Worries about a global economic slowdown have weighed on stocks since late April. Throughout this summer swoon, I’ve emphasized that economic data would likely improve in the second half of the year, setting the stage for another rally in the stock market.

The past few weeks have produced a few signs that economic conditions have improved. Japan’s industrial production expanded at the fastest monthly rate in more than 50 years, with factory output surging 5.7 percent in May. A rebound in Japan’s manufacturing sector eased supply-chain disruptions that had weighed on US productivity. The Institute for Supply Management’s (ISM) US factory index jumped to 55.3 in June–its first gain in four months.

These encouraging developments were offset by disappointing slip in the ISM’s Non-Manufacturing Purchasing Managers Index, an indicator that tracks activity in the US service economy. Although the US economy has yet to turn the corner, conditions aren’t as dire as they were a month ago.

These economic improvements, coupled with another stopgap resolution to Greece’s sovereign debt crisis, have pushed stocks higher over the past week. For the time being, lower commodity prices have also reduced concerns about a major retrenchment in consumer spending.

But the stock market is notoriously volatile during the summer months, as trading volume declines substantially while many institutional investors are on holiday. This latest rally may not prove durable in this choppy market, but the S&P 500 should rally in the second half of 2011.

Investors should monitor how stocks react to Friday’s Employment Situation Report from the Bureau of Labor Statistics and second-quarter eanrings announcements. US companies have consistently generated earnings that beat analysts’ expectations over the past two years, but some worry that Wall Street hasn’t reduced its estimates enough to account for recent economic softness. We will monitor earnings releases closely over the next few weeks and issue Flash Alerts to keep you apprised of company-specific developments.

To prepare you for earnings season and familiarize new subscribers with the Portfolios, we’ll pick up the thread from the last issue and revisit the investment theses behind another chunk of our holdings.

In This Issue

The Stories

We revisit our investment theses for 12 holdings in the model Portfolios. See Wildcatters, Proven Reserves and Gushers.

Low break-even rates and charter coverage distinguish the winners from the losers in a bifurcated tanker market. See Tanker Trades.

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

The Stocks

Electricite de France (Paris: EDF, OTC: ECIFF)–Hold in Nuclear Power Field Bet
EOG Resources (NYSE: EOG)–Buy < 115
Occidental Petroleum Corp (NYSE: OXY)–Buy < 100
Petrobras (NYSE: PBR A)–Buy < 37
Sunoco Logistics Partners LP (NYSE: SXL)–Buy < 85
Afren (LSE: AFR)–Buy <GBp 175
Joy Global (NSDQ: JOYG)–Buy < 99
Spirit AeroSystems (NYSE: SPR)–Buy < 26
Tenaris (NYSE: TS)–Buy < 47
Knightsbridge Tankers (NSDQ: VLCCF)–Buy < 27.50
Nordic American Tanker Shipping (NYSE: NAT)–Hold
World Fuel Services Corp (NYSE: INT)–Buy < 40
Peabody Energy Corp (NYSE: BTU)–Buy < 72.50

Wildcatters Portfolio

Electricite de France

One of the world’s largest energy companies, Wildcatters Portfolio holding Electricite de France (Paris: EDF, OTC: ECIFF) controls most of the French electricity grid and operates a massive fleet of global power plants, the majority of which are located in Europe. The company also boasts assets in Asia, Brazil and the US, though these operations make only a limited contribution to the group’s revenue and earnings.

The French energy giant owns a fleet of nuclear power plants that has total generation capacity of about 75 gigawatts–a big part of our original investment thesis.

We added the stock to the model Portfolios in the July 26, 2006, issue, The Nuclear Option, noting that the company stood to benefit from robust economic growth throughout Europe and initiatives to reduce carbon emissions. This bet proved prescient. With the stock up 118.5 percent from the initial recommendation, we downgraded the stock to a hold and advised subscribers to cash out half their position on July 17, 2007.

In the intervening years, shares of Electricite de France have tumbled substantially from the high hit in January 2008, reflecting a precipitous decline in European electricity demand during the financial crisis and global recession. We’ve continued to rate the stock a hold over this period.

Nevertheless, the stock has struggled to rally significantly from its early 2009 low, weighed down by macro issues such as the ongoing sovereign debt crisis in the EU and concerns about economic growth in the eurozone. Meanwhile, the disaster at the Fukushima Dai-ichi nuclear power facility in early March prompted many investors to bail out of stocks associated with atomic energy. Switzerland and Germany’s plans to decommission their reactors over time also didn’t help the stock.

The 2008 credit crunch has also made investors leery of the company’s substantial debt load, while its close ties with the French government–which owns roughly 85 percent of the utility giant–has proved both a blessing and a curse. Although this relationship and the firm’s extensive experience with nuclear power afford the company growth opportunities that might not be available to rivals, shareholders’ interests sometimes come second to the whims of the French government and labor unions.

Nevertheless, the company has enjoyed a few regulatory wins in recent months. In November 2010, France’s parliament approved the Nouvelle Organisation du Marche d’Electricite, or NOME Bill, which forces the French utility to sell a quarter of its nuclear power generation to competitors at a set price. On April 2011, French energy minister Eric Bresson announced that this fixed price, or ARENH, would be EUR40 per megawatt starting July 1.
Analysts widely regarded this announcement as a victory for Electricite de France, though the company’s management had noted that a tariff of at least EUR42 would be necessary to meet future investments in its fleet of nuclear power plants. Nevertheless, rivals had called for a much lower tariff and the ARENH could increase when it comes up for review.

