Strategists at Goldman Sachs (NYSE: GS) recently called for a short-term correction in commodity prices, while Saudi Arabia’s Minister of Petroleum and Mining Resources Ali al-Naimi stated that the global oil market is “oversupplied.” The minister also indicated that the Saudis would scale back production somewhat. These widely publicized statements have conspired to push oil prices and related equities lower in recent weeks.

Goldman Sachs’ analysis of the global oil market echoes my caveat in previous issues of The Energy Strategist, in which I warned that rising oil prices could temper demand growth and produce at least a temporary pullback in Brent crude oil and related equities. Moreover, investors have sizable profits to protect after a strong first quarter for energy commodities.

However, investors should take advantage of the recent dip to buy high-quality names. Mr. al-Naimi is correct that world markets are well-supplied right now in terms of oil inventories, but these stockpiles are only a modest buffer against rising demand.

Rather than focus on weekly fluctuations in oil inventories, investors should remember that the world’s spare production capacity–proven oil fields that can be brought online quickly–continues to decline. The ongoing civil war in Libya has accelerated this long-term trend.

Moreover, contrary to popular belief, sky-high energy prices aren’t the best news for energy stocks. Producers can make more money when energy prices are elevated, but demand destruction becomes a concern when oil reaches or exceeds $120 per barrel.

Oil prices should remain elevated in 2011, generating plenty of earnings growth for our favorite Portfolio holdings. But oil-related names aren’t the only game in town. International natural gas prices have jumped in the wake of the 9.0-magnitude earthquake that hit Japan in March. Australasian coal markets also offer substantial growth potential.

In This Issue

The Stories

The recent rally in North American natural gas prices and related equities doesn’t reflect fundamentals. See Out of Gas.

Meanwhile, rising demand in international markets for LNG offers plenty of upside for the model Portfolio’s newest holding. See International Gas.

First-quarter results from two of our coal-related holdings suggest that the coal super cycle shows no signs of abating. See Coal on Track.

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

The Stocks

Range Resources Corp (NYSE: RRC)–SELL
Petrohawk Energy Corp (NYSE: HK)–Hold
Oil Search (ASX: OSH, OTC: OISHY)–Buy < AUD8
Teekay LNG Partners LP (NYSE: TGP)–Buy < 41
Golar LNG Limited (NSDQ: GLNG)–Hold in Energy Watch List
Golar LNG Partners LP–Buy in Energy Watch List
Peabody Energy Corp (NYSE: BTU)–Buy < 72.50
Joy Global (NSDQ: JOYG)–Buy < 99

Out of Gas

US natural gas prices have climbed considerably since the earthquake and tsunami struck Japan’s Tohuku region. The June 2011 futures contract bottomed at $3.93 per million British thermal units (BTU) in early March, before soaring to a high of $4.57 per million BTUs. At present, the June natural gas futures contract goes for about $4.32 per million BTUs, roughly 10 percent higher than its March low.

The 12-month calendar strip, or the average price of the next 12 months’ worth of natural gas futures, smoothes out seasonal effects and provides a better indication of investors’ sentiment toward this energy commodity.The 12-month calendar strip currently stands at $4.62 per million BTUs, up from lows of well under $4 per million BTUs. Although the recent rally in US natural gas prices is a welcome break after years of depressed prices, underlying supply-demand conditions don’t support this move. In fact, with the US market about to enter a period of seasonally weak demand, natural gas prices could beat a hasty retreat between now and the onset of peak hurricane season in August and September.

Two factors have driven the recent rally in North American gas prices:

• North American natural gas prices and shares of gas-levered producers have rallied in sympathy with the recent surge in international natural gas prices and the price of liquefied natural gas (LNG); and
• President Obama’s March 30, 2011, speech at Georgetown University extolled the virtues of using clean-burning natural gas in vehicles as a substitute for oil-derived gasoline and diesel fuel.

The past two issues of The Energy Strategist addressed the differences between the North American natural gas market and the market for gas in Europe and Asia.

The March 24, 2011, issue The Fallout discussed how oil-indexed supply contracts with Russia have made many European nations eager to ramp up imports of LNG. This issue also explored rising demand for natural gas in Japan and Asian emerging markets.

Meanwhile, Producing Returns was the most recent issue to examine how strong production growth from prolific shale gas fields has glutted US and Canadian natural gas markets. All indications suggest that this supply overhang will persist at least through 2011.

Over the past few weeks, several ill-informed commentators have suggested that US natural gas prices will pick up because the cost of imported LNG will increase. This sophistic logic has no grounds in reality.

Source: Energy Information Administration

The amount of domestically produced natural gas–which accounts for the bulk of US supply–has increased significantly, as drilling activity in the nation’s shale gas fields has accelerated. Higher output leads to higher inventories of gas in storage.

