The Stories

Concerns about economic weakness in the US and EU continue to dominate the tape. Here’s an update on our outlook for the global economy. See It’s the Economy (Again).

The widening spread between the price of West Texas Intermediate crude oil and Brent crude oil serves as a reminder that the oil market is both local and global. Here’s why we favor companies with exposure to Brent crude oil at this time. See Global Theater.

Take advantage of ongoing volatility in the stock market to lock in attractive yields on our favorite defensive-growth plays. See Buy High-Yield Safe Havens.

The tanker market continues to take a beating, but a tightening supply-demand balance in international LNG markets offers long-term growth. See Portfolio Updates.

Which Portfolio holdings boast the best short-term prospects? See Fresh Money Buys.

The Stocks

Schlumberger (NYSE: SLB)–Buy < 100
Weatherford International (NYSE: WFT)–Buy < 28
Core Laboratories (NYSE: CLB)–Buy < 115
Petroleum Geo-Services (OTC: PGSVY)–Buy < 17.50
Seadrill (NYSE: SDRL)–Buy < 38
Chevron Corp–-Buy < 105
Eni (NYSE: E)–Buy < 52
ExxonMobil Corp—Buy < 78
Knightsbridge Tankers (NSDQ: VLCCF)–Buy < 27.50
Nordic American Tankers (NYSE: NAT)–Hold
Oil Search (ASX: OSH, OTC: OISHY)–Buy < AUD8

It’s the Economy (Again)

The boundless creativity of financial journalists has produced at least a dozen rationales for the extraordinary gyrations suffered by US equity markets since the beginning of August. But investors are worried primarily about one thing: the state of the global economy.

As I noted in the Aug. 23, 2011, Flash Alert, Strategy Session, the odds that the US will slide into recession over the next six months stand at 1-in-3. We continue to monitor the economic situation closely and will keep readers apprised of any changes to our outlook via additional Flash Alerts. With the prospects of an economic contraction weighing on investors’ minds, even inconsequential data points can roil the stock market.

The economic recovery is clearly fragile, but the outlook remains murky. Although data points suggest that economic activity has improved markedly in recent weeks, equity markets remain volatile. The Institute of Supply Management’s Purchasing Managers Index (PMI) and other surveys of business sentiment suggest that fear continues to rule the day.

Three important economic data set have come out since my Aug. 23 Flash Alert.

The Federal Reserve Bank of Richmond’s Fifth District Survey of Manufacturing Activity usually doesn’t move the markets. However, the most recent installment of this survey attracted more scrutiny than usual, largely because the Federal Reserve Bank of Philadelphia’s August 2011 Business Outlook Survey indicated that expectations for future economic activity had deteriorated substantially. Investors looked to the results of the Richmond Fed’s survey to ascertain whether the Philadelphia Fed’s dismal business outlook was an outlier or a harbinger of further economic weakness.

Check out this graph of the Institute for Supply Management’s Manufacturing PMI–one of our favorite leading indicators of US economic health—and the regional indexes released by the Federal Reserve Banks of Philadelphia and Richmond.

Source: Bloomberg

The trends in the two regional Fed surveys tend to track one other and the national PMI data closely over time, albeit with plenty of outliers. The 2001 and 2007-09 downturns stand out on the graph: Regional expectations for business activity tumble well into negative territory (left-hand scale) and Manufacturing PMI drops into the low to mid-40s (right-hand scale).

When the Federal Reserve Bank of Philadelphia’s general economic index plummeted to minus 30.7 from 3.2 in July, this marked one of the largest single-month declines in the indicator’s history and one of the biggest upside or downside surprises. (Analysts’ consensus estimate called for a reading of 2.) The last time the index plumbed these depths was in March 2009, when the Manufacturing PMI had sunk to 36.5 and the economy was in the final months of the Great Recession. In 2001 the Philadelphia Fed’s index of general economic activated also dipped below minus 30 when the Manufacturing PMI was about 43.

If the August Manufacturing PMI reading declines to 43, the US recession debate will be all but over–at that point, the question will be about the severity and duration of the economic contraction. Given the historical precedents, the rapid deterioration in business sentiment reported by the Federal Reserve Bank of Philadelphia spooked anxious investors.

Although the Federal Reserve Bank of Richmond’s index of regional business conditions slipped to minus 10 from minus 1 in July, the S&P 500 still rallied because these numbers didn’t corroborate the big downturn reported by its counterpart in Philadelphia. Most of the index’s underlying components were weak, including expectations for future orders and production.

But a reading of minus 10 is significantly higher than what one would expect in a recessionary environment. Also consider that the Richmond Fed’s index bottomed at minus 7 in August 2010 amid last summer’s temporary soft patch.

Business conditions in the Federal Reserve Bank of Richmond’s district suggest that the most recent reading from its counterpart in Philadelphia was an outlier.

In short, the US economy has softened. The August manufacturing PMI will likely drop to less than 50, but the business environment isn’t as dire as the Philadelphia Fed’s index of general economic conditions would suggest.

The Census Bureau’s advance estimate of durable-goods orders also gave investors a glimmer of hope. Durable goods are defined as products that have a useful life of three or more years–for example, machinery, motor vehicles and aircraft. These purchases (or lack thereof) indicate how confident companies are in the health of the economy.  

Analysts typically scrutinize the headline change in orders and durables excluding transportation, a number that factors out order for jumbo jets and other big-ticket items.