Meanwhile, the French government approved a 1.7 percent increase to the rate Electricite de France charges residential customers and a 3.2 percent rate hike for commercial and industrial clients.

With a massive portfolio of nuclear reactors throughout Europe and plans to build 10 more over the next decade, Electricite de France remains a solid bet on rising demand for carbon-free power generation. Rising coal and natural gas prices in Europe only reinforce this case. The company’s long-term growth opportunities in the UK are particularly compelling.

At these levels, the stock represents an attractive value for long-term investors and a dividend yield of 4 percent provides a reliable income stream. However, we continue to rate Electricite de France’s American depositary receipt a hold because of a lack of near-term catalysts. We are also shifting the stock from the Wildcatters Portfolio to the Nuclear Power Field Bet.

EOG Resources

Over the past year, a trend has emerged among US-based E&P outfits. Buffeted by depressed natural gas prices and a surfeit of supply, operators are scaling back spending on natural gas production while announcing plans to boost output of oil and natural gas liquids (NGL).

EOG Resources (NYSE: EOG) was among the first E&Ps to begin this transition, securing territory in key US unconventional oil fields roughly four years ago. This foresight should pay off: The company has amassed substantial acreage in the most prospective areas of five major shale oil plays: the Eagle Ford, the Bakken, the Niobrara the Barnett Combo and the Leonard Shale.

This rapidity with which management implemented this new strategy is staggering. In 2007 natural gas accounted for 77 percent of EOG’s revenue; in 2010 the firm garnered 65 percent of its revenue from liquids output, roughly three quarters of which was from oil. NGL production contributed the remaining quarter of liquids-related revenue.

Expect this trend to continue over the longer term. Management estimates that in 2011 and 2012 roughly 80 percent of EOG’s capital expenditures (CAPEX) will be funneled into oil and liquids-rich natural gas production. The remaining 20 percent will support key natural gas operations, including holding acreage and advancing its efforts to export liquefied natural gas (LNG) from North America. (We discussed its Kitimat LNG joint venture in the Sept. 26, 2010, issue of The Energy Letter, Cheniere Energy Partners and LNG Exports.)

In total, EOG expects to grow oil production by 55 percent in 2011 and 30 percent in 2012. Natural gas output, on the other hand, will decline by 6 percent in 2011 and 3 percent in 2011.

Here’s a look at each of EOG’s main horizontal oil and NGL plays.

Eagle Ford Shale

At a recent industry conference, EOG described the Eagle Ford as its biggest and best play. The company boasts 595,000 acres in the region: 520,000 acres in the play’s oil window, 26,000 acres in the NGL-rich window and just 49,000 in the dry-gas window. The company estimates that its holdings contain potential (not proven) reserves of 900 million barrels of oil equivalent (BOE), 77 percent of which is oil and 11 percent of which is NGLs.

The company has already drilled between 96 horizontal wells in its Eagle Ford acreage and has shared results from more than half of these wells. Several producers have drilled vertical wells in the region for as many as 25 years. This production history, coupled with ongoing production results from horizontal wells, makes EOG confident in its reserve estimates. The company has ramped up drilling activity and has 21 rigs operating in the region.

With crude oil commanding more than $90 a barrel, EOG earns attractive returns on its oil wells. And the company should be able to boost its potential reserve estimates over time as it optimizes production methods, drills more wells and proves longer production results from existing wells.

Bakken Shale

EOG was also one of the first movers in the Bakken Shale, producing and testing wells in the region back in 2006. EOG has assembled about 600,000 net acres and estimates total potential reserves at 420 million BOE. The average well in the region yields more than 80 percent crude oil and roughly 10 to 15 percent NGLs.

EOG also recently tested wells located in the western part of its acreage, near the border of North Dakota and Montana. Results from these wells resembled those from other wells in the Bakken Lite, suggesting that EOG’s holdings are productive across a wide geographic area.

Barnett Combo

The Barnett Shale, located near Fort Worth, Texas, was the first major unconventional gas play to be widely exploited in the US. But the field’s northern reaches also contain large volumes of oil and NGLs. EOG is the only major producer with significant exposure to the Barnett Combo and holds about 185,000 net acres in the core of this liquids-rich play. Management estimates the Barnett Combo’s total potential reserves at 370 million BOE.

Although this 25,000-acre expanse in the eastern portion of the play likely contains the most oil, the geology is by far the most challenging. Results from its first horizontal wells suggest that EOG is learning the best ways to produce this portion of the play.

Management plans to drill about 231 wells in the Barnett in 2011.

Leonard Shale

The Leonard Shale is a small play in the Permian Basin, along the border of Texas and New Mexico. Of the 120,000 acres EOG holds in this field, the company has drilled on only 31,000 of these acres and has completed seven horizontal wells.

Early results indicate that each well generates about 400,000 BOE worth of reserves. Output consists of about 41 percent oil, 31 percent NGLs and 28 percent natural gas. At this juncture, management estimates total possible reserves at 65 million BOE.

