In August, the correlation between stocks in the S&P 500 approached a record high, as macro-level concerns overshadowed industry- or stock-specific developments. The first few trading sessions were particularly brutal for equity investors, as panic-stricken traders sold stocks en masse and allocated the proceeds to US Treasury bonds and other traditional safe havens.

The stock market has stabilized and traded sideways in recent weeks, but volatility remains a fact of life in these uncertain times. Although the ongoing sovereign-debt crisis in the EU and weakness in the US economy remain causes for concern, investors continue to treat the worst-case scenario as the most likely outcome.

Sensationalist reports from the press haven’t helped to calm jittery investors. The Bureau of Labor Statistics’ latest payrolls data sparked innumerable headlines about “zero jobs growth” in August. This shoddy reporting that overlooked the roughly 45,000 Verizon Communications (NYSE: VZ) on strike. Meanwhile, the private sector added 17,000 new jobs last month. Add in the striking Verizon workers and the US economy gained about 62,000 jobs in August–a result that’s consistent with lackluster economic growth.

More important, the Institute for Supply Management’s Purchasing Managers Indexes (PMI) indicated that economic activity expanded in both the manufacturing and non-manufacturing segments of the US economy. Both PMI readings bested analysts’ consensus estimates.

Although economic growth will remain sluggish, the odds of the US sliding into recession over the next six months are roughly 30 percent. Assuming the US economy dodges a contraction, the stock market should rally into year-end.

Meanwhile, Brent crude oil continues to hover near $115 per barrel, down roughly 10 percent from its 2011 high and up about 50 percent from 12 months ago. West Texas Intermediate (WTI) crude oil continues to lag its European counterpart but still trades at about $90 per barrel. With oil prices at these levels, producers should continue their robust drilling programs and post solid earnings growth.

However, the outlook for US natural gas prices is less sanguine, as the supply overhang should persist into 2012. Whereas the recent correction in the broader market provides an opportunity to pick up shares of US oil producers at favorable valuations, investors should steer clear of names levered to the domestic natural gas market.

In This Issue

The Stories

Our outlook for US natural gas prices for the back half of 2011 and early 2012 remains unchanged, though we expect market conditions to improve over the long term. See Too Much Gas.

The model Portfolios remain underweight US natural gas producers after we booked gains on Range Resources Corp (NYSE: RRC) and Petrohawk Energy earlier this year. See Light on Gas.

The oilier US-based E&P names in the model Portfolios have pulled back amid fears of a US recession and a slowdown in the global economy. At these levels, either WTI and Brent crude oil prices should be much lower, or these stocks should be trading at a much higher valuation. See Value in Oil-Focused E&Ps.

Gushers Portfolio holding SeaDrill (NYSE: SDRL) turned in a strong second-quarter. Here’s an update on our investment thesis. See Earning Its Keep.

Want to know which stocks to buy now? See Fresh Money Buys.

The Stocks

Cheniere Energy (AMEX: LNG)–SELL in Energy Watch List
Cheniere Energy Partners LP (NYSE: CQP)–SELL in Energy Watch List
Cabot Oil & Gas Corp (NYSE: COG)–Hold in Energy Watch List
Range Resources Corp (NYSE: RRC)–Hold in Energy Watch List
Chesapeake Energy Corp 4.5% Preferred D (NYSE: CHK D)–Buy < 105
EOG Resources (NYSE: EOG)–Buy < 125
Oasis Petroleum (NYSE: OAS)–Buy < 36
Occidental Petroleum Corp (NYSE: OXY)–Buy < 100
SeaDrill (NYSE: SDRL)–Buy < USD38

Too Much Gas

North American natural gas prices should remain at depressed levels throughout the fall and could decline even further as hurricane season draws to a close. The reason is simple: US natural gas output continues to outstrip demand.