No matter how you slice it, the July numbers were strong. Orders of durable goods were up 4 percent in July, roughly two times the growth rate in June. Economists’ consensus estimate called for a 2 percent increase. Meanwhile, even with transportation-related orders backed out, demand for durable goods increased by 0.7 percent, a marked improvement to the 0.1 percent growth reported in June.

At the same time, the data underlying this report was collected before Standard & Poor’s downgraded the US government’s credit rating and the stock market swooned. Orders of durable goods likely weakened in August. This highlights the biggest risk to the US economy: That negative sentiment will sap any improvement in business activity.

Although we peg the odds that the US economy will slip into recession at 1-in-3, we expect the world’s leading economy to continue to suffer through a prolonged period of lackluster growth. Expect the next few years to bring their fair share of modest upticks in economic growth and additional growth scares.

The US isn’t the only developed economy that has weakened; burdened with an ongoing sovereign-debt crisis and fiscal austerity measures, Europe appears to be in worse shape. The Ifo Business Climate Index, which has traditionally been a reliable predictor of German economic performance, fell in August to its lowest level since June 2010. With growth stalling in Europe’s largest economy, many worry that the EU could slip into recession.

But the Eurozone PMI Composite indicator held steady at 51.1, defying analysts’ consensus expectations, which had called for the index to decline to 50 in August. Readings above 50 indicate expansion, while readings in the mid-40s are consistent with a recession. As of yet, this indicator hasn’t deteriorated to levels that would suggest an imminent downturn. This index was bolstered by Germany’s stronger-than-expected Manufacturing PMI and France’s Non-Manufacturing PMI. 

That’s not to suggest Europe is out of the woods. Rather, recent PMI data from the region suggests that the market’s dire projections about the eurozone have yet to come to fruition.

Worries about the global economy slipping into recession continue to outweigh company-specific factors in the energy patch.

Global Theater

Investors should also heed the price spread between West Texas Intermediate (WTI) and Brent crude oil. The oil prices you read about in the newspaper and hear about on television often refer to WTI, the variety of crude oil that underlies futures contracts traded on the New York Mercantile Exchange. WTI typically reflects supply and demand conditions in the US and Canadian oil markets. Brent crude oil, on the other hand, tends to reflect global supply and demand dynamics.

For many years, these distinctions were a moot point. As the world’s largest oil consumer, US demand used to drive crude oil markets. In fact, an entire generation of traders has regarded US oil supply and demand dynamics as a proxy for the world market. This explains some oil traders’ unhealthy fascination with weekly inventory reports released by the US Energy Information Administration (EIA).

Brent crude oil traditionally trades at a $1 to $2 discount to WTI because it’s of slightly inferior quality. But regional supply and demand conditions can throw off this balance. For example, in 2005 WTI traded at a larger-than-average premium to Brent because of hurricane-related supply disruptions on the Gulf Coast. In early 2009 Brent commanded a significant premium to WTI, reflecting surging demand in emerging markets at a time when developed economies remained mired in recession.

This familiar relationship between WTI and Brent crude oil has unraveled once again.

Source: Bloomberg

Although both oil benchmarks have pulled back from their 2011 highs, WTI has taken a much bigger hit than its European counterpart. Whereas the price of WTI has tumbled roughly 28 percent from its high in late April to its recent low of about $82 per barrel, Brent crude oil has declined by only 15 percent from its high of almost $127 per barrel to its recent low of $107 per barrel.

Meanwhile, Brent has commanded premiums of as high as $30 per barrel in recent trading sessions.

Despite its increasing irrelevance to the global oil market, WTI remains the most widely quoted oil benchmark in the US media. Accordingly, many investors incorrectly assume that oil prices have weakened substantially, raising questions about why US gasoline prices haven’t moderated by a similar proportion. Here’s the crude reality: At the end of last week, a barrel of Brent crude oil went for $107, up 48.8 percent from year-ago levels. The price of WTI is up only 12 percent over the same period.

Two factors account for the unusual price spread between Brent and WTI. Local supply conditions at the physical delivery point in Cushing, Okla., have depressed WTI prices: Rising US imports of Canadian oil, higher domestic output from North Dakota’s Bakken Shale and an uptick in ethanol production have prompted pipeline operators to add new lines or reverse the flow of existing lines to carry crude south to Cushing and other refinery centers.

This shift has not only glutted storage facilities at Cushing, but reversed pipelines have also limited flows out of the hub. When an influx of crude oil overwhelms refining capacity, stockpiles build, and the price of WTI declines. This logistical logjam can only be resolved by the construction of new pipelines to move crude oil from Cushing to the Gulf Coast.

Light, sweet crude oils trade at Brent-like prices on the Texas Gulf Coast, but there isn’t enough pipeline capacity to bring oil from Cushing down to the coast to arbitrage away the difference.  

A few companies that have proposed projects to develop oil pipelines to connect Cushing to the Gulf Coast, including Proven Reserves Portfolio bellwether Enterprise Products Partners LP (NYSE: EPD). The master limited partnership (MLP) recently announced the termination of joint venture with Energy Transfer Partners LP (NYSE: ETP) to develop such a project. But management also indicated that it remains committed to the project and will continue to solicit commitments from shippers.

Even if one of these proposed pipelines gets the go-ahead and comes onstream, there won’t be enough new capacity to alleviate the glut at Cushing.