Recent wells drilled in the region have produced 400 to 800 barrels of oil per day and 1.2 to 2 million cubic feet of gas, a production mix that suggests similar economics to wells in the Barnett Combo play.

Niobrara Shale

EOG has pared its position to 220,000 acres in Colorado’s Niobrara Shale and has three rigs working the play. In its most recent update, the company’s recent wells produced less than 600 barrels of oil per day. But these wells were operated at restricted rates, so these initial figures may not reflect the full potential of these wells. Other wells drilled by EOG since late 2009 have generated IP rates as high as 1,558 barrels of oil per day and 350,000 cubic feet of gas.

Management has grown more optimistic in its outlook for the Niobrara. Strong well results in the latter half of the year could serve as a positive catalyst for the stock.

Shale Gas 

EOG also boasts sizeable positions in the cheap-to-produce Haynesville Shale of East Texas and Louisiana and its potential 9 trillion cubic feet of reserves in British Columbia’s Horn River play.

Management correctly believes that it won’t get full value from ramping up gas production in the current environment, but these will be premier holdings when natural gas prices recover.

EOG’s most exciting natural gas-related prospect is its 49 percent stake in the proposed Kitimat LNG export terminal in British Columbia, a facility that would ship LNG to gas-hungry Asian markets. E&P giant Apache Corp (NYSE: APA) owns the remaining 51 percent of the facility.

The two Kitimat partners are in preliminary negotiations to sign long-term contracts where the price of LNG exported from the terminal is linked to oil prices. Such contracts are typical in Japan and South Korea.

If completed, the facility would substantially boost the value of EOG’s Horn River play and provide a welcome release valve for its gas production.

One of the best-placed companies in most of the major and minor US oil- and NGL-rich plays, EOG Resources is a buy up to 115.

Wildcatters Portfolio holding Occidental Petroleum Corp (NYSE: OXY) is an international oil and gas exploration and production company (72.3 percent of 2010 revenue) that also operates a US chemicals business (20.3 percent) and owns midstream assets (7.4 percent).

The company reported first-quarter core income of $1.6 billion, up from $1.1 billion a year ago. Higher price realizations on crude oil offset a production that fell slightly short of management’s forecast, largely because of weather-related delays in the Permian Basin and contract-related shortfalls in Iraq. Although the firm’s Libyan operations contributed to the firm’s total output in the first quarter, management’s current guidance factors in zero production from the war-torn nation for the rest of the year.  

In the fourth quarter, management announced a deal to divest its troubled Argentinean operations–which hadn’t been profitable for four years–to China Petroleum & Chemical Corp (NYSE: SNP). After taxes, the long-anticipated deal will net Occidental Petroleum roughly $2.5 billion.

This lost production will be offset by output from the 180,000 additional acres the company acquired in the Bakken Shale and Three Forks portion of the Williston Basin. This deal, worth $1.4 billion, significantly expands the firm’s operations in the area and should enable the company to expand production to 30,000 barrels of oil equivalent per day over the next five years. The firm currently has seven rigs operating in the Bakken and will increase this number to 12 by year-end.

Occidental Petroleum also paid $1.8 billion to Royal Dutch Shell (NYSE: RDS.A) for 92,800 acres in south Texas that contain more than 360 billion cubic feet of gas equivalent in proven, developed reserves. Higher-value condensate and natural gas liquids account for about 30 percent of revenue from the field.

The company’s US upstream operations offer plenty of upside. The leading producer of hydrocarbons in Texas, Occidental Petroleum’s operations within the state are centered in the Permian Basin, an area with a long production history that’s been revitalized by advances in squeezing oil from mature wells. Management estimates that the company is responsible for roughly 20 percent of the oil produce in the Permian.

Carbon dioxide (CO2) injections account for about 60 percent of the company’s Permian output, while 30 percent is generated by water flooding. Both technologies facilitate production in mature fields by artificialy increasing well pressure. Primary drilling and production account for just 10 percent of output, though management has noted that its acreage contains over 2,000 prospective drilling sites and that the firm continues to sink test wells in the promising Bone Springs area.

Once the Occidental Petroleum’s Century Plant comes online, the company should have sufficient volumes of CO2 to ramp up production in the Permian. The first train came onstream in the fourth quarter, while the second should be ready in 2012. These operations provide a reliable, low-cost source of oil.

But the firm’s most exciting domestic opportunity is in California, where it has a growing inventory of more than 3,700 drilling locations, the majority of which are prospective for oil and located in areas that are held by production. Few investors would regard California as a huge energy producer–probably because the population boom of the 1940s and huge oil discoveries in the Middle East distracted many producers from developing the area.

Beginning in 1998 with the acquisition of its Elk Hills acreage from the government, Occidental’s geologists have made some unprecedented discoveries in the state, including a massive conventional find in Kern Country that management estimates could contain upward of 175 to 250 million barrels of oil equivalent.

And that says nothing about the approximately 870,000 acres the company holds in prospective shale plays. A long history of seismic activity in the area has essentially pre-fractured the field, substantially lowering costs. The company has identified 520 geologically viable shale drilling locations in California, roughly 250 of which are outside Elk Hills and Kern County. In 2011 management plans to drill 107 shale wells outside Elk Hills proper–the firm sank 26 wells in the first quarter.