The second-largest source of US gas supply is imports from Canada. Thanks to the surge in US production, the importance of Canadian imports has declined. This trend has allows Canada to dedicate more of its domestically produced natural gas to oil sands producers and other major consumers.

The barely perceptible blue-shaded area at the bottom of this graph depicts the negligible contribution of LNG imports to the US supply picture. In 2010 LNG imports amounted to less than 2 percent of the US natural gas market. And the above graph overstates LNG’s importance to the US market. Check out this graph of US LNG imports (left-hand scale) and US LNG import prices (right-hand scale).

Source: Bloomberg

In spring and summer 2007, US LNG imports surged. At the time, a strong economy boosted demand for natural gas and the shale gas revolution was in its early stages; a tight supply-demand balance made LNG imports more attractive.  

In subsequent years, the US became a market of last resort for LNG cargoes. This transition began in spring and summer 2008, when surging demand for natural gas in Europe pushed up the price of LNG, prompting the US to rely more heavily on domestic output.

By early 2009, LNG prices had slumped. Demand for gas declined on both sides of the Atlantic amid the global recession and financial crisis. US LNG imports ticked up during these troubled times. Because the US has superior capacity to store natural gas, it was the only market large enough to absorb excess LNG. US importers accepted these LNG shipments at bargain prices.

In late 2010 and early 2011, LNG prices started to climb as demand for gas recovered in Europe and Asia. In addition, the boom in new LNG production (liquefaction) projects began to wind down toward the end of 2010. As demand picked up, the excess LNG supplies in the global market began to dissipate.

More recently, LNG prices have surged in the wake of the devastating earthquake in Japan. With demand for LNG on the rise in international markets and prices heading higher, US LNG imports should decline even further.

The US is also unlikely to export significant volumes of LNG in the near term. The Kenai LNG plant owned by ConocoPhillips (NYSE: COP) and Marathon Oil Corp (NYSE: MRO) has operated since 1969 and remains the sole US export terminal. However, that will soon change. In February the facility’s operator and 70 percent owner ConocoPhillips announced that the plant would be mothballed once its latest long-term contract expires. Meanwhile, proposed liquefaction terminals are years away from becoming reality.

In short, the US isn’t an important player in the global LNG market. The same is true of neighboring Canada. Rising natural gas prices in international markets have no bearing on the US market. Moreover, traders can’t capitalize on the widening gulf between European and US natural gas prices because the US lacks the ability to export its domestic output to Europe.

Much has also been made of President Obama’s Remarks on America’s Energy Security, a speech delivered at Georgetown University on March 30 that highlighted natural gas as a crucial component of the nation’s drive for energy independence.

Although the president’s comments are encouraging, talk is cheap. Widespread substitution of natural gas for gasoline as a transportation fuel won’t occur overnight. Even with significant government subsidies, it would take time for trucking firms to convert their fleets to run on gas instead of diesel. Natural gas-powered passenger cars aren’t feasible until fueling stations are in place.

The idea that natural gas demand in the transportation sector will surge over the next two to three years is hopelessly optimist. In the best-case scenario, natural gas-powered vehicles might begin to gain traction at least 10 years down the line.

Not only are there few legitimate upside drivers for natural gas prices in the near-term, but the onset of shoulder season could also prove to be a significant downside catalyst. Check out this graph, which compares levels of working natural gas in storage thus far in 2011 (the red line) to the six-year average (the blue line).

Source: Energy Information Administration

As you can see, US gas in storage remains at above-average levels for this time of year. Although a cold winter reduced gas in storage to levels that were below the long-term average, this trend has reversed as temperatures become milder. In recent weeks, the amount of US natural gas in storage has been 5 to 10 percent higher than the long-term average.

Seasonality is another important consideration. Demand for natural gas peaks during winter heating season (November through March) and summer cooling season (May through August); consumption of natural gas declines during the intervening shoulder season, increasing the amount of gas in storage. With activity in US shale gas plays going strong, storage levels will likely build at a faster-than-normal pace this spring. Though one should never bet on the weather, advance forecasts suggest that summer 2011 won’t be as hot as summer 2010, potentially reducing the amount of natural gas consumed during cooling season.

The next major upside catalyst for gas is hurricane season, which doesn’t reach its peak until August and September.

At the same time, the US gas-directed rig count has declined from almost 1,000 rigs in August 2010 to 885 last week, suggesting that larger producers have begun to scale back drilling activity after securing their leaseholds by production.

Nevertheless, US natural gas production will have to decline substantially for prices to hae any upside. With an overhang of drilled wells awaiting hydraulic fracturing, natural gas prices are unlikely to tick up until at least 2012. In short, my outlook for the US gas markets hasn’t changed from my Road Map for 2011.