Demand conditions haven’t helped matters. As WTI prices tend to reflect the US supply-demand balance, traders have likely expressed their concerns about the domestic economy and the possibility of a second recession by selling oil futures linked to WTI.

Meanwhile, Brent crude oil’s strength reflects a much tighter supply and demand balance for crude oil outside the US. Although much of the scuttlebutt over the past couple of months has focused on the lackluster outlook for the US and developed European economies, the emerging markets continue to drive demand for crude oil, natural gas and coal.

You can’t analyze the global oil market by parsing weekly changes in US inventories; rising oil consumption in China, India and other emerging markets continue to tighten the supply-demand balance. Between 2000 and 2010, developed-world oil demand shrank by almost 1.7 million barrels per day. US oil demand alone was off by half a million barrels. In fact, since hitting an all-time annual high in 2005, US oil demand has declined by 1.65 million barrels per day.

Despite ongoing weakness in the US economy, domestic oil consumption has yet to collapse. According to the most recent report from the EIA, average oil and refined products demand over the past four weeks amounts to 19.4 million barrels per day, down a paltry 0.1 percent.

With the US economy likely to grow at a subpar rate even if it skirts a second recession, the nation no longer drives global energy consumption; in this regard, leadership has passed to the emerging markets.

Whereas developed-world oil demand declined from 2000 to 2010, oil consumption in countries outside the Organization for Economic Cooperation and Development (OECD) has soared by 12.5 million barrels per day. Chinese oil demand has roughly doubled in 10 years. In 2000 the country’s oil consumption represented roughly a quarter of US demand; today, China consumes about half of the US total and accounts for more than 10 percent of global oil demand. It’s only a matter of time before China’s more than 1 billion consumers unseat the US as the world’s biggest oil market.

Meanwhile, India–world’s fourth-largest oil consumer–uses more oil each day than Germany and the Netherlands combined. In another seven to 10 years, India will overtake Japan to become the world’s third-largest oil consumer.

These demand trends are reflected in the widening gap between WTI and Brent crude oil. Key emerging economies also show no signs of slowing.

While US policymakers and their counterparts across the pond look for ways to pep up their lackluster economies through unconventional monetary and fiscal policies, emerging markets such as China and India have faced a different problem: inflation. China, India and other emerging markets have been tightening monetary and fiscal policy in an effort to bring down inflationary pressures and prevent the formation of bubbles in the housing and stock markets. Policymakers in emerging markets tend to focus on broader measures of inflation instead of the “core” rate that excludes food and energy prices. Over the past 12 months, the surge in commodity prices has translated into rising inflation.

Economic growth in China and other emerging markets has slowed from a white-hot pace but remains robust. China’s Purchasing Managers Index (PMI) for manufacturing has declined steadily over the past year but remains above 50. The next release doesn’t come out until next week, but a few advance data points indicate that the Chinese economy is already reaccelerating.

For example, HSBC (LSE: HSBA, NYSE: HBC) publishes a “Flash PMI” number before the official release. This flash PMI number jumped from 48.9 to 49.8, a far larger increase than most economists had expected.

Meanwhile, the advance estimate of the MNI Business Sentiment Index indicated that new orders jumped 3.39 percent during the August reporting period, up from a 3.02 percent increase in July and a contraction of minus 3.89 percent in June. The advance report also showed improvement in index’s production component.

Bottom line: The Chinese economy continues to perform well and has picked up modestly after a policy-induced slowdown. Moreover, credit troubles and concerns about looming recession in developed countries should reduce pressure on emerging markets to tighten their monetary policies. A positive outlook for the Chinese economy has also supported Brent crude oil prices.

According to the International Energy Agency’s (IEA) latest Oil Market Report, global oil demand is expected to reach 89.5 million barrels per day in 2011, up 1.2 million barrels per day from 2010. The IEA forecasts that oil demand in 2012 will grow by 1.6 million barrels per day to 91.1 million barrels per day. To put this into perspective, global oil demand amounted to 70 million barrels per day in 1995.

The IEA report forecasts a decline in US and EU oil demand in 2011 and 2012, which prompted the agency to scale back its estimate of consumption growth. Nevertheless, Asia, Latin America and the Middle East will drive oil demand over the next two years.

At the same time, the IEA’s lower oil demand forecast pales in comparison to the downward revisions made to its oil production estimates. At the beginning of 2011, the agency projected non-OPEC oil production growth of 600,000 barrels per day in 201; the IEA’s latest report reduces this estimate to roughly 400,000 barrels per day.

Of course, the loss of Libya’s 1.5 million barrels per day of oil exports has shifted the focus to OPEC production. Saudi Arabia has stepped into the breach and tapped its spare productive capacity to offset this shortfall. As a result, OPEC’s spare capacity to produce crude oil has dropped from more than 5 million barrels per day to about 3.25 million barrels per day, or roughly 3.5 percent of global oil demand. This represents an extraordinarily tight buffer between supply and demand. With global oil demand rising faster than non-OPEC supply, OPEC’s spare capacity cushion should shrink even further in coming years.

Rebel forces in Libya appear to have made significant headway against Muammar Qaddafi, prompting most analysts to conclude that Africa’s longest serving dictator is no longer in power. With opposition forces rolling into Tripoli, journalists speculated that Libyan oil production could be restored quickly, easing the shortage of spare capacity that’s elevated the price of Brent crude oil in recent months.