In the Jan. 5, 2011, issue Road Map for 2011, I called for natural gas prices to remain range-bound in 2011; this forecast has panned out thus far. Check out this graph of the 12-month strip for natural gas prices at the Henry Hub. The average of the next 12 months of futures prices, the 12-month strip eliminates some of the inherent seasonality in gas prices and approximates the average price a gas producer with no hedges would receive for its full-year output.

Source: Bloomberg

Although the 12-month strip price for natural gas prices generally has hovered between $4 and $5 per million British thermal units (BTU), the long-term outlook for demand and pricing remains favorable.

The cleanest-burning fossil fuel, natural gas should continue to win market share from coal, a transition hastened by stricter restrictions on carbon dioxide (CO2) emissions. Given the opposition to the construction of new nuclear reactors, natural gas-fired plants remain the best option to boost baseload power while reducing the amount of CO2 released into the atmosphere.

Meanwhile, the relative abundance of natural gas in the US could eventually lead to increased fuel switching in the transportation sector. Natural gas-powered vehicles (NGV) have already made inroads into taxi and bus fleets and caught on in the waste-management industry.

But the game changer for US natural gas demand would be increased adoption of NGVs in the commercial trucking industry. Although this transition would reduce energy costs and CO2 emissions, the amount of infrastructure investment needed to support widespread adoption of NGVs in the US is a significant challenge that will take some time to overcome.

Over the past few years, politicians and industry leaders occasionally hype the prospect of legislation that would subsidize the use of natural gas as a transportation fuel. When that happens, NGV-related stocks enjoy a short-live bump. For example, Westport Innovations (TSX: WPT, NSDQ: WPRT), a firm that makes natural gas-powered engines, surged from $19 in late March to $28 per share in early April after President Obama delivered a speech that highlighted natural gas as a crucial component of the nation’s energy independence.

Don’t believe the hype. With a contentious election looming on the horizon and lawmakers focused on cutting spending, a transformational bill such as the New Alternative Transportation to Give Americans Solutions Act (NAT GAS Act) stands scant chance of passing.

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

On May 20, 2011, the US Dept of Energy granted Cheniere Energy (AMEX: LNG) permission to export as much as 2.2 billion cubic feet of LNG per year. LNG is a super-cooled form of natural gas that can be easily transported via specialized tankers to any country with import (regasification) terminals.

Although the Kenai LNG port in Alaska is the nation’s sole export terminal, the US is home to several import facilities. Built before the shale gas revolution transformed the US market, these liquefaction terminals operate at a fraction of their capacity because the country no longer needs to import LNG. Several of these operators have received approval to re-export LNG imported from other regions for temporary storage in the US, but these modest volumes don’t come close to making up for lost imports.

Cheniere Energy’s stock popped after the Dept of Energy approved the company’s export application, rallying almost 50 percent in only a few days. The company may have some of the regulatory approvals in hand–the Federal Energy Regulatory Commission has yet to approve the site plan officially–but adding liquefaction capacity to the company’s Sabine Pass import terminal will require substantial investments of time and capital.

The firm’s construction plan involves two phases, each of which will cost $3 billion to complete–a tall order for a company with a market capitalization of $500 million and almost $3 billion in existing debt. Even in the best circumstances, the first phase of the project wouldn’t be operational until 2015 or 2016. Meanwhile, potential LNG exports of 2.2 billion cubic feet per day will barely cause a ripple in a US natural gas market that amounts to roughly 60 billion cubic feet per day.

Not only are US LNG exports highly unlikely to provide a meaningful release valve for the nation’s current supply overhang, but investors should also steer clear of names whose growth prospects depend entirely on planned liquefaction terminals. Cheniere Energy and the master limited partnership Cheniere Energy Partners LP (NYSE: CQP) rate a sell in the Energy Watch List.

The supply side of the equation also lacks any meaningful catalysts for a durable recovery in natural gas prices.

Whereas an unhealthy preoccupation with US oil inventories belies rising demand in emerging markets (see Why US Gasoline Prices Remain Elevated), weekly US natural gas storage statistics still provide meaningful insight into the “closed” North American markets. Here’s a look at US working gas in storage relative to the five-year maximum, minimum and average storage levels.