Based on this bearish outlook, the time is right to reduce the model Portfolios’ exposure to natural gas-focused producers. The previous issue of The Energy Strategist included profiles of Wildcatters Portfolio holding Range Resources Corp (NYSE: RRC) and Gushers Portfolio holding Petrohawk Energy Corp (NYSE: HK), the two stocks with the most direct exposure to natural gas prices.

Although these names have performed well since we downgraded them to hold, overly eager investors will lose interest in the stocks once the market comes to grips with the weak near-term outlook for natural gas prices. Shares of Range Resources would be particularly vulnerable if natural gas prices decline in spring. That’s not to suggest the company is poorly run. Range Resources is the preeminent producer in the Marcellus Shale, and management continues to divest noncore assets to fund its drilling activity in the region.

In addition to the Range Resources’ ongoing efforts to lower drilling costs, the company also benefits from the liquids-rich areas of the Marcellus. Prices for natural gas liquids (NGL) have remained robust, thanks to rising demand from the petrochemicals industry.

Westlake Chemical Corp (NYSE: WLK) is the latest major chemicals producer to announce efforts to boost its output of ethylene, a key building block in many plastics. In a remarkable change of fortune, producing many basic chemicals in the US is now cheaper than producing the same chemicals in the Middle East.

Nevertheless, shares of Range Resources are vulnerable to a correction in natural gas prices. Sell Range Resources Corp and book a gain of roughly 28 percent from our recommendation in late 2009.

The biggest risk to this call is that Range Resources remains a potential takeover target. A number of international integrated energy firms–Total (France: FP, NYSE: TOT), BP (LSE: BP, NYSE: BP), ExxonMobil Corp (NYSE: XOM) and CNOOC (Hong Kong: 0883, NYSE: CEO)–have purchased stakes in US unconventional oil and gas fields.  

With its acreage in the liquids-rich Eagle Ford Shale, Petrohawk Energy would be a more enticing takeover play. If such a deal went through, the stock could fetch north of $35 per share. That being said, we continue to rate Petrohawk Energy Corp a hold based on the company’s enviable acreage in the Eagle Ford and ability to grow its liquids production.

Oil-focused producers EOG Resources (NYSE: EOG) Suncor Energy (TSX: SU, NYSE: SU), Oasis Petroleum (NYSE: OAS), and Occidental Petroleum Corp (NYSE: OXY) remain our favorite E&P stocks.

International Gas

The past two issues of The Energy Strategist have outlined the bullish case for companies with exposure to international LNG markets. Within the model Portfolios, British LNG giant BG Group (LSE: BG, OTC: BRGYY), compressor manufacturer Dresser-Rand (NYSE: DRC) and LNG tanker owner Teekay LNG Partners LP (NYSE: TGP) fit this bill.

Here’s another name that stands to benefit from growing LNG demand. Though its shares trade in Australia, Oil Search (ASX: OSH, OTC: OISHY) is headquartered in Papua New Guinea and operates all of the country’s producing oil and gas fields.

Source: Geographicguide.net

Papua New Guinea shares the island of New Guinea with Indonesia. The nation has a population of just over 6 million people and is just a touch larger than California. With a per capita gross domestic product  of about USD2,500, Papua New Guinea (PNG) is a frontier economy that, like neighboring Indonesia, is rich in oil, natural gas and other vital resources.

Oil Search is headquartered in PNG’s capital of Port Moresby, located on the country’s southern coast. The company’s main base of operations includes the Gulf of Papua, located to the northwest of Port Moresby, as well as the Southern Highlands province.

Oil Search’s 2010 production amounted to 7.657 million barrels of oil equivalent, more than 88 percent of which was crude oil. Note that this is an annual production figure, not barrels per day. The company’s production has declined steadily over the past five years, as depicted in the graph below.

Source: Oil Search

Five years ago, Oil Search produced more than 10 million barrels of oil equivalent; at the end of 2010, its output had declined by roughly 25 percent–largely because of declining pressure in its mature wells.

The company has taken steps to offset that decline, drilling new wells in these older fields that target untapped pockets of oil. For example, Oil Search has sunk wells in Agogo, a smaller satellite field that’s adjacent to Kutubu, the firm’s largest play. One of these wells struck oil and now produces 1,500 to 2,000 barrels per day.

Fields such as Agogo should help to offset declines in Oil Search’s mature fields over the next few years. Management expects the company’s oil production to hover between 6.2 and 6.7 million barrels per year range in 2011-13. For comparison, the firm produced about 6.768 million barrels of crude oil 2010.

Rising oil prices have helped the the company’s bottom line and offset recent output declines. In 2010, for example, Oil Search’s output declined roughly 6 percent from the prior year, but revenue surged 14 percent and earnings before interest and taxation jumped 27 percent.

If all Oil Search had to offer was declining output from a handful of aging oilfields, the stock wouldn’t warrant a second look. But the company is in the midst of a transformation that should quadruple its production. The main driver of this is the Papua New Guinea LNG (PNG LNG) project.