But investors need to be skeptical of any claims that “This time it’s different.” All the talk of a quick restoration of Libyan oil production is eerily reminiscent of predictions that Iraqi oil production would quickly recover and swamp global oil markets with excess supply. Iraqi oil production continues to increase, but early predictions about the country’s output have proved hopelessly optimistic.

Questions remain about how close the rebels are to victory–early reports that Qadaffi’s two sons had been captured were later denied. Even when the civil war comes to an end, stability and security will remain a concern. Tribal divisions could make it difficult to consolidate political power, and Qaddafi loyalists will likely continue to disrupt the recovery effort. The damage sustained by the Libya’s energy infrastructure also forecloses a rapid restoration of the country’s oil exports. Although the rebels may bring some production–maybe up to 500,000 barrels per day–online in areas firmly under their control in the near term, the country’s oil output may never return to pre-conflict levels. OPEC will need to maintain production at current levels to offset lower output from Libya.

If the US economy skirts recession, WTI could narrow the price gap with Brent crude oil. If concerns about global economic growth intensify and spread to emerging markets, a barrel of Brent crude oil could recede into the $80s. Nevertheless, rising demand in emerging markets and limited supply growth mean that investors should prefer oil producers with exposure to Brent crude oil. WTI will also remain at levels that incentivize investments by US producers.

Finally, investors’ general failure to appreciate the durability of the Brent to WTI price gap has unduly punished shares of some of our favorite growth stocks. With Brent oil prices well above $100 per barrel and unlikely to fall below $95 per barrel, international oil and gas producers will continue to spend on new oil production projects. 

Solid second-quarter earnings and an uptick in international markets haven’t spared the group from the carnage in the broad market. Panicked investors have also overlooked the relative resilience of Brent crude oil prices in this fraught environment.

Some of this weakness is a function of investor conditioning. When the outlook for global growth dims, investors sell higher-beta names first. The Philadelphia Stock Exchange’s Oil Services Index has exhibited a beta of 1.40 over the past five years; the S&P 500 Energy Index, on the other hand, has a beta of 1.07 over the same period. A beta of 1.0 indicates that a particular sector tends to move at about the same speed and in the same direction as the S&P 500 as a whole. Betas of greater than 1.0 imply more volatility and less than 1.0 suggest less volatility.

If the S&P 500 breaches its technical support near 1,100 or 1,120, expect services names to give up more ground. But these stocks appear extraordinarily cheap. For example, shares of Wildcatters Portfolio holding Schlumberger (NYSE: SLB)–an industry leader with a flawless–currently trade at 3.23 times book value and less than 20 times forward earnings estimates. The stock traded at similar valuations from late 2008 to early 2009, a period when global spending on oil and gas production ground to a standstill and Brent crude went for $40 to $65 per barrel.  

Patient investors should continue to regard weakness in these growth-oriented names as a buying opportunity. Among the majors, Schlumberger rates a buy up to 100 and Weatherford International (NYSE: WFT) is a buy up to 28. Niche players Core Laboratories (NYSE: CLB) and Petroleum Geo-Services (OTC: PGSVY) rate a buy under 115 and 17.50, respectively. We discussed these companies’ growth prospects and second-quarter results at length in the Aug. 4, 2011, issue, Turning the Corner.

Buy High-Yield Safe Havens

Since the Aug. 4 issue of The Energy Strategist, we’ve issued three lengthy Flash Alerts, all of which highlighted the appeal of groups that offer above-average dividend yields and steady businesses.

Many of my favorite safe havens have little or no exposure to the economy or to commodity prices. That means that regardless to what happens to US gross domestic product or to oil prices, these names should continue to flourish and generate the steady cash flows needed to keep paying their quarterly dividends and distributions. MLPs are one of my favorite high-yield safe havens.

Whereas the S&P 500 has given up roughly 8.7 percent since the end of July–one of its worst one-month showings in the index’s history–the Alerian MLP Index is down less than 5 percent. We highlighted our favorite MLPs and outlined an effective buying strategy in the Aug. 8 Flash Alert, Don’t Panic: Opportunities Abound. In some cases, investors who followed this strategy were able to pick up MLPs at a more than 10 percent discount to their current trading prices.

A few subscribers have asked me how defensive the MLPs really are given the fact that the group was hit hard during the credit crisis of late 2008 and early 2009. Many investors mistakenly assume that collapsing commodity prices were the biggest challenge master limited partnerships (MLP) faced in fall 2008 and early 2009.

Some MLPs have exposure to the price of oil, natural gas and natural gas liquids (NGL) and a handful of smaller names had to cut their distributions when energy prices plunged.

But these firms represent the exceptions rather than the rule. Most MLPs have only modest exposure to economic conditions and commodity prices, thanks to a combination of hedges and long-term, fee-based contracts. Although the Great Recession and plummeting commodity prices were an undeniable hindrance, the vast majority of MLPs did not cut their payouts during the 2007-09 swoon.

In fact, frozen credit markets presented the biggest challenge to energy-focused MLPs at the height of the financial meltdown. New pipelines, processing plants and storage facilities require significant up-front investment to build. MLPs usually raise capital to fund these projects by issuing secondary units or tapping the credit markets; the credit crunch prevented MLPs from making these investments and growing their distributions.

To worsen matters, many MLPs relied on credit lines that needed to be rolled over frequently and were subject to periodic redeterminations. In some instances, the interest rates on these loans were indexed to the London Interbank Offered rate (LIBOR), which soared when the credit crunch hit.