Source: Energy Information Administration

The amount of natural gas in storage began 2011 near the five-year maximum–a symptom of a severe oversupply. During the winter months, storage levels decline to meet elevated demand for heating. By the end of this year’s winter withdrawal season, natural gas inventories were in line with the five-year average.

Meanwhile, storage volumes have increased at a slower-than-average pace this summer. Normally, one would expect below-average supply to support with stronger prices; however, investors must scrutinize the factors behind the decline in gas storage levels relative to seasonal norms. In this case, an unusually hot summer is the culprit. Check out this graph of US cooling degree days (CDD), or the difference between a day’s average temperature and 65 degrees Fahrenheit. For example, if the mean temperature on a given day is 90 degrees, that would equate to a CDD of 25.

Source: National Oceanic and Atmospheric Administration

As of the most recent week’s data, summer 2011 has been about 9.6 percent hotter than the five-year average. In fact, July was one of the hottest months on record in the US. Natural gas is used to produce electricity and run air conditioning systems; above-average summer temperatures are behind the uptick in gas demand.

Traditionally, US demand for natural gas declines rapidly from mid-September to mid-November in advance of the winter heating season. Meanwhile, the supply of natural gas remains robust.

Source: Energy Information Administration

The US Energy Information Administration (EIA) releases data on marketed US natural gas production with a three-month lag. As you can see, US gas output in May reached an all-time high of roughly 66 billion cubic feet per day and production held steady in June.

Producers continue to scale back their capital expenditures on gas drilling now that acreage in unconventional dry-gas fields such as the Haynesville Shale is held by production. Chesapeake Energy Corp (NYSE: CHK), for example, has allocated 75 percent of its 2012 budget to liquids production–a business that offers superior margins–and only 25 percent on natural gas. In 2011 the firm spent roughly equal amounts on liquids-rich and dry-gas plays. The decreased investment in natural gas drilling is also visible in the US natural gas-directed rig count.

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Source: Bloomberg

The number of rigs targeting natural gas dropped off sharply when commodity prices collapsed in late 2008-09. Despite depressed natural gas prices, the rig count stabilized and began to increase into mid-2010. This apparent disconnect between natural gas prices and drilling activity stemmed from contracts that required operators to sink a commercially productive well within a specified time frame to extend their leasehold. Producers also stepped up drilling in plays that contained high-value natural gas liquids (NGL) such as ethane, propane and butane.

Since mid-2010, the US gas-directed rig count has declined by about 10 percent. But this drop hasn’t restricted US natural gas output. In fact, US gas production has accelerated. As producers gain experience in the nation’s shale gas plays, the efficiency of their drilling operations has improved immensely. Today, operators sink wells at a much quicker pace and have optimized their drilling and hydraulic fracturing techniques to maximize output.

Producers have also shifted rigs from higher-cost fields to the most prolific plays. In the hottest unconventional plays, producers continue to benefit from the relatively high value of NGLs contained in raw natural gas streams. (See Why Some Natural Gas Is Worth $7.28?)

These trends appear to have lowered the equilibrium price for natural gas–the price at which producers are incentivized to ramp up drilling–to the neighborhood of $5 per million BTUs from as high as $7 per million BTUs. Some gas-producing fields are even profitable when gas goes for less than $4 per million BTU.

Adjustments on the supply and demand side eventually will return natural gas prices to between $5 and $6 per million British thermal units. Low prices and lower CO2 emissions will drive the shift to natural gas-fired plants, while industrial users will also increase their use of natural gas. Supply growth should also level out as producers allocate more money oil-rich plays.

But natural gas prices will remain constrained in the near term. Lately, the US gas-directed rig count has stabilized and ticked slightly higher. As demand for natural gas moderates in the fall shoulder season, expect the volume of natural gas in storage to exceed the five-year average.