Management estimates that constructing the PNG LNG facility will have cost $14 billion by the time it’s completed in 2014. PNG’s economy is expected to grow about 8 percent and double in size over the next five to seven years, with the PNG LNG deal contributing the majority of that growth.

The main PNG LNG complex is located near Port Moresby and will consist of two LNG liquefaction trains, each capable of producing about 3.3 million metric tons per annum (MTPA) of LNG for export. Gas to feed these trains will be sourced from the Hides, Angore and Juha gas fields located onshore in PNG. Additional gas supplies coproduced from Oil Search’s oil plays will feed these plants.

Like most projects of its size, PNG LNG is owned and funded by a consortium of companies. In this case, ExxonMobil Corp is the largest stakeholder, with a roughly one-third share, and will operate the facility. Oil Search, which holds a 29 percent stake in the project, is the second-largest player in PNG LNG. In addition, the company is responsible for producing the fields that will supply natural gas to the PNG LNG trains.

Although owning ExxonMobil would give investors exposure to the PNG LNG project, this endeavor is one among many for the integrated energy giant. With a market capitalization of roughly USD1 billion, the PNG LNG project could move Oil Search’s earnings needle substantially.  

Other major stakeholders in PNG LNG include the PNG government, which holds a16.8 percent stake; Australian energy firm Santos (ASX: STO, OTC: SSLTY), which owns a 13.5 percent stake; Nippon Oil, which owns a 4.7 percent interest; and local landholders who collectively hold a 2.8 percent interest in project.

PNG LNG is slated to come online in 2014, with both trains running by year-end. Oil Search’s share of total production will be 18 million barrels of oil equivalent per year–a huge uptick from its 2010 output of 7.6 million barrels of oil equivalent per year.

Long-term supply agreements with major gas consumers cover 100 percent of PNG LNG’s total capacity.

Source: Oil Search, Santos

Not surprisingly, China and Japan feature prominently in the customer list and would likely be interested in purchasing additional LNG volumes.

Oil Search is working on this angle. The company is performing detailed seismic surveys of some of its onshore and offshore blocks as it prepares to ramp up exploratory drilling. Management hopes that this initiative will identify additional gas reserves that would support a third or fourth LNG train.

In addition, the project partners may be able to make some more modest changes to the engineering of the two planned trains to increase their capacity by 0.3 MTPA.  

On March 28, 2011, Oil Search hosted an analyst meeting and tour of its facilities in PNG. Management indicated that they would like to accelerate some of their exploratory drilling work in either later this year or in 2012. As it’s much cheaper to build an additional train on an existing site than preparing a greenfield location, Oil Search and its partners likely will decide to add at least one additional train to the PNG LNG project. Management also indicated that recent events in Japan and the Middle East will only enhance Asian demand for reliable LNG supplies.

The financing for the project is already in place, with debt funding about 70 percent of the project. Oil Search will owe another $1.2 billion related to the project over the next three years, but strong cash flows from its existing oil projects should be enough to foot the bill. In addition, Oil Search would likely have no trouble tapping the debt markets if additional capital were necessary.

Finally, it always helps to have the most deep-pocketed company on the planet as a lead partner in a project of this magnitude. ExxonMobile has invaluable experience completing projects of this magnitude.

Oil Search’s American depositary receipts (ADR) trade thinly–only a few thousand shares change hands on most days. Investors should buy the local shares on the Australian stock exchange to ensure sufficient liquidity. Buying shares in Australia used to be a pain for US-based investors, but many brokers will now handle such transactions and some will handle the trades online. Investors who opt for the ADRs should use a limit order to avoid overpaying for the stock. Oil Search, a new addition the Gushers Portfolio, rates a buy under AUD8; the company’s ADR, which represents 10 local shares, rate a buy up to USD85. Note that the model Portfolio will track the local shares.

Units of Proven Reserves Portfolio holding Teekay LNG Partners yields 6.7 percent and remains one of our favorite plays on rising demand for LNG in international markets. The master limited partnership (MLP) on April 4 announced a secondary offering of 3.7 million units to raise $143.9 million in capital. The stock has pulled back in the wake of that announcement, offering investors an outstanding buying opportunity.

Units of MLPs typically sell off sharply after management announces a secondary offering, as the new units dilute the stakes of existing holders. For example, if an MLP has 100 million units outstanding and issues 10 million new units, the stake of existing holders declines by about 10 percent.

But investors in well-run MLPs needn’t worry about the temporary dilution that occurs when a partnership issues new units; MLPs typically use the proceeds to fund organic growth projects or to acquire other companies or promising assets, which generate additional distributable cash flow and set the stage for higher disbursements to unitholders. Historically, MLPs increase their distributions within a quarter or two of completing a secondary offering to fund expansion.