Some MLPs relied on private investment in public equity (PIPE) deals in which the MLP would raise cash by selling shares of restricted stock to a hedge fund or other institutional investor. Desperate for liquidity at the height of the credit crunch, many of these investors dumped their MLP units to raise cash.

Although some MLPs still rely on credit lines, most have taken advantage of robust investor demand for additional units and ultra-low cost of capital available in the corporate bond market.

For example, Linn Energy LLC (NSDQ: LINE), which formerly relied on PIPE deals and credit lines to finance its growth projects, has replaced these funding sources with 10-year bonds. Unlike credit lines, these bonds don’t have to be rolled over frequently and carry fixed rates.

Now the company tends to use its $1.5 billion credit line to fund deals and then repays the balance by issuing new units or selling bonds., Linn Energy has also announced a “continuous equity offering,” under which it will sell $500 million in units over a period of time. This is another easy and relatively inexpensive way for Linn Energy to raise capital without exposing itself to short-term financing risks.

In other words, most MLPs have restructured their finances, reducing their vulnerability in the event of another global credit crunch.

Reading the sensationalist headlines in the mainstream media, you might think that the EU’s ongoing sovereign-debt crisis had already shut down credit markets. But the TED spread–the three-month LIBOR minus the yield on a three-month Treasury note–continues to hover at levels that are well below those that prevailed in summer 2010, when Greece’s fiscal crisis first sent investors scurrying for the exit. When the Ted spread spikes, confidence in the banking system has eroded.

The past few weeks have brought a modest bifurcation in the corporate bond market. Investors have piled into the safest investment-grade names, depressing yields. Meanwhile, high-yield fare has come under modest selling pressure. Consider that the yield on Linn Energy’s 10-year bonds–rated B by Standard & Poor’s–has ticked up to about 7.5 percent in recent weeks. Nevertheless, this is a fraction of the almost 12 percent it paid to borrow money in early 2009.

Meanwhile, investment-grade MLP Enterprise Products Partners, quite possibly the most conservative play in the model portfolios, just priced $1.25 billion in bonds on Aug. 10, right into the heart of the recent market turmoil and instability in EU credit markets. One tranche of Enterprise’s offering was $600 million in 5.7 percent bonds maturing in 2042; demand for that issue has been strong, and the current yield stands at almost 5.55 percent. Enterprise Products Partnerswould be crazy not to borrow money at 5.55 percent for 30 years. However, it’s tough to fathom why an investor would prefer such a paltry yield when the stock currently yields 6 percent and has considerable distribution growth potential.

The MLP also issued $650 million worth of bonds that will mature in 2022. Those bonds currently yield just 4.21 percent. The downgrade of US sovereign debt and ongoing issues in Italy and Spain have had absolutely no impact on Enterprise’s cost of apital.

With access to capital at relatively low costs, most of our favorite MLPs have no problem funding growth projects that will ultimately lead to higher distributions. The group is actually far more defensive and resistant to credit market conditions than was the case in 2008-09.

MLPs aren’t the only high-yield safe havens. Investors should also accumulate shares of contract driller Seadrill (NYSE: SDRL)l the company boasts the newest and most advanced fleet of deepwater drilling rigs in the industry and its entire fleet is booked out under long-term contracts offering fixed rates and guaranteed cash flows.

All of SeaDrill’s operating deepwater rigs are booked under long-term contracts with international oil companies such as Total (Paris: FP, NYSE: TOT), ExxonMobil Corp (NYSE: XOM) and Royal Dutch Shell (NYSE: RDS.A). The financial might of its customers, coupled with solid contract coverage that guarantees attractive day rates, ensures that the company’s ample dividend is supported by a reliable stream of cash flow.  In total, SeaDrill’s backlog of revenue for its deepwater rigs stands at $8.4 billion.

Moreover, the company’s 12 operating rigs and five units slated for delivery over the next few years are of recent vintage and include advanced features that command premium daily rates. In the first half of 2011, SeaDrill added $2.5 billion worth of contracts to its backlog and exercised an option to build another deepwater rig–a testament to the robust demand in this segment of the market.

The firm also owns shallow-water jack-up rigs and vessels that support offshore drilling operations. Both fleets are supported by solid backlogs of long-term contracts.

Seadrill recently boosted its quarterly dividend to $0.75, though the company’s payout ratio suggests that management could hike the disbursement to $0.80 by early 2012. Currently yielding near 10 percent, Seadrill rates a buy under 38.

Major integrated oil companies are another go-to defensive play during periods of weakness. Big international oil companies derive the majority of their revenue and earnings from producing oil and gas, with the remainder coming from refining and chemicals.

But these behemoths tend to work on major international oil and gas projects. Such deals often require large up-front capital commitments but benefit from low long-term operating costs that ensure profitability when commodity prices weaken. Moreover, our favorite names boast relatively clean balance sheets that support ample quarterly dividends.

Of the two Super Oils in the model Portfolios, Proven Reserves holding Chevron Corp (NYSE: CVX) is the safest play. The California-based energy giant boasts a market capitalization of roughly $200 billion and carries $11.52 billion in debt but has nearly $18 billion in cash and is rated AA by Standard & Poor’s.

Chevron currently pays a quarterly dividend of $0.78, equivalent to a yield of about 3.2 percent. Although this dividend yield pales in comparison to those offered by many of our favorite MLPs, it’s still superior to the S&P 500’s dividend yield of 2 percent. The energy giant also has a long history of increasing its dividends over time; the payout is up more than 9 percent annualized over the past five years.

