The Yield Isssue

Although the risk of the US slipping into recession remains elevated, our proprietary Recession Radar indicates that a prolonged period of relatively slow growth remains the most likely outcome at this point.

In fact, recent data suggest the US economy has stabilized. Earlier this week, the Manufacturing Purchasing Managers Index (PMI) ticked up to 51.6 in September–an increase of 1 percentage point from the August reading. Monthly PMI numbers greater than 50 indicate that economic activity picked up in the manufacturing sector.

Automobile sales also surged to more than 13 million annualized units in September, while data from ADP Employer Services indicate that the US created 91,000 jobs last month–almost 20,000 more payroll additions than the consensus estimate.

In April and May, the stock market began to swoon when US economic data consistently fell short of expectations. A slew of better-than-expected economic data could support a year-end rally in US equities.

The EU’s ongoing sovereign-debt crisis remains a wildcard. Policymakers have moved slowly to address the problems in Greece, Italy and Spain, reminding voters of the downside of fiscal integration. Despite the popular outcry against bailouts, policymakers understand that an Italian or Spanish government default would devastate the global economy, strain the EU financial system and potentially touch off a global credit crunch.

Recent news flow suggests that the EU may announce a coordinated plan to recapitalize the region’s embattled banks and support fiscally weak national governments before the G-20 meets in early April.

In the near term, expect the uncertainty to roil equity markets and cap any upside. We continue to recommend a three-pronged investment strategy:

  • Buy high-yield safe havens. Our top picks include master limited partnerships (MLP) and dividend-paying stocks such as SeaDrill (NYSE: SDRL). In this issue, I also examine US royalty trusts, as well as some high-yield bonds and preferred shares issued by US independents.
  • Buy cheap growth. The recent selloff of cyclical energy names reflects the growth scare that began earlier this summer and intensified amid signs of an economic slowdown in the developed world and fear that the EU sovereign-debt crisis would yield a global credit crunch. In many instances, this downdraft doesn’t reflect industry fundamental. The previous issue of The Energy Strategist highlighted the discrepancy between the Peabody Energy Corp’s (NYSE: BTU) stock price and the tight supply-demand balance for seaborne metallurgical coal. Meanwhile, the dramatic pullback in shares of Weatherford International (NYSE: WFT) and Schlumberger (NYSE: SLB) belies the fact that Brent crude oil remains above $100 per barrel and is up 25 to 30 percent year over year. (See Outlook for Oil Services Stocks.)
  • Consider some shorts and hedges. We recently booked a sizable profit on half our short position in First Solar (NSDQ: FSLR). Investors seeking to go short should consider Diamond Offshore (NYSE: DO) and First Trust ISE Revere Natural Gas (NYSE: FCG).
With macro-level fears ruling the ticker, investors can easily lose sight of stock- and industry-specific fundamentals. Join me on Oct. 11 at 2:00 p.m. EST for my next Live Chat session. This is your opportunity to ask me any questions you might have about specific Portfolio holdings, developments in the energy patch or macroeconomic concerns. Click here for more details and to set up an email reminder about the Live Chat.

In This Issue

The Stories


1. The recent volatility in US equities markets offers opportunities to pick up units our favorite MLPs at bargain prices. See Buying Yield: Master Limited Partnerships.

2. We share our top pick from the roughly 15 US-listed energy trusts. Our favorite boasts a 12 percent yield and plenty of potential upside. See Buying Yield: US Royalty Trusts.

3. Concerns that the EU sovereign-debt crisis could erupt into a full-blown credit crunch give investors