Over the past two years, we’ve consistently reminded subscribers to buy our favorite MLPs in the downdraft that typically occurs when a partnership issues new units–provided that the proceeds will be invested in growth initiatives. In each case, our Portfolio holdings have eclipsed their pre-offering price within three months. Teekay LNG Partners LP rates a buy under 41.

Golar LNG Limited (NSDQ: GLNG) is another name that owns LNG carriers and floating storage regasification units (FSRU). In March 2011, the company owned a fleet of 13 LNG carriers, four of which were being converted into FSRUs. Golar LNG Limited recently spun off four of these vessels in a master limited partnership (MLP).

Five of Golar LNG Limited’s existing vessels are currently booked under long-term time charters, while four of its other LNG carriers feature short-term arrangements that last 12 to 18 months. Whereas Teekay LNG Partners arranges long-term contracts for its vessels to lock in fixed rates, Golar LNG Partners has significant exposure to spot market pricing.

Although oil tanker rates remain depressed because of a glut of ships, spot rates for LNG carriers have improved steadily. As new liquefaction projects have come online, excess carrier capacity has been absorbed. In addition, fewer new carriers available for charter have entered the fleet in recent months.

That’s why shares of Golar LNG Limited have outperformed Teekay LNG Partners since earthquake ravaged Japan’s Tohuku region. Investors have become increasingly optimistic about LNG carrier rates because Japanese demand for the fuel has increased.

 For now, Golar Limited rates a hold in the Energy Watch List because of valuation concerns. 

Golar LNG Partners LP (NSDQ: GMLP) began trading on NASDAQ on April 7, 2011. The Bermuda-based partnership was formed by Golar LNG Limited and owns LNG carriers and FSRUs.  

When natural gas is cooled to minus 260 degrees Fahrenheit at a liquefaction facility, it condenses into a liquid that’s roughly 1/600th of its original size. In this form, large volumes of natural gas can be safely transported overseas in specially designed ships. Regasification terminals return LNG to its gaseous state before pipelines transmit the product to end users.

FSRUs are a substitute for onshore, fixed LNG regasification units. Many FSRUs are converted LNG carriers that add the capacity to regasify LNG.

At present, Golar LNG Partners has four main assets:

• The Golar Spirit was originally an LNG carrier constructed in 1981. In 2007 this carrier was retrofitted and converted into an FSRU. It’s currently booked on a long-term contract to Brazilian national oil company Petrobras (NYSE: PBR). This agreement expires in 2018.
• The Golar Winter is also an FSRU conversion project. The original LNG carrier was built in 2004 and retrofitted in 2008. The partnership has leased this vessel to Petrobras under a long-term time charter that expires in 2019.
• The Methane Princess is an LNG carrier built in 2003 and leased under a long-term time charter to British energy giant BG Group (London: BG, OTC: BRGYY). This agreement expires in 2024.
• A 60 percent stake in the Golar Mazo, an LNG carrier built in 2000 that’s under a time charter with Indonesian state-owned oil giant PT Pertamina. This contract expires in 2017. Chinese Petroleum Corp owns a 40 percent interest in this carrier.

All of Golar LNG Partners’ carriers and FSRUs are booked under time charter contracts that lock in fixed rates over multi-year period, ensuring that the MLP will receive the contracted rates for the duration of its contracts, regardless of the supply of LNG carriers and the price of natural gas.

For the duration of these time charters, Golar LNG Partners effectively operates a fee-based business with no significant commodity exposure. In addition, Golar’s counterparties on all four assets are solid: Three of its four carriers and FSRUs are leased to fully or partly state-owned energy firms that boast solid credit ratings.

The fourth is contracted to BG Group, an $82 billion company that owns gas reserves, liquefaction capacity, LNG carriers and LNG regasification facilities.

As Golar’s charter rates are fixed under long-term contracts for years into the future, acquisitions offer the best opportunity for growth, especially potential drop-down transactions from its parent, Golar LNG Limited. Such deals usually involve favorable terms and enable the MLP to boost its distribution immediately. Golar LNG Partners has the right to purchase the Golar Freeze and the Khannnur in drop-down transactions over the next 24 months.

The Golar Freeze is an FSRU that was recently retrofitted from an LNG carrier originally built in 1977. The FSRU is currently booked under a long-term contract to Dubai’s main natural gas supplier.

The Khannur is an LNG carrier built in 1977 that’s slated to be converted into an FSRU next in 2012. Two Indonesian energy companies, PT Pertamina and PT Perushaan Gas Negra (Indonesia: PGAS), are in line to book this vessel under an 11-year contract.

Although there’s no guarantee that Golar LNG Partners will acquire either asset, these transactions are likely as long as the firm’s access to the capital markets remains unconstrained.