Chevron has one of the most attractive long-term oil production growth profiles of any of the major oil companies. Generating meaningful production growth from such a high base is a major challenge.

Furthermore, crude oil accounts for roughly 70 percent of the company’s production mix. Chevron also generates almost 72 percent of its upstream (oil and gas production) earnings outside the US, a huge competitive advantage when oil and LNG command superior prices in international markets.

Chevron has an exciting slate of new projects in the hopper, though most won’t generate much output growth until after 2015. Management expects overall production to grow at an annualized rate of 1 percent from 2010-14 and 4 to 5 percent from 2014-17.

The list of growth projects includes the massive Gorgon LNG facility in Australia. In a conference call to discuss second-quarter earnings, management noted that this project is roughly one-quarter complete. Chevron is also a leader in West Africa, with 161,000 barrels of oil equivalent per day from Angola and 253,000 barrels of oil equivalent per day from Nigeria. Further expansion is planned, including the start-up of Agbami 2 in Nigeria this year and a massive $9 billion LNG project in Angola in 2012. Chevron is also a major player in Brazil, Asia and the deepwater Gulf of Mexico.

Shares of Chevron took a hit in early August, but the stock fared better than the market averages and most energy names. Less volatile than the S&P 500, Chevron Corp rates a buy up to 105. Buy the stock aggressively on dips under 90.

Shares of Proven Reserves Portfolio holding Eni (Milan: ENI, NYSE: E) have absorbed a much harder hit than many of its peers for one simple reason: It’s an Italian company at a time when concerns about Italy’s economy and sovereign-debt levels have investors in a panic.

Eni has more leverage than Chevron Corp but still earns an A+ rating from Standard & Poor’s. Although bond traders worry about the Italian government’s finances, they don’t appear to be too concerned about Eni. Among its many outstanding bond issues, Eni has an EUR50-million bond issued in 2004 that matures in 2024. With 13 years remaining until maturity, the bond currently yields 4.22 percent–about 80 basis points less than the Italian government pays to borrow money for 10 years. Eni isn’t guilty by association and doesn’t even have any major debt repayments due until 2013.

But fearful investors have jettisoned the stock in earnest; the company’s American depositary receipt currently sports a dividend yield of 7.5 percent–the largest of any Super Oil and well above the average of just over 5 percent for its EU peers.

Eni has several potential upside catalysts over the next few years. For example, the firm is pursuing a number major new upstream oil and gas projects, including the Zubair oilfield in Iraq, the Kashagan project in the Caspian Sea and several major deals across West Africa and North Africa.

Meanwhile, a potential end to the Libyan civil war and the establishment of a new government could yield better terms for Eni’s extensive operations in the country. Under the Qaddafi regime, draconian tax rates limited the profitability of its operations in Libya.

Of course, it’s not all roses at the company’s Rome headquarters. As part of the Italian government’s efforts to shore up its finances, energy companies will be subject to a 4 percent earnings tax. This announcement was unwelcome news, but this new tax won’t jeopardize the company’s current dividend.

Moreover, with the Italian government looking to privatize its stake in Eni and other enterprises, Eni is likely to divest its gas transport business and other assets. Not only would Eni realize cash from that sale, but such a deal would also transform the company into a purer play on its exploration and production business. Eni rates a buy under 52.

The latest pullback has also prompted the return of ExxonMobil Corp (NYSE: XOM) to the Proven Reserves Portfolio. With a market capitalization of $360 billion, ExxonMobil is the largest energy company in the world and one of the safest stocks you can own. The company is one of the few corporations or, for that matter, governments that has maintained a triple-A bond rating from Standard & Poor’s.

Because we prefer Chevron over the long haul, we tend to regard ExxonMobil as a shorter-term trade when valuations appear attractive. Most recently, we added the stock to the model Portfolio in July 2010 to take advantage of the selloff that followed the Macondo oil spill in the Gulf of Mexico. We sold this position in June of 2011, booking a gain of more than 40.

ExxonMobil benefits from a number of tailwinds. On the exploration & production front, the firm has more than 130 major oil and gas projects in development including, from endeavors in oil sands to deepwater drilling projects and shale oil and gas plays.

Eleven major projects have started up this year or are planned to get underway in 2012 or 2013, including the deepwater Pazflor and Kizomba developments in Angola, the Usan deepwater field in Nigeria, another Phase of the Kashagan mega-project in the Caspian and an oil sands development deal in Canada. All told, these endeavors will add 1.4 million barrels of oil equivalent per day to ExxonMobil’s production by 2016. Crude oil will account for about 80 percent of this new production. Of course, some of these gains will be offset by declining output from more mature fields, but it’s still a solid slate of deals that offer attractive economics even at far lower oil prices. 

When investors return to the energy sector, ExxonMobil will be among the first plays to get a boost. Buy ExxonMobil Corp up to 78.

Portfolio Updates

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 has 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.

Shipbroker Clarkson estimates the industry’s current order book at 155 new very large crude carriers (VLCC)–about 30 percent of the existing fleet of double-hulled vessels–39 of which are slated for delivery in the remainder of 2011. In the second quarter, 15 of the 18 newly built VLCCs slated for delivery actually joined the fleet. If all outstanding orders are delivered, the global fleet of VLCCs could swell to more than 700 vessels.