Management continues to leverage the firm’s experience in maximizing production from mature fields to win business in the Middle East. The firm recently inked a 30-year contract with the Abu Dhabi National Oil Company to participate in the development of the Shah natural gas field, one of the region’s largest. The company will have a 40 percent stake in the play, and management expects capital expenditures of roughly $4 billion. But the field won’t enter production until 2014.

In the meantime, Occidental’s operations in Iraq offer the most near-term upside. Along with Proven Reserves holding Eni (Italy: E, NYSE: ENI) and Korea Gas, the company is in a consortium to develop Iraq’s Zubair field. Because of the structure of this contract, production levels can fluctuate from quarter to quarter.

Over the long haul, Occidental’s expertise in maximizing production from onshore fields should enable it to grow its business in the Middle East. Meanwhile, the Permian Basin provides a solid production base and plenty of opportunity to expand through bolt-on acquisitions. The company’s dominant acreage position in California also shows promise. Occidental’s chemicals division should benefit over the next few quarters from rising margins and elevated export demand. Occidental Petroleum Corp rates a buy under 100.

Petrobras

Shares of Brazilian national oil company Petrobras (NYSE: PBR A) have underperformed most oil and gas producers over the past few months. Nevertheless, the company has continued to report major oil and natural gas discoveries in the deepwater Santos and Campos basins offshore Brazil.

Recently, fellow Wildcatters Portfolio holding BG Group (LSE: BG/, OTC: BRGYY) upped reserve estimates on its fields offshore Brazil. But this announcement did little to boost shares of the company’s partner, Petrobras.

These pre-salt plays are often located 10,000 feet beneath the ocean’s surface and require drilling lengthy wells through complex salt formations. Petrobras’ experience operating in these harsh conditions and the state-of-the-art technology that enables the company to produce these fields will be useful in future developments and offshore plays in the Gulf of Mexico and West Africa.

In 2010 Petrobras produced about 2.1 million barrels of crude oil per day in Brazil. Management plans to boost that output to almost 3 million barrels of oil per day by 2014 and 4 million barrels of oil per day by 2020. To meet these ambitious goals, the company’s most recent business plan calls for investing USD224 billion between 2010 and 2014.

Why has the stock lagged shares of other exploration and production firms? Some investors fear that the Brazilian government’s majority voting share in Petrobras distorts the company’s investment decisions, forcing it to do the right thing rather than what’s best for minority shareholders.

Over the long run, the extraordinary growth potential of Brazil’s deepwater fields should outweigh any concerns about the government’s heavy hand.

Government interference cuts both ways. Investors groused that the company overpaid when it issued USD67 billion worth of new equity to purchase USD43 billion for new concessions to drill offshore Brazil. But the government also passed a law that requires Petrobras to have at least a 30 percent stake in any new deepwater projects offshore Brazil.

The national oil company’s refining business is another cause for concern. Refiners process crude oil into gasoline and diesel fuel; they make more money when gasoline and diesel prices rise relative to the price of oil. Petrobras’ refineries face tight margins because government-instituted price controls on gasoline and diesel prices prevent the firm from offsetting rising input costs.

At the same time, fuel demand continues to grow at a blistering pace in Brazil; Petrobras’ refineries are running at well over 90 percent of their capacity to keep up with demand. The company must add refineries in an effort to ease this bottleneck, though current diesel and gasoline prices hardly incentivize this investment.

The key question is to what degree weakness in the refining business will offset the long-term growth in Petrobras’ oil production. In the short-term, the recent pullback in oil prices will relieve some margin pressure. Simple supply and demand eventually will force the government to raise price caps on gasoline and diesel.

Meanwhile, the release of the company’s 2011-15 business plan could be an important catalyst for the stock. The market should reward the company if the increase to its capital budget for exploration and production outpaces funding for its downstream operations.

As my colleague Yiannis Mostrous and I point out in The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, state involvement in business is a fact of life after the past 20 years of resource nationalism. Moreover, the Brazilian government’s influence on Petrobras has proved relatively benign compared to other state-run oil companies. Buy Petrobras under 37.

Proven Reserves Portfolio

Sunoco Logistics Partners LP

One of the most conservative master limited partnerships (MLP) in our coverage universe, Sunoco Logistics Partners LP (NYSE: SXL) will shift from the growth-oriented Wildcatters Portfolio to the income-focused Proven Reserves Portfolio.

Sunoco Logistics operates 5,400 miles of crude oil pipelines, 2,500 miles of refined product pipelines and owns 42 refined products terminals with some 24 million barrels of oil storage capacity. Roughly 85 to 90 percent of the partnership’s quarterly cash flow is locked in under long-term, fixed-rate contracts with major energy producers, so dramatic swings in oil and gas prices won’t threaten the MLP’s distribution. In fact, the company has boosted its payout in 25 consecutive quarters.

The company’s crude oil pipeline network is primarily based in Texas, connecting oilfields in West Texas and the key oil hub at Cushing, Okla. to the Gulf Coast and Sunoco Logistics’ massive crude oil terminal in Nederland, Texas.

Sunoco Logistics’ West Texas Gulf Expansion will add capacity to transport another 100,000 barrels of oil per day from West Texas to the Nederland terminal, accommodating rising oil output from the Permian Basin. Demand for additional pipeline capacity was so strong that the MLP was able to lock in cash flow under long-term contracts before the firm even broke ground on the project.