Golar LNG Partners will likely enjoy new expansion opportunities as global demand for LNG accelerates. Over the past few years, a number of LNG export projects have come onstream, but rising demand for natural gas in Asia and the EU–particularly Germany. LNG won’t become an important part of the North American gas supply picture, but it will be crucial in many parts of the world. That should drive demand for LNG carrier ships and FSRUs.

Another positive for Golar LNG Partners is that its parent and general partner (GP) is controlled by Norwegian billionaire John Fredrikson. Income-oriented investors should be familiar with Norway’s richest man; he’s chairman or president of a long list of companies, including deepwater contract driller Seadrill (NYSE: SDRL), tanker giant Frontline (NYSE: FRO) and Golar LNG Limited. Fredrikson is one of the most experienced players in the tanker and drilling businesses and has a long history of shareholder-friendly activities.

Frontline has suffered in recent years because of a weak market for oil tankers, but its stock was one of the leaders during the tanker bull market of 2003-08. Seadrill has been the best-performing deepwater driller in recent quarters and continues to grow earnings and dividends rapidly.

Fredrikson’s experience is an undeniable asset for Golar LNG Partners. For example, the partnership can save on ship repair and maintenance costs by bundling its needs with those of its larger parent.

Golar LNG Partners’ F-1 Registration statement outlines the company’s planned distributions. The partnership’s minimum distribution per unit is $0.3850 per quarter, equivalent to an annual payout of $1.54. Given the firm’s fixed-rate time charters and fee-based income streams, Golar LNG Partners will likely pay at least $1.54 per unit in its first full year as a public company– equivalent to a yield of about 6.2 percent at current prices. Because Golar LNG Partners won’t disburse its first quarterly distribution for another three months or so, Yahoo Finance, Google Finance and most brokers’ sites list the stock’s yield as zero percent.

Golar LNG Partners pays an incentive distribution right (IDR) to its GP that’s based on the size of distributions paid to unitholders. When the quarterly payout is $0.4428 per unit or less, the GP’s receives an IDR that amounts to 2 percent of the total distribution. Above this threshold, the IDR increases gradually to a maximum of 48 percent.

If Golar LNG Partners acquires the Golar Freeze and the Khannur, the MLP’s quarterly distributions would likely approach $0.4428 per unit. Typically, MLP IPOs are structured so that initial thresholds for IDR growth are low, encouraging the GP to pursue initiatives that will enable the MLP to increase its distributable cash flow. With a quarterly distribution of $0.4428 per unit, the MLP’s units would yield almost 7.1 percent.

Golar LNG Partners is also taxed differently than most other MLPs. Like Aggressive Portfolio holding Navios Maritime Partners, Golar LNG Partners is technically an MLP but has elected to be taxed as a C corporation for US federal income tax purposes. Headquartered in Bermuda, the MLP has no US assets and earns no revenue in the US, exempting it from US corporate income taxes.

As a C-corp, Golar LNG Partners reports its distributions on a standard form 1099, not a form K-1. In addition, Golar LNG Partners doesn’t generate unrelated business taxable income, making this security suitable for an IRA or 401(k) account. Although Golar LNG Partners offers investors some of the benefits of a corporation in terms of tax filings, some of the tax advantages of the MLP structure also apply. Roughly 70 percent of the MLP’s distribution is classified as a dividend; the remainder is a non-dividend distribution that the Internal Revenue Service treats as a return of capital. Return of capital payments from Golar LNG Partners aren’t immediately taxable but do reduce your cost basis.

Golar LNG Partners should benefit from growing international demand for LNG and its focus on long-term, fee-based contracts. The MLP could grow distributable cash flow rapidly over the next 12 to 14 months through asset drop-downs from its parent.

Growth Portfolio holding Teekay LNG Partners already offers exposure to the global LNG market, though the MLP is unlikely to grow distributions as quickly as Golar LNG Partners over the next couple of years because it’s a larger firm and its stock already yields 6.7 percent. As we already have exposure to this trend, we will track Golar LNG Partners LP as a buy in our Energy Watch List.

Coal on Track

Peabody Energy Corp (NYSE: BTU) reported strong first-quarter results, beating the Street’s consensus forecast for revenues and earnings.

The stock initially sold off in reaction to the news because of what some traders regarded as weak guidance for full-year earnings. But Peabody Energy has a history of conservatism, and broader trends in the coal market remain supportive. By the end of the trading session, the stock had recovered virtually all of its intraday losses.

The driver of Peabody’s performance in the quarter was once again Australia. As we explained in the Feb. 16, 2011, issue Fundamental Strength, coal mine output in the nation was hit hard by severe flooding across Queensland and parts of New South Wales that lasted for much of the first quarter. In Peabody’s case, Australian production volumes were off by about 10 percent from the year-ago quarter.