Recognizing their plight, tanker operators have sought to cancel or postpone these orders. Some tanker operators have also 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.

Scrapping older tankers and single-hulled models remains the best way for operators to address the industry’s overcapacity. Akron Trade & Transport of the United Arab Emirates recent sale of the Astakos single-hulled VLLC–the oldest vessel in the fleet–to an Indian scrapyard for more than $550 per deadweight ton should encourage more tanker owners to pursue demolition.

These mounting headwinds, coupled with concerns that a global economic slowdown will weigh on crude oil demand, have sent day rates in the spot market spiraling lower. The Baltic Dirty Tanker Index, which measures the cost of seaborne oil transportation based on 12 shipping routes, has declined by 45 percent from year-ago levels.

With new one-year time charters going for roughly $22,000 per day, companies welcoming newly built VLCCs to their fleets face major challenges: This day rate is at least $8,000 to $10,000 below the break-even rate on many of these vessels.

Given these difficulties, it’s little wonder that Frontline’s (Oslo: FRO, NYSE: FRO) 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.” Only 11 percent of the company’s vessels will be covered by time charters in 2012.

These headwinds prompted analysts to lower their earnings estimates for tanker operators. Meanwhile, the Bloomberg Tanker Index has plummeted by 32.2 percent over the past 12 months.

On the other hand, shares of Gushers Portfolio holding Knightsbridge Tankers (NSDQ: VLCCF) have pulled back by only 9.9 percent, buoyed by the company’s limited exposure to the vagaries of the spot market. The stock has returned 17.7 percent since we added it to the model Portfolio in the June 23, 2010, issue.

Knightsbridge Tankers owns four VLCC tankers. One ship operates on the spot market and is managed by a cooperative. The other three VLCCs are on time charters: The Hampstead’s deal expires in May 2012, the Camden’s contract terminates in July in August 2012, and the Mayfair’s charter ends in July 2015. The Kensington’s four-year time charter with fellow shipper Frontline expired, reducing the vessel’s time-charter equivalent revenue by roughly $1 million.

In addition to VLCCs, Knightsbridge Tankers also owns four smaller dry-bulk carriers, ships designed to transport dry commodities such as coal, grains and metals. These four ships, both built and put into service last year, aren’t due to come off their time charters until 2013-16.

Because Knightsbridge Tankers’ 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 ample dividend.

Although the company’s second-quarter cash flow from operations fell about $2.5 million short of its interest and dividend obligations, the firm simply dipped into the $55 million in cash on its balance sheet to make up the difference. Management also reaffirmed that the company will pay its usual quarterly dividend of $0.50 per share for the third quarter.

Knightsbridge Tankers’ relatively low break-even rates sets it apart from its struggling peers and puts the company in a strong position to weather a challenging operating environment.

For example, whereas Frontline’s VLCC fleet boasted an average daily break-even rate of USD29,700 per vessel in the first quarter–a losing proposition at prevailing prices. Knightsbridge’s VLCCs under standard time charters have a daily break-even rate of $16,200 per vessel, while its Cape-size dry-bulk carriers break even at day rates of $8,500. In the second quarter, the average day rate for its time-charted VLCCs came in at $29,000. Its dry-bulk vessels commanded an average day rate of $36, 600.

With a solid balance sheet and limited exposure to weak prices in the spot market, Knightsbridge Tankers continues to rate a buy up to 27.50. However, income-oriented investors should note that the stock is a much riskier play than the MLPs and integrated oil and gas name highlighted in the first half of this issue.

Whereas shares of Knightsbridge Tankers have proved relatively resilient, Wildcatters Portfolio holding Nordic American Tanker Shipping (NYSE: NAT) has given up 22.1 percent since June 30 and 34.9 percent since the stock joined the model Portfolio on June 24, 2010.

Nordic American owns a fleet of 17 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 two additional 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 17 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 second 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 doesn’t face as many headwinds as its peers.

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

International LNG

Unlike oil, natural gas continues to trade in regional markets, largely because of transportation constraints. For example, the insular US natural gas market consumes most of its domestic production.  But in recent years, US investors have grown increasingly aware of opportunities in international LNG markets.

With all the fervor surrounding the US shale gas revolution–it’s not every day that a country transitions so quickly from a growing importer of natural gas to one with an oversupply–it’s easy to overlook the international implications of this domestic supply glut, particularly on the global market for liquefied natural gas (LNG).

Disconcerted by the breakdown between domestic natural gas prices and drilling activity, North American commentators tend to regard international LNG markets as a potential outlet for production from the continent’s prolific shale gas fields.

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

This technology is far from a recent innovation; the energy industry has relied on this technology for over 50 years. In fact, 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. Despite the hype from Cheniere Energy Partners LP (AMEX: CQP), no LNG export facilities are likely to be built in the Lower 48 for at last another five years.

Interest in these projects underscores the gradual transition of natural gas from a regional fuel to a (somewhat) global commodity, though regional nuances persist.

In Germany and many other European countries, utilities sign long-term gas supply contracts with Gazprom (Russia: GAZP, OTC: OGZPY) for access to pipeline gas. These “take-or-pay” contracts feature prices indexed to crude oil prices. European utilities must accept delivery of a contracted volume of gas or pay a penalty; with European gas markets well supplied in recent years, these penalties have grown significantly.

Natural gas prices in many markets have been depressed relative to oil in recent years. But European countries burdened with oil-based, fixed-rate contracts with Russia have paid prices far above the prevailing rate on the spot market.