Sunoco Logistics has also enlarged the Nederland terminal, adding two additional tanks in the first quarter of 2011 and another two by early 2012. These projects will increase Nederland’s storage capacity to 22 million barrels of oil. As with the company’s pipelines, customers pay Sunoco Logistics a fee to guarantee access to the facility regardless of whether they use their contracted capacity.

In addition to storage fees, Sunoco Logistics earns income from ancillary services such as fuel blending–for example, blending ethanol with gasoline to meet regional requirements. The MLP is also expanding its butane blending business rapidly in response to rising production of this NGL. Butane is cheap relative to oil and gasoline, incentivizing refiners to blend cheaper butane with more expensive gasoline. This business also features long-term contracts that guarantee minimum cash flows. Management plans to roll out this proprietary butane blending technology at all of the company’s terminal facilities over time.

The company is also expanding its exposure to NGLs via another project. The Marcellus Shale in Appalachia contains large quantities of natural gas and significant volumes of ethane, an NGL that’s used to make ethylene and other key petrochemicals. But the region lacks sufficient capacity to transport ethane from the region to  petrochemicals processing facilities.

Sunoco Logistics is working on an ethane pipeline that would collect volumes from the Marcellus and transport them to a major petrochemicals complex in Sarnia, Ontario. Management expects the first phase of this project to come online in 2012. The project would utilize an existing refined-product pipeline that’s already in place, reducing costs.

The firm’s network of refined-product pipelines–pipes that convey gasoline, diesel and other fuels from refineries to storage and distribution facilities–is concentrated in the Northwest. Refined product pipelines are arguably the most conservative and, for lack of a better term, boring businesses in which an MLP can be involved.  

Refined-product pipelines usually feature long-term contracts with refiners that provide for a minimum cash flow regardless of oil prices or demand. Rates are typically adjusted for inflation, with tariffs resetting on an annual basis; this often results in major tariff increases when inflation pucks up. Even better, refined-product pipelines usually service a single refinery, a monopoly-like situation.

Sunoco Logistics covered its distribution by more than 1.2 times in the most recent quarter and has boosted its payout by more than 7 percent over the past year. Management plans to raise the MLP’s distribution by 6 percent in 2011 but has a long history of exceeding its own distribution growth targets. Sunoco Logistics Partners LP, which tends to perform well in periods of uncertainty, rates a buy when the stock dips below 85.

Gushers Portfolio

Afren

UK-based Afren (LSE: AFR) has amassed an impressive portfolio of 29 high-potential assets in or offshore 11 African nations. The company focuses on acquiring undeveloped or unappreciated fields, a strategy that lowers the firm’s cost base and enables it to offset development costs relatively quickly. These overlooked gems may not move the needle for a major integrated oil company like ExxonMobil Corp (NYSE: XOM) but can be huge successes for a relatively small firm like Afren whose market capitalization is USD2.6 billion.

Thus far, its Nigerian interests have proved the most successful. In an interim statement published on May 19, management reaffirmed its 2011 net oil production guidance of 40,000 barrels of oil equivalent per day. Much of this output will come from two plays offshore southeast Nigeria, the oil-producing Okoro and Ebok fields.

Discovered in the 1970s, Okoro sat idle for decades. In 2010 the field yielded an average of 16,055 barrels of oil per day, outstripping expectations. In the first quarter of 2011, this production rate declined to 14,200 barrels of oil per day, but the company recently completed two infill wells–secondary wells drilled in producing fields to limit the distance hydrocarbons must travel through the formation–that should boost gross production to about 21,000 barrels of oil per day. 

After Afren plowed USD310 million into developing and producing Ebok in 2010, the first phase of the program came onstream in February 2011 and flowed 17,000 barrels of oil per day from five wells–slightly above management’s expectations. The second production phase, which management expects to be completed in the back half of the year, should yield an additional 20,000 barrels of oil per day.

Envisioning Ebok as a hub for its operations offshore Nigeria, Afren is drilling additional appraisal wells in the nearby Okwok field to determine the best approach to developing this oil-focused play and sinking an exploration well in OML 115, another field that’s prospective for oil.

Rising production from Afren’s Nigerian fields and higher oil prices prompted the company to tap the corporate bond market for USD500 in capital, some of which was deployed immediately into a string of acquisitions and some of which will fund ongoing exploration and appraisal operations.

Not only did the company acquire 12 assets onshore and offshore eastern Africa when it purchased Black Marlin Energy Holdings in 2010, but the firm also bought a 74 percent interest in the Tango Block offshore Tanzania.
In 2010 Afren’s exploratory drilling program yielded a reserve replacement rate of about 500 percent, and the UK-based operator has more in store for the second half of 2011.

Any of these wells could serve as an upside catalyst for the stock, particularly wells in 100 percent-owned Block L18 offshore Kenya and the 40 percent-owned Block 1101 offshore Madagascar. Afren also holds a 35 percent interest in the Keta Block after farming out the operatorship to Proven Reserves Portfolio holding Eni. In exchange for a stake in the play, the Italian integrated oil and gas firm will pay for the first appraisal well and seismic data and award Afren a USD50 production bonus if the field comes online.