The prospect of hurricane-related shut-ins has also buoyed natural gas prices in recent weeks. Tropical Storm Lee dumped a deluge of rain across the Gulf Coast, forcing operators to temporarily evacuate some rigs and interrupting gas processing operations in the region. This disruption could cause a temporary dip in US natural gas and oil inventories. With another storm brewing in the Mid-Atlantic, oil- and gas-related operations on the Gulf Coast aren’t in the clear yet. Depending on the trajectory of this developing storm, natural gas prices could rally a bit further. But these gains will evaporate once hurricane season winds down.

My current forecast calls for the 12-month strip for Henry Hub prices to hover around $4 to $5 per million BTU, though prices could pull back dramatically when gas storage volumes rise to above-average levels.

If natural gas output moderates in 2012, we will consider adding some exposure to North American producers. At this point, there’s no sign that supply overhang will subside.

Note that we remain bullish on international markets for natural gas. Not only does LNG demand continue to increase in emerging markets, but Germany’s decision to phase out its fleet of nuclear reactors will also force the country to increase its reliance on natural gas. A tightening supply-demand balance has pushed natural gas prices in the UK to roughly $11 per million BTUs, while supply contracts in Asia are often indexed to the price of Brent crude oil. For an in-depth discussion of these trends and our top LNG plays, consult the April 21, 2011, issue International Opportunities in Coal and Natural Gas.

Light Gas

At the beginning of 2011, the model Portfolios included four names with exposure to North American shale gas production. In subsequent months, we pared this number to two stocks, Wildcatters Portfolio holdings Chesapeake Energy Corp 4.5% Preferred D (NYSE: CHK D) and EOG Resources (NYSE: EOG).

We booked a 28 percent gain on Range Resources Corp (NYSE: RRC) in the April 21, 2011, issue, taking advantage after value-oriented investors bid up the stock in the early part of the year. In a Flash Alert issued on July 15, 2011, we sold our stake in Petrohawk Energy for a 92 percent profit after international mining giant BHP Billiton (ASX: BHP, NYSE: BHP) acquired the company in an all-cash deal worth $12.1 billion.  

Shares of Range Resources have generally trended higher since we cashed out our position, bucking the weak market and depressed natural gas prices. From a tactical perspective, our decision to sell the stock was a mistake. However, despite the stock’s strong relative strength, now isn’t the time to buy Range Resources or other US gas-focused producers.

Check out this table tracking the year-to-date performance of a number of stocks issued by US-based oil and gas producers.

Source: Bloomberg

Shares of EXCO Resources (NYSE: XCO), Quicksilver Resources (NYSE: KWK) and Ultra Petroleum Corp (NYSE: UPL) have pulled back by at least 32 percent in 2011, reflecting the challenges facing natural gas-focused producers.

Price to cash flow is one of the most widely watched metrics for exploration and production (E&P) stocks; investors prefer names that can finance their intended drilling budgets with cash flow rather than taking on debt or issuing new shares. Both EXCO Resources and Ultra Petroleum look cheap on this basis, a sign that investors are skeptical of these firms’ growth prospects.

Shares of oil-focused producers Brigham Exploration (NSDQ: BEXP) and Oasis Petroleum (NYSE: OAS) have also performed reasonably well, though they’ve declined in recent weeks amid weakness in the broader market.

Two anomalies stand out in this table. Natural gas-focused names Chesapeake Energy Corp, Range Resources, EQT Corp (NYSE: EQT) and Cabot Oil & Gas Corp (NYSE: COG) have outperformed in 2011, while shares of Apache Corp (NYSE: APA) and Wildcatters Portfolio holding Occidental Petroleum Corp (NYSE: OXY) have lagged somewhat. This underperformance belies the 23 percent increase in the price of Brent crude oil since the beginning of the year and stagnant North American natural gas prices. The valuations on oil-centric names also appear attractive relative to most gas-heavy names.