European utilities have lobbied Gazprom hard to amend the pricing structure. To date, the Russian giant has refused most of these requests, with support from the government. These long-term, oil-indexed deals aren’t the only option for European utilities. Germany and other EU countries can also buy gas from producers in the North Sea or import LNG via terminals around Europe.

With European nations eager to find alternatives to Russian gas and German demand likely to skyrocket as it phases out its nuclear reactors, European LNG prices should continue to ratchet up.

Even more impressive, rising demand for LNG in–where else–emerging markets has also helped to absorb excess supply and should continue to drive demand over the long term.

For example, the Chinese government’s long-term plans call for natural gas to account for 10 percent of the country’s energy mix, one-third of which will be imported via pipelines or LNG.

Natural gas has been growing in popularity in China, particularly in power-generation facilities located near major cities. Concerns about air quality mean that many of the high-rise residences constructed during China’s recent housing boom are equipped for piped gas. Further migration to urban areas will only increase demand.

LNG imports will be part of the solution. In December 2010 Chinese LNG imports topped 1,000 metric tons, five times their December 2008 level and a new all-time high.

China’s first re-gasification terminal opened in Guangdong province in 2006, and the country currently boasts three import facilities. But that capacity is slated to expand substantially over the next decade. Chinese energy companies also continue to invest in projects overseas that will ensure a steady supply of natural gas.

In July 2011, China imported 1.18 million metric tons of LNG–up 66 percent from a year ago–and natural gas consumption reached its highest level in five months. These imports cost USD8.30 per million British thermal units. That’s more than two times the current spot prices at the Henry Hub, the US benchmark and delivery point for futures traded on the New York Mercantile exchange.

Whereas much of China’s growing LNG imports will stem from long-term supply contracts, India, Japan and South Korea will continue to drive spot prices higher. In the near term, Japan has ramped up LNG imports to offset nuclear reactors damaged by the magnitude-9.0 earthquake that hit the Tohoku region. Japan’s LNG imports increased 14 percent in July.

Over the long term, India will be an important source of demand growth on the spot market. India’s lack of energy resources represents another opportunity for LNG producers, primarily in Australia and Qatar.

India’s Ministry of Petroleum and Natural Gas expects LNG imports to increase from 33 million cubic meters (mcm) per day to 162 mcm per day by fiscal year 2029-30. Over this period the government expects natural gas to grow to 20 percent of India’s energy mix from 9 percent. LNG imports could easily exceed estimates if expected pipeline imports don’t materialize–a distinct possibility–or domestic production falls short of expected production.

Two LNG terminals currently operate in India, Petronet LNG’s (Bombay: 532522) 10 mtpa facility at Dahej and Royal Dutch Shell’s (LSE: RDSA, NYSE: RDS.A) 3.6 mtpa installation at Hazira. Petronet LNG plans to add 2.5 mtpa of additional capacity. Ratnagiri Gas and Power’s 5 mtpa plant in Dabhol remains under construction, though 1mtpa of capacity could come online before the project is completed. Two additional LNG import terminals are in the early stages of planning.

In short, rising LNG demand in Asia and continental Europe should be a boon for Portfolio holdings BG Group (LSE: BG/, OTC: BRGYY) and Oil Search (ASX: OSH, OTC: OISHY). We discussed BG Group at length in the Aug. 3, 2011, issue.

Oil Search is Papua New Guinea’s largest oil and gas producer and operates all the country’s oil fields. In the second quarter, the company generated USD114 million in net profits–a year-over-year increase of 117 percent–as higher oil price realizations offset a slight decline in production.

Infill drilling in these older fields and new exploration efforts should enable the company to produce 6.2 to 6.7 million barrels of oil per year from 2011 to 2013.

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 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 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 a 16.8 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. 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. This drilling program will get underway in 2012.

The financing for the project is already in place, with debt funding about 70 percent of the project. Oil Search will owe another USD1.2 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. ExxonMobil has invaluable experience completing projects of this magnitude.

With a handful of drilling-related catalysts on the horizon in the fourth quarter of 2011 and throughout 2012, Oil Search’s local shares rate a buy under AUD8 for aggressive investors.

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 Fresh Money Buys that includes both stocks and some hedge recommendations designed to limit your risk amid market downturns.

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: The Energy Strategist

After the market’s latest swoon, shares of Suncor Energy (TSX: SU, NYSE: SU) offer an outstanding value for investors seeking long-term growth. Nevertheless, we are dropping the stock from the Fresh Money Buys.

Suncor operates crude oil production projects in Canada’s oil sands region. The oil sands remain one of the most important long-term source of oil production growth in the world; the region represents a tremendous asset for North America and Suncor’s operations are among the best-run in the business.

But, the Fresh Money Buys focuses on stocks with the best near-term upside potential. Suncor Energy suffers from one disadvantage: Its exposed to WTI oil prices rather than the more attractive Brent market. As I explained earlier in this issue, I see Brent continuing to trade at a significant premium to WTI for the foreseeable future. Moreover, if I am wrong about the US economy skirting recession I can see WTI prices dipping under $70 per barrel in the short-term. In that event, some of Suncor’s projects wouldn’t be particularly profitable. Note that Suncor Energy remains a buy under 48 in the Wildcatters Portfolio.

Intalian energy giant Eni joins the the Moderate Risk allocation. We’re also adding Chevron Corp and Linn Energy to the Low Risk category.