But Australia is the world’s leading exporter of metallurgical (met) coal used to make steel. It’s also a key player in the global market for thermal coal, a variety that’s burned in power plants. Disruptions from Australia’s devastating floods put pressure on volumes but also sent the price of hard coking coal to the moon. These price increases more than offset the company’s production shortfall. In the first quarter, the firm’s Australian revenue soared 30 percent, while its revenue per ton sold jumped 43 percent in the quarter.

Better yet, all of the firm’s Australian mines are back onstream. Key rail lines damaged during the deluge are up and running, as of the end of March. In fact, Peabody is once again building up normal inventories of coal, stockpiles that cushion the firm against temporary supply disruptions.

Peabody’s US business is no longer the major driver of the company’s growth. US thermal coal markets remain pressured by US utilities’ excess stocks of coal. Although the supply-demand balance in Asian and European thermal coal markets is much tighter, US producers have limited capacity for producers to export thermal coal.

US met coal markets are a different story. The US exports significant quantities of met coal, and prices in this market are more closely tied to global demand. Prices for met coal in the US rose sharply in the wake of Australia’s floods, as US coal is seen as a partial substitute for lost Australian volumes.

Comments from Peabody Energy’s management also suggest that the US thermal coal market is gradually healing. The firm reported strong demand and an increase in coal shipments from all of its major mining operations in the western US. During Peabody Energy’s conference call to discuss first-quarter earnings, management explained that it has already sold all of its 2011 US coal production under contracts that lock in prices and volumes.

But these contracts also allow buyers to accelerate their coal orders. In other words, they can ask to have volumes scheduled for delivery in the second or third quarter delivered earlier in the year. A number of customers requested accelerated delivery in the first quarter, suggesting that demand for thermal coal is robust.

Peabody energy also plans to open a terminal that will allow the firm to export thermal coal produced in the Powder River Basin to coal-hungry Asian markets. In the first quarter, the company announced an agreement to export as much as 24 million metric tons of thermal coal from this terminal.

During the Q-and-A portion of the conference call, management stated that the export terminal permitting process was expected to take two years and construction would take about 18 months. Such a facility could drive earnings growth down the line. Prices for thermal coal in Asia are expected to be far more robust that in the US, and demand is growing at a far faster pace.

More generally, global demand for both met and thermal coal appears healthy. The recent spike in both thermal and met coal prices in the wake of Australia’s floods inevitably leads concerns about demand destruction. But in the case of coal markets, this argument doesn’t appear to have much merit.

One analyst asked if there was any sign of a drop in Chinese demand for coal. Management replied that Chinese imports of met coal are actually higher than they were in the same quarter one year ago. Although China is making efforts to ramp up domestic met coal production, it doesn’t produce the highest-quality grades of met coal, a key to efficient steel production.

Chinese imports of thermal coal were lower than the same quarter one year ago. But management indicated that situation would improve. Supply disruptions in Australia and Indonesia impacted China’s ability to import more coal. Meanwhile, sky-high coal prices prompted some Chinese utilities to draw down inventories.

But China’s coal-fired power demand was up roughly 10 percent from a year ago in the first quarter, and it’s estimated that Chinese stockpiles are down 20 to 50 percent in most regions. With the government hiking electricity tariff rates to ensure utilities can afford to buy the coal needed to keep power flowing, the near-term outlook for Chinese coal demand remains robust..

Meanwhile, Indian thermal coal imports have jumped by a third in the past 12 months as the nation rapidly opens new coal-fired power plants.

Peabody Energy’s management team has long referred to global coal demand growth as a super cycle that’s likely to last many years. Take advantage of the recent dip to buy Peabody Energy Corp under 72.50.

Mining equipment giant Joy Global (NSDQ: JOYG) joined the Gushers Portfolio on Nov. 23, 2010–a week after we sold Bucyrus International (NSDQ: BUCY), the subject of a takeover bid from Caterpillar (NYSE: CAT) for a roughly 150 percent gain. That Caterpillar’s management was willing to pay a 50 percent premium to acquire Bucyrus International speaks to the magnitude of the growth opportunity in mining equipment, particularly in Australia, India and China.

Since we added to Joy Global to the model Portfolio, the stock has returned 29.1 percent. Strong fundamentals suggest that further upside is in store over the next several years.

Joy Globalconducts business through three units: Joy Mining Machinery for underground mining equipment, P&H Mining for surface equipment and Continental Crushing and Conveying.

Joy Mining and Machinery is the company’s largest segment and accounts for a little more than half of total sales and backlog. A subtle difference between Bucyrus International and Joy Global is that former focuses a bit more on surface mining equipment. The basic underground mining equipment Joy produces is more or less identical to that built by Bucyrus and includes conveyors and shuttle cars for transporting coal, continuous and long-wall miners for shearing coal and hydraulic roof supports. Joy is generally perceived as having a slight edge in the underground mining business.