Most of the top-performing producers in this table share one commonality: Significant exposure to the Marcellus Shale, a prolific play whose core has emerged as one of the nation’s lowest-cost gas-producing regions. Wells in certain parts of this formation remain profitable when gas prices hover around $3 per million British thermal units. Producers that hold the best acreage have consistently surprised investors by posting better-than-expected revenue and output growth in 2011.

For example, EQT’s Marcellus leasehold comprises 520,000 acres. That amounts to about 3.5 acres per every 1,000 shares; of the E&P names listed in this table, EQT offers the most exposure to the Marcellus.

The firm will drill about 100 wells in the play in 2011–10 wells northern Pennsylvania, 57 in western PA and 33 wells in West Virginia. Each well costs about $6 million and allows EQT to book reserves of 7.3 billion cubic feet of gas. With natural gas prices at $5 per million BTUs, EQT delivers returns of 72 percent after taxes, gathering, transmission and drilling costs are subtracted. When natural gas dips below $4 per million BTUs, EQT still earns a positive return.

Cabot Oil & Gas–one of the top-performing E&P stocks in 2011–also generates a significant amount of its revenue from the Marcellus Shale. The firm’s acreage in northeastern Pennsylvania produces primarily contains dry natural gas with little to no NGL content to boost wellhead economics.

But Cabot Oil & Gas’ production costs are so low that management estimates it earns about a 60 percent return on wells when natural gas trades at $3 per million BTUs. The company’s average well yields an initial production rate of 16.9 million cubic feet per day and an average 30-day production rate of 13.6 million cubic feet per day.

With a number of new pipelines slated for completion by the end of 2012, the Marcellus operator will be able to ramp up its production and drilling activity significantly.

To identify the best E&P stocks, The Energy Strategist focuses on the quality of a company’s reserves. Range Resources’ fast-growing reserve base in the Marcellus Shale earned it a spot in the Gushers Portfolio in late 2009.

Shares of EQT, Range Resources and Cabot Oil & Gas have outperformed because analysts focused on the bearish outlook for natural gas prices and overlooked the low-cost nature of these firms’ reserves. At the same time, the premium valuations that these stocks command make them vulnerable to any disappointment, from lower-than-expected production growth and unexpected cost increases to delays in the construction of pipeline and processing infrastructure needed to accommodate their output.

Some analysts have also argued that natural gas prices at less risk of a decline than oil prices, which have more than tripled from their 2009 low. This investment thesis has two weaknesses. Only a US recession in the second half of 2011 or early 2012 would send WTI to less than $70 per barrel or Brent crude oil toward $80 per barrel. At this point, we expect the US economy to avert another pull back.

In the event of a recession, US natural gas prices wouldn’t be immune to the carnage, as the industrial sector accounts for about one-third of US gas demand. For example, the group’s natural gas consumption declined by roughly 12 percent from year-ago levels in the first half of 2009. Industrial demand also fell 9 percent in the first half of 2001. Producers would likely rein in drilling to reflect reduced demand, but these efforts wouldn’t affect natural gas prices right away.

With gas-focused E&Ps such as Range Resources and Cabot Oil & Gas trading at premium valuations, these names are unlikely to outperform oilier names if demand deteriorates.

A flurry of acquisitions in recent quarters has also heightened expectations that further consolidation in the shale gas space could drive stock prices higher. To avoid being blindsided by a major deal, we will forego shorting the major independent US gas producers. Range Resources Corp and Cabot Oil & Gas Corp rate a hold in the Energy Watch List.

Investors seeking a safer play on natural gas should consider Wildcatters Portfolio holding Chesapeake Energy 4.5% Preferred D, which has returned almost 19 percent year to date through a combination of price appreciation and a quarterly dividend of $1.125 per share.

At the current price, Chesapeake Energy 4.5% Preferred D yields 4.6 percent, compared to a yield of less than 1 percent on the common stock. In addition, each preferred share is convertible into 2.2727 shares of the common stock. Although it wouldn’t be the best move to convert the stock today, this option is good through 2049 and means that the preferreds tend to follow the common stock higher over time.