Since we first highlighted Afren in the April 7, 2010, issue The Search for More Oil, the stock has returned 58 percent. The company offers exposure to an exciting combination of low-risk exploratory assets offshore Nigeria and high-potential drilling prospects on Africa’s east coast. A recovery in oil prices in the back half of 2011 is the icing on the cake. Take advantage of the recent pullback and buy Afren under GBp175.

Joy Global

Mining equipment giant Joy Global (NSDQ: JOYG) joined the Gushers Portfolio on Nov. 23, 2010–a week after we sold Bucyrus International, 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 29.2 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.

Spirit AeroSystems

Spirit AeroSystems (NYSE: SPR) is the world’s largest independent manufacturer and supplier of commercial aircraft components. In 2010 fuselage systems generated 49 percent of the company’s revenue, propulsion systems accounted for 25 percent of sales, and wing systems contributed 26 percent.

Although Boeing (NYSE: BA) spun off Spirit AeroSystems in 2005, the firm still works closely with its former parent under long-term supply agreements related to specific aircraft series. These single-source contracts for critical airline parts can offer superior (albeit not spectacular) margins to the design-build work associated with developmental projects such as Boeing’s oft-delayed 787 Dreamliner. In these instances, the airplane components have yet to be standardized, leaving plenty of room for costly overruns–a major challenge to profitability.

This challenge struck home in the first quarter, when the company’s operating profit declined 25 percent from the prior year to $70 million because of a $28 million charge related to Sikorsky Aircraft Corp’s CH-53K helicopter program that pushed the contract closer to a loss. First-quarter profit margins also contracted to 6.6 percent from 8.9 percent a year ago. At present, Spirit AeroSystems is involved in six developmental projects that are in varying stages of flight testing.

Despite these headaches, securing these developmental contracts and seeing them through are essential to Spirit AeroSystems’ long-term growth. In an industry with so many single-source agreements, winning contracts held by competitors is almost impossible.

Fortunately, Spirit AeroSystems holds a number of design-build contracts for the next-generation Boeing 787 Dreamliner and Airbus’ A350, revolutionary airplanes that rely on composite materials to improve fuel efficiency.

Although Spirit AeroSystems confirmed that it wouldn’t make any money on the first 500 Dreamliners for which it manufactures components, the design is expected to be a huge draw in an industry that constantly battles against rising fuel prices. Orders related to the Boeing 787 already account for 21 percent ($5.9 billion) of SpiritAerosystems’ backlog, while orders associated with the Airbus 350 represent 12 percent ($3.3 billion).

Moreover, demand for airplanes continues to recover from the financial crisis and global economic downturn, with emerging markets leading the way. Shares of Spirit AeroSystems are down 4.2 percent since we highlighted the stock in the March 24, 2010, issue Investing in Efficiency. The stock could face near-term headwinds if another disappointing quarter forces management to lower its full-year guidance–a distinct possibility as the company builds inventory for the Dreamliner and other long-cycle projects. But the company’s longer-term growth story remains intact. Buy Spirit AeroSystems under 26.

Tenaris

Tenaris (NYSE: TS) is the world’s leading producer of steel pipe products and tubular goods, or oil country tubular goods (OCTG) in industry parlance. The Luxembourg-based company outfits all three segments of the energy industry, from upstream (exploration and production) to midstream (pipelines and other transportation infrastructure) and downstream (refineries).

In 2010 the power and process industries accounted for about 11 percent of Tenaris’ USD7.7 in annual revenue, while other industrial users accounted for another 11 percent. The oil and natural gas industry generated 78 percent of the firm’s revenue last year. Here’s a rundown of the company’s basic products and their applications:

• Steel Casing sustains the walls of oil and natural gas wells during and after drilling;
• Steel Tubing transmits oil and gas to the surface after drilling;
• Steel Line Pipe conveys crude oil and gas from the well to refineries, storage facilities and loading and distribution centers;
• Mechanical and Structural Pipes have a wide range of industrial applications, including the transportation of various liquids and gases under high pressure;
• Cold-Drawn Pipe features diameters and wall thicknesses suitable for use in boilers, super heaters, condensers, automobile production and other industrial applications;
• Premium Joints and Couplings are specially designed connections used to join tubes and pipes in high-temperature or high-pressure environments; and
• Coiled Tubing is used for oil and gas drilling, well interventions and subsea pipelines.

However, Tenaris’ biggest growth opportunities hinge on a key investment theme that underlies many of the holdings in our model Portfolios: the end of easy oil. As production from established oil and gas reserves continues to dwindle, producers have sought to grow output by tapping expensive-to-produce reserves trapped in shale and other tight reservoir rock or located in deepwater fields around the world.

In 2010 Tenaris benefited from the uptick in drilling activity in US shale oil and gas plays, a market that drove a 130 percent increase in US OCTG sales volumes. In addition to high demand for specialty connectors among shale gas drillers, the company also has exposure to the many pipeline and gathering projects underway to service emerging shale plays.

But rising demand in the deepwater market remains the leading growth driver for Tenaris. Management estimates that about 69 percent of the OCTG products used in offshore drilling are premium quality, a product mix that yields higher margins and limits price competition from Chinese manufacturers.

The Macondo oil spill served as a stark reminder that failure isn’t an option in deepwater drilling. Given the extremes of pressure and temperature in deepwater drilling environments, oil and gas producers are largely price takers when inventories of premium tubular goods are at normal levels. Although rising steel prices are a concern, Tenaris should be able to pass these costs on to customers.

