’s management team remains one of the best in the business.

Including the value of dividends paid out, shares of Nordic American Tanker Shipping (NYSE: NAT) are down about 7.5 percent since we added the stock to the Portfolio in the June 23, 2010, issue A Full Tank of Oil. In contrast, shares of Knightsbridge Tankers (NSDQ: VLCCF) have returned almost 38 percent over the same period. Nordic American Tanker Shipping now rates a hold.

Nordic American owns a fleet of 17 Suezmax class tankers, the largest vessels capable of navigating the Suez Canal. The average size of the company’s ships is between 150,000 and 160,000 deadweight tons. In addition to its 17 existing tankers, Nordic American has two tanker ships slated for delivery in the back half of 2011.

Nordic American is known for keeping most of its ships under spot contracts. When a company books a tanker on the spot market, the rate is based on prevailing supply and demand conditions. These rates are notoriously volatile and depend on a number of factors, including global oil demand and the number of new ships being added or subtracted from the global fleet. The Baltic Dirty Index is one common gauge of spot rates.

Source: Bloomberg

As you can see, tanker rates ran up in late 2010 but have declined once again and remain low by historical standards.

An influx of newly built tankers is a concern. Elevated charter rates from 2006 to 2008 prompted operators to order dozens of new ships. In 2010, 63 of the biggest tankers were added to the fleet; this year a further 68 vessels are scheduled to hit the market.

But operators are scrapping older vessels as new ships are delivered. In addition, the world phased out the use of single-hull tankers; most of these vessels were removed from the fleet by the end of 2010. Nevertheless, these reductions won’t be enough to offset the number of newly-built ships entering the market in 2011. These headwinds will begin to ease in 2012, when the backlog of new deliveries will decline. The recovery in spot tanker rates is a 2012 story.

Nordic American is a well run company with low debt and a long history of paying out the majority of its cash flow in the form of dividends. A solid balance sheet also means that the firm will have the opportunity to buy ships on the cheap in 2011; thanks to the glut of ships, second-hand tankers are attractively priced. But that will set up Nordic for growth in 2012 and beyond, not in early 2011.

In contrast, Knightsbridge Tankers books its vessels under time charters. The company owns a fleet of double-hulled Very Large Crude Carriers (VLCC)–vessels that are much larger than Suezmax tankers–and four Capesize dry bulk ships. Dry bulk carriers transport commodities such as iron ore and coal. Capesize carriers are among the largest dry bulk ships.

All Knightsbridge’s ships are booked under long-term time charters that lock in rates for the term of the contract. Only one of its VLCC time charters is due to expire in 2011; Knightsbridge will have to find a new contract for that ship and will take a hit on rates.

After that, Knightsbridge has two additional ships coming off charter in summer 2012. By that time, the market will have absorbed newly-built vessels, making for a healthier rate environment.

Because these charters guarantee Knightsbridge Tanker’s rates, the firm doesn’t have to worry about near-term volatility in spot markets. This reliable cash flow enables Knightsbridge to sustain its generous dividend. Yielding more than 8 percent, shares of Knightsbridge Tankers rate a buy under 27.50.

Fresh Money Buys

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 18 Fresh Money Buys that includes 16 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: The Energy Strategist

I’m adding Oasis Petroleum to Fresh Money Buys list for the reasons outlined in today’s issue. The list contains 16 stocks and two hedges, though several names are close to or above their buy targets at this time.

I have received a few questions about the two hedges, short positions in First Solar (NSDQ: FSLR) and Diamond Offshore Drilling (NYSE: DO). Both stocks have rallied over the past few weeks, so we’ve lost money on these holdings.

Both stocks have been buoyed by the broader rally in energy-related names and the stock market in general. In addition, because shares of First Solar and Diamond Offshore Drilling underperformed in the latter half of 2010, bargain hunters are likely allocating money to these “value” plays.

Fundamentals don’t justify this upside. First Solar is a leader in thin-film solar technology. Spending on solar developments is driven primarily by government subsidies, as the technology isn’t economic without such support. Subsidies in Europe are declining, particularly in key markets such as Germany.

The latter’s generous alternative energy program provides for above-market tariffs for a term of 20 years, guaranteeing companies an attractive profit for installing solar panels. But the government has begun to calculate the ultimate cost of this arrangement. In an age of austerity, Germany is systematically cutting these subsidies. Sell First Solar short above 110.

Diamond Offshore Drilling is a deepwater contract driller with one of the oldest fleets in the industry. The firm also suffers from its heavy exposure to the US Gulf of Mexico, where operations have been interrupted by the Gulf moratorium on drilling as well as ongoing delays in issuing new permits.

The company’s older rigs will have a tough time complying with new post-Macondo requirements for safety. In addition, they’re just not powerful enough to handle some of the complex wells being drilled in deepwater these days. Diamond is already taking steps to rebuild its fleet by ordering new rigs, but that strategy will take time.

Investors will continue to prefer Gushers Portfolio holding Seadrill (NYSE: SDRL), which boasts a fleet of brand-new rigs and a hefty dividend yield. Sell Diamond Offshore Drilling short above 60.

Shorting Diamond and First Solar is a hedge for those with a large portfolio of energy stocks. In a strong energy market, these picks won’t make you any money but any losses should be more than offset by gains in our other recommendations. If the energy sector pulls back, the short positions in Diamond Offshore and First Solar can help to soften the blow.