Value in Oil-Focused E&Ps

The current market offers investors an opportunity to pick up shares of oil-focused producers that hold high-quality reserves and continue to grow their output. The previous issue of The Energy Strategist focused on the local logistical issues weighing on the price of WTI relative to Brent crude oil, which serves as a better proxy for global supply-demand conditions.

To reiterate, I remain bullish on oil prices in general and prefer stocks with exposure to the price of Brent crude oil. The oilier US-based E&P names in the model Portfolios have pulled back amid fears of a US recession and a slowdown in the global economy. At these levels, either WTI and Brent crude oil prices should be much lower, or these stocks should be trading at a much higher valuation.

Shares of EOG Resources, Occidental Petroleum and Oasis Petroleum (NYSE: OAS) all represent solid bargains at their current price.

Although more than 70 percent of EOG Resources’ output came from natural gas in 2010, the E&P was one of the first major independent producers to shift its capital spending away from natural gas shale fields in favor of crude oil and NGLs.

The share of liquids in EOG Resources’ total output has steadily increased in recent quarters, and that trend is set to continue; 80 percent of the firm’s 2011 capital spending plans target oil and liquids. Management projects that the company’s natural gas output will remain flat in 2011, while its liquids production is expected to surge 47 percent year over year. By 2012, management estimates that nearly three-quarters of the firm’s North American revenue will come from oil.

EOG Resources is already the largest oil producer in North Dakota, thanks to its 600,000 acres in the Bakken Shale and Three Forks formations–one of the hottest oil-levered plays in the US. The firm is also the largest oil producer in the Eagle Ford Shale, where it has 535,000 net acres in the play’s oilier portions. EOG Resources also boasts acreage in the Barnett oil play in the northern reaches of the Barnett Shale and the Bone Springs horizontal oil play in the Permian Basin.

Over the long term, the company has opportunities to benefit from both North American and international gas markets. EOG plans to export gas extracted from the massive Horn River play in British Columbia via the Kitimat LNG terminal in which it owns a 30 percent stake.

Apache Corp and EnCana Corpo (TSX: ECA, NYSE: ECA) also have an interest in this project and expect the terminal to come onstream as early as 2015. Given the financial strength of the companies involved, the odds of this liquefaction facility coming to fruition are much greater than Cheniere Energy’s proposed terminal on the Gulf Coast. Once completed,  EOG will be able to export Horn Rover gas to Asia at prices indexed to Brent crude oil. 

In the US, EOG has significant acreage positions in the core regions of the Marcellus, Barnett and Haynesvulle Shale. Although we prefer EOG for its emphasis on oil- and liquids-rich plays, most of its dry-gas leasehold is held by production. .

Investors unfamiliar with any of these plays should check out my primer on unconventional oil, the Oct. 20, 2010 issue Rough Guide to Shale Oil. With WTI prices near $90 per barrel and Brent crude oil trading at about $115 per barrel, EOG earns extremely high rates of return on its investments in these oilier plays. Take advantage of the recent dip in EOG Resources and buy the stock under 125.

Oasis Petroleum is a pure play on the Bakken Shale of North Dakota and Montana, where the company holds over 300,000 net acres. Although this small company should be considered a more aggressive pick that EOG Resources, rapid production growth and strong well results should act as a catalyst for shares.

Oasis is ramping up its drilling activity and had a total of seven rigs working at the end of the second quarter. Management plans to introduce two additional rigs by year-end. In addition, Oasis has secured a total of three dedicated fracturing crews to complete the wells it drills. A shortage of fracturing capacity has plagued many US-based oil and gas producers this year; there simply aren’t enough crews available to handle all the wells being drilled.

Like all Bakken producers, Oasis’ production suffered because of torrential rains and flooding the first half of 2011. In the second quarter, the company’s output missed production forecasts, disappointing investors and putting a lid on the stock. But this shortfall stemmed entirely exogenous factors that have been cited by all producers in the region; the quality of the company’s acreage isn’t in dispute. With weather conditions normalizing, Oasis’ results should improve dramatically.

Meanwhile, management still expects production to surge to at least 11,000 barrels of oil equivalent per day by the end of 2011–up from about 8,100 barrels of oil equivalent per day at the end of the first quarter.

Given this strong oil output growth, Oasis’ forward price-to-cash-flow ratio of 7.0 looks reasonable compared to Bakken-focused peers such as Brigham Exploration. Buy Oasis Petroleum under 36.

Occidental Petroleum reported Second-quarter output growth that fell slightly short of management’s estimate–largely because of the way its production-sharing contracts in the Middle East are structured. Under these agreements, the company’s share of the output decreases when oil prices rise and increases when oil prices decline, enabling the company to earn a relatively stable rate of return..

One of Occidental’s most promising domestic projects is the Kern River field in California, where the company is the largest acreage holder. The use of horizontal drilling and fracturing techniques promises to unlock significant additional production from this play, and Occidental has ramped up its rig count over the past six months to 29 units from 20 units .

Elsewhere in the US, Occidental holds significant acreage in the Permian Basin of west Texas, The Williston Basin in North Dakota. In the Permian, Occidental will almost double its rig count to 25 by the end of the year.

Management expects the firm to grow its monthly domestic production by 3,000 to 4,000 barrels through the end of 2011. The company’s Middle Eastern volumes depend on oil prices, but any decrease in volumes would be offset by higher prices. In addition, Occidental has significant operations in Libya and may benefit from some return of volumes there over the next few quarters. Buy Occidental Petroleum Corp under 100.

Earning Its Keep

Gushers Portfolio holding SeaDrill (NYSE: SDRL) has come a long way since 2005, when its fleet consisted of 11 drilling rigs. Today, the outfit is the second-largest contract driller by enterprise value and boasts a growing portfolio of roughly 60 rigs. SeaDrill posted second-quarter revenue of USD995 million–down slightly from the prior quarter–while operating profit held steady at $430 million, buoyed by an uptick in the contribution from its deepwater rigs.

SeaDrill remains our favorite contract driller for several reasons.

For one, the stock tends to trade at a premium to its peer group because of the company’s ample quarterly dividend, which equates to a 9.5 percent yield at the current share price. This sky-high yield has captured the fancy of income-hungry investors, particularly in an environment where corporate bonds and many dividend-paying equities offer scant yields and little upside potential.

The stock’s stratospheric dividend yield has enabled the company to grow its market capitalization substantially since its primary listing shifted from Oslo to the New York Stock Exchange.

 But investors who bet on high-yielding fare must closely scrutinize the sustainability of the firm’s underlying business rather than assuming that it will pay the same dividend (or higher) in perpetuity. When the operating environment deteriorates to the point that the company must slash its dividend, investors suffer a double whammy: Not only is their income stream reduced, but the stock also pulls back significantly in the wake of such an announcement.

Consider the case of tanker operator Frontline (NYSE: FRO), another company partially owned by SeaDrill’s Chairman John Fredriksen. The firm announced a second-quarter dividend of $3.00 per share in August 2008, the height of the commodities bubble. Today, the embattled company pays a quarterly dividend of $0.02 per share. Meanwhile, the stock price has plummeted by 88 percent since Aug. 27, 2008, undone by high break-even costs on the company’s tanker fleet and a glut of excess capacity that threatens to depress day rates until at least 2010.

Fortunately, the outlook for SeaDrill is much sunnier. With roughly $8 billion in debt, the company has taken on significant leverage in an effort to grow its fleet rapidly. But management has invested the proceeds wisely, assembling the industry’s second-largest fleet of deepwater drilling rigs–a business line that boasts strong fundamentals.

Faced with maturing fields and sluggish reserve-replacement rates, the world’s major exploration and production companies will continue to invest heavily in deepwater developments over the long term. On the other side of the equation, rising global demand for oil and natural gas should incentivize long-term investment in deepwater fields.