In the near term, two factors should drive earnings growth for Tenaris. OCTG inventories have declined from the high reached during the financial crisis and global economic downturn, while rising oil prices and a tightening supply-demand balance in international natural gas markets have given producers the confidence to hike capital budgets and green-light new exploratory projects. (See Here Comes the Spending).

These market dynamics enabled the company to grow first-quarter operating income by 43 percent from year-ago levels.

Over the long term, Tenaris’ global reach, commitment to quality and close relationships with customers should ensure that the firm reaps the rewards of an improving product mix as spending on deepwater drilling activity increases. Tenaris continues to rate a buy under 47.

World Fuel Services

Unlike most of our Portfolio holdings, World Fuel Services Corp (NYSE: INT) isn’t involved in oil and natural gas production; rather, the company serves as a middleman to customers looking to reduce fuel costs.

World Fuel Services purchase aviation and marine fuels in bulk, passing on a portion of the savings to its global customer base. The company’s global energy distribution network also shields its clients from the expense associated with building and maintaining an in-house energy logistics solution.

For example, a major cruise line with ships traversing the world might contract with World Fuel Services to secure bunker fuel in remote areas without paying exorbitant prices to local suppliers. World Fuel Services boasts fuel-buying operations in about 200 countries and an extensive database of local relationships and price differentials. In this instance, saving a few dollars per ton of bunker fuel can significantly improve a cruise line’s profit margins.

Historically, maritime customers such as cruise lines, tanker operators and dry-bulk shippers have accounted for about half World Fuel Services’ revenue, with the remainder divided among passenger and freight airlines and operators of land-based transportation. But acquisitions have diversified the company’s business mix: In the first quarter of 2011, marine customers accounted for 43 percent of revenue, the aviation industry generated 37 percent, and land-based transportation contributed 20 percent,

World Fuel Services doesn’t necessarily benefit from rising oil and fuel prices. As a middleman, the outfit earns a spread between the price it pays for buying fuel in bulk and the price it charges customers for fuel and ancillary logistical services. In general, rising or falling energy prices don’t have a significant impact on the company’s margins, as these price fluctuations are reflected in the rates charged to customers. However, extreme shifts in energy prices can stimulate or destroy demand, which would affect the company’s business.

Although the stock has pulled back alongside the broader market since late April, elevated oil prices didn’t erode sales volumes in the first quarter. Deliveries to aviation customers soared 38 percent from year-ago levels, while volumes sold to marine transportation outfits jumped by 9 percent and operators of land-based transportation fleets

Crude oil prices have pulled back from their springtime high, lowering fuel costs. As I explained in a Flash Alert issued on June 24, the International Energy Agency’s decision to release about 2 million barrels of oil per day from strategic reserves worldwide will provide only a temporary respite from high oil prices. The threat of further releases from government stockpiles should help cap oil prices this summer, easing worries about demand destruction.

Volatile oil prices make it tougher for firms in energy-intensive businesses to manage fuel-related expenses. In this environment, World Fuel Services’ promise of consistent fuel supplies and cost savings is an easy sell.  

World Fuel Services traditionally has grown through acquisitions, taking advantage of a fragmented market. In early 2011, World Fuel Services acquired the Hiller Group, an aviation fuel supplier in Florida­­­­. In March, it completed the purchase of Nordic Camp Supply, a fuel distributor to the military. Ascent Aviation, the company’s most recent addition, supplies fuel and de-icing fluids to 450 US airports. Management expects the deal to be accretive to earnings within the 12 months after the transaction closes. Buy World Fuel Services under 40.

Tanker Trades

Knightsbridge Tankers

To say that the past three years have been challenging for companies that own and operate oil tankers is an understatement. At the height of the financial crisis and Great Recession, tanker companies struggled to cope with the evaporation of short-term financing and a precipitous decline in global oil demand.

The economic recovery has brought little relief for tanker companies with substantial exposure to the spot market, where vessels are available for short-term leases. Although US oil demand continues to recover from its recessionary nadir and consumption in China and other emerging markets has increased markedly, spot rates have recovered only marginally over the past few years.

In many ways, these challenges are the industry’s own doing: Tanker capacity has swamped demand for oil shipments. The roots of this overhang trace back to the last bull market for tankers, when many operators ordered new vessels from shipyards based on overzealous assumptions about demand trends.

The industry’s current order book stands at 137 new vessels–about a third of the existing fleet of double-hulled vessels–62 of which are slated for delivery in 2011 and 59 of which should arrive in 2012. Recognizing their plight, tanker operators have sought to cancel or postpone these orders.

According to the world’s largest supertanker operator Frontline (Oslo: FRO, NYSE: FRO), the industry abstained from ordering any very large crude carriers (VLCC) in the first quarter and 28 percent of new vessels slated for delivery during that period have yet to arrive. Moreover, some tanker operators have converted outstanding VLCC orders into carriers capable of carrying liquefied natural gas (LNG), a market where tanker rates continue to climb amid rising demand for natural gas in Europe and Asia. Meanwhile, only 13 Suezmax ships were delivered, a slippage of 43 percent.

From the beginning of the year to June 10, VLCCs traveling from the Middle East to the Far East commanded an average day rate of USD19,129, well below Frontline’s break-even rate of roughly USD29,700 per day. At times, these day rates dipped to as low as USD5,045.