Joy’s surface mining business accounts for a bit more than one-third of sales. The company operates in the same basic product categories as Bucyrus International, though it lags the latter when it comes to draglines and other bigger pieces of equipment.

The Continental Crushing and Conveying business consists of equipment used to break coal and other mined materials into smaller pieces for ease of sorting, transport and storage.  This business, Joy’s smallest, chips in a little more than 10 percent of revenue. Like Bucyrus, a sizeable chunk of Joy’s revenue comes from more stable and profitable after-market service and parts contracts.

Together, Joy Global and Bucyrus International control more than three-quarters of the global market for specialty mining equipment, enjoying a duopoly in key market segments. Joy Global continues to benefit as senior and junior mining outfits ramp up capital expenditures to boost production and take advantage from a tightening supply-demand balance in global markets for met coal, iron ore and copper. According to management, capital expenditures within the mining industry should grow another 20 to 25 percent in 2011, before leveling out to a 10 to 15 percent range over the next three to four years.

CEO Michael Sutherlin reiterated this outlook during Joy Global’s conference call to discuss first-quarter earnings:

We see most of our customers, major customers at ramp-up phase and they’re talking to us about projects over the next four or five years, sometimes three, four, five projects over the next four, five years. So we think that they’re going to get those projects in the pipeline and they’re going to be pretty consumed in doing the project planning and project build on those over the next four or five years.

So we see our major customers ramping up in the next–the last year, this year, and we probably see them beginning to level out at a high expansion rate over the subsequent two or three years.

We are seeing a lot of projects being announced by smaller companies…where they’re beginning to look at investments on a longer horizon. So we see the combination of those continuing to build a strong CapEx [Capital Expenditures] outlook, but we don’t expect the CapEx growth to be what it has been over the last couple years. We do expect it to moderate to a more sustainable level and typically that sustainable level is more in the 10 percent to 15 percent range.

This year, management expects coal and copper miners to drive results, with Australasia accounting for much of the strength in coal-related revenue and South American driving copper-related sales. Joy Global’s near-term opportunities in the coal market have little to do with the massive run-up in prices after the flooding in Australia.

As management pointed out, the majority of operators had moved their mining equipment to safety in advance of the deluge, and any equipment cleaning and maintenance work offers only low margins. And most of the firm’s customers haven’t ramped up capital expenditures simply because of the temporary jump in prices of Australian hard coking coal; most expect prices to return to a normalized growth trend. That being said, the flooding in Queensland did delay the delivery and installation of some orders, though the company expects to have worked through this backlog by its third quarter.

Meanwhile, management continues to position Joy Global for the future. The firm has ambitious plans expand its presence in China, investing heavily in new production facilities that will meet rising demand in Australasia and position the firm to take advantage of long-term growth opportunities in the Middle Kingdom. The company is also eyeing strategic acquisitions in the Chinese market and plans to open service centers in India and Russia.

In Joy Global’s fiscal first quarter ended Jan. 11, 2011, orders were up 52 percent from a year ago, with bookings for underground mining equipment up 73 percent and bookings for surface mining equipment up 23 percent. Orders for original equipment more than doubled in both segments, while orders for aftermarket products–a lucrative business that offers higher margins–were up 18 percent.

Joy Global’s first quarter also yielded two major deals.

First, the company secured an order from India for three smaller-model shovels, its first shovel order from this country in 12 years; previously, these contracts forced the supplier to accept uncapped liability for consequent damages. With that impediment finally out of the way, Joy Global is well-positioned to win additional business from Coal India, which plans to replace and upgrade its aging shovel fleet as part of an initiative to grow production by 50 percent. Better still, the recently awarded contract includes life cycle services, locking in any aftermarket parts business. Over the long term, management aims to increase the number of these lucrative deals.

Second, Joy Global booked full-scope contract to manufacture, deliver, install and maintain a longwall system in an Australian coal mine. This deal reflects the mining industry’s transition toward long-term, full-service contracts as producers seek to improve efficiency–a boon for Joy Global, which secures follow-on sales for aftermarket parts. That being said, Caterpillar’s acquisition of Bucyrus International means that Joy Global faces stiff competition for these full-service contracts.

Despite these positive developments, Joy Global’s first-quarter earnings fell short of analysts’ estimates. This shortfall doesn’t stem from any fundamental weakness, but rather seasonality in the company’s earnings. Joy Global’s fiscal first quarter includes a high number of holidays and takes place at a time when many workers in the Southern Hemisphere go on vacation. Conversely, the company’s fourth-quarter revenue usually offset early weakness. Management also raised its 2011 revenue guidance from $3.9 to $4.1 billion to $4.0 to $4.2 billion.  

With exposure to favorable growth trends in copper, iron ore and coal mining, shares of equipment manufacturer Joy Global rate a buy up to 99.

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 stocks 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.

Source: The Energy Strategist