SeaDrill’s near-term outlook is also bullish. During a conference call to discuss second-quarter earnings, CEO Alf Thorkildsen noted that the number of ultra-deepwater rigs has declined significantly over the past six months and that customers continue to book newly built rigs before the vessels even leave the shipyard. Management also noted an increase in customer inquiries regarding vessels whose contracts roll off in coming quarters.

With management expecting day rates on ultra-deepwater rigs to tick up to around $500,000 per day in the back half of the year, the company actually plans to hold back some of its units to take advantage of an expected in pricing. Much of the increased demand for ultra-deepwater rigs will come from Brazil and West Africa, though Thorkildsen also noted that he expects activity in the Gulf of Mexico to pick up significantly in coming years:

What I see is that the demand side in 2011 is very strong. That will have a spillover effect into 2012. We see extension of contracts, we see new contracts and most importantly is that there are significant discovery both in Africa and in Brazil particularly which is of interest. We have not seen the effect yet on Gulf of Mexico, but I am also very optimistic going forward into that market. The permits are still not up to the same level as before Macondo, but we see that there is an increase in permits and we know that it is a very prospective deepwater area and I am therefore somewhat more optimistic that we will have a better balance between supply and demand for all the newbuilds in 2013.

In addition to SeaDrill’s outsized exposure to deepwater drilling–dynamically positioned floating rigs generated 66 percent of the firm’s second-quarter revenue–we also like the company’s commitment to assembling a modern fleet. In fact, 51 of the company’s 60 drilling rigs were built after 2000.

At the end of the second quarter, its fleet of deepwater drilling rigs sported an average age of two years. These high-specification rigs are in high demand among oil and natural gas producers, particularly in a post-Macondo world. The firm also boasts the largest and most modern fleet of jack-up and tender rigs in the industry, providing the firm with a distinct advantage over firms with older fleets.

Thorkildsen highlighted the increasing bifurcation of the jack-up market during a recent presentation at Barclays Capital’s CEO Energy-Power Conference:

We see in that [the jack-up] market a fantastic and a dramatic bifurcation of this business. The old jack-ups, there are 100 of them at the moment which are either cold stacked or warm stacked. At the same time, we see that our modern jack-ups get us and provide us a very decent return. I have never seen a market like that before where at one time we have laid up jack-ups and at the same time we have very decent return. That bifurcation is not only coming into the jack-up market. I also believe it is coming into the floater as well as the tender rig business. For SeaDrill, that has been one of the strategies of, therefore, only have very modern equipment and I think we will benefit from that going forward.

In the second quarter, management noted rising demand for jack-up rigs in the Asia-Pacific region (an area in which the firm has a strong foothold) and the Arabian Gulf, a market it entered with its acquisition of Scorpion Offshore in 2010.

SeaDrill has invested judiciously in its growth, weighing the costs of newly built vessels versus acquisitions. For example, the company recently paid $54 million for a one-third stake in Asia Offshore Drilling, a company with three $185 million premium jack-ups under construction. Under the terms of the deal, SeaDrill will oversee the marketing and operation of these units upon delivery.

After ordering new rigs before many of its competitors, the firm also has the option to purchase nine additional newly-built rigs at locked-in, a distinct advantage as the cost of new rigs increases and near-term delivery slots fill up.

Thorkildsen summed up the best reason to invest in SeaDrill during a Sept. 6 presentation to analysts: “While other major drillers are spending cash and…replacing their aging fleet, SeaDrill [is] identifying and selectively growing its already modern fleet at attractive rig prices. That is how we think we want to create value for our shareholder. That’s the story.”

With a growing fleet of high-specification rigs, SeaDrill should continue to increase its earnings and dividend. Meanwhile, the company’s outstanding contracts increased to $12.2 billion in the second quarter, which, combined with a profit margin of roughly 60 percent, should provide ample support for the firm’s dividend. Buy SeaDrill up to USD38.

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