With only 11 percent of its fleet covered by long-term charters in 2012, Frontline will continue to struggle. Even worse, the average day rate on a five-year charter is USD34,500–a price that offers only limited profits for Frontline. Given these challenging fundamentals, it’s little wonder that the company’s Vice President Tor Olav in late May told delegates at the Nor-Shipping conference: “We have to go through a lot of pain before we’re into profitable territory. We have just started on a down cycle, which is going to be brutal.”

Frontline’s difficulties stand in stark contrast to Gushers Portfolio holding Knightsbridge Tankers (NSDQ: VLCCF), which has 77 percent of its tankers booked under time charters.

Knightsbridge owns four VLCC tankers. One ship operates on the spot market and is managed by a cooperative. The other three VLCCs are on time-charter deals: One expires in June 2011, one in May 2012 and the final in August 2012.

In addition to VLCCs, Knightsbridge also owns two smaller dry-bulk carriers, ships designed to transport dry commodities such as coal, grains and metals. These two ships, both built and put into service last year, aren’t due to come off their time charters until 2014.

Because Knightsbridge’s fleet is small, the single spot VLCC provides some leverage to an improvement in spot rates. Meanwhile, the time-chartered ships offer a bit of income stability that supports the firm’s 9 percent dividend yield. And with an average break-even rate of USD18,700 per day, Knightsbridge will have much more flexibility than Frontline when its current time charters expire.

Despite the differences between the two companies, Frontline Chairman John Fredriksen’s bearish outlook on the spot market for supertankers prompted shares of Knightsbridge and other companies with low operating costs and solid time-charter coverage to sell off.

Frontline is regarded a bellwether for tanker stocks; many investors assume that the industry’s fortunes follow those of its largest operator. Take advantage of this misunderstanding and buy Knightsbridge Tankers up to 27.50.

Nordic American Tankers

Whereas shares of Knightsbridge Tankers have returned 31 percent since we highlighted the stock in the June 23, 2010, issue A Full Tank of Oil, Wildcatters Portfolio holding Nordic American Tanker Shipping (NYSE: NAT) have given up 16.6 percent.

Nordic American owns a fleet of 16 Suezmax tankers, the largest vessels capable of navigating the Suez Canal. The average size of Nordic’s ships is between 150,000 and 160,000 deadweight tons. In addition to its 16 existing tankers, Nordic has three tanker ships slated for delivery in 2011.

Nordic American is known for its concentrated exposure to the spot market, where ships are contracted for immediate use. There are advantages and disadvantages to both spot-market contracts and time charters; spot contracts offer more upside in strong tanker markets and more downside when rates are weak.

Time charters provide for more predictable average rates over time but don’t give firms as much upside leverage to improving tanker rates. Currently, all of Nordic American’s 16 ships are on spot contracts.

In the case of Nordic American and many other tanker operators, ships contracted at spot rates aren’t managed directly by the owner. Rather, these ships are managed as part of a cooperative with other major tanker operators. This arrangement offers superior economies of scale for many of the costs associated with marketing tankers. Nordic American’s tankers are in cooperatives along with ships owned by other major operators such as Teekay Corp (NYSE: TK) and Frontline.

Nordic American has a clear-cut dividend policy: The company distributes all of its cash flows as dividends to shareholders, though management can withhold a certain reserve of cash to handle corporate expenses such as maintenance or payments on new-build vessels.

The direct tie between dividends and cash flows means that Nordic American’s payout rises and falls from one quarter to the next based on spot market tanker conditions. For example, in the strong tanker market of 2005, Nordic American paid out $5.85 per share in dividends; amid depressed spot conditions in 2009, the operator paid out just $2.35.

For the first quarter of 2011, Nordic American paid a dividend of $0.30–much better than the $0.10 it paid in the fourth quarter of 2009 and the $0.25 it disbursed in March 2010. For investors willing to bet on an improvement in the day rates available on the spot market, Nordic American is the best option. But we would caution that any improvement could be a long time coming.

With no debt and more than $100 million in cash on its balance sheet, Nordic American has the firepower to acquire tankers at depressed valuations, while its average break-even rate of $11,300 ensures that the company has a fighting chance to maintain its dividend.

But given the uncertainty surrounding day rates in the spot market, Nordic American Tanker Shipping continues to rate a hold.

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. 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: Bloomberg, The Energy Strategist

­Fresh News

Mongolia announced that the Tavan Tolgoi metallurgical coal deposit will be developed by a consortium that includes Wildcatters Portfolio holding Peabody Energy Corp (NYSE: BTU) (24 percent stake), China’s Shenhua Coal (40 percent) and a group of Russian and Mongolian operators (36 percent).

Nevertheless, the deal remains shrouded in uncertainty. A government official refuted previous reports and announced that a deal had yet to be finalized. This might have been in reaction to some strong words from South Korea; a consortium of South Korean firms apparently lost their bids even though they were short-listed as potential developers.

At the end of the day, however, Peabody will likely be involved in the play; the Mongolian government is keen to keep the US as an ally. With demand for metallurgical coal rising rapidly in China and other emerging markets, spot prices have soared over the past several months. Mongolia’s proximity to China makes the Tavan Tolgoi deposit even more attractive.

Buy Peabody Energy Corp under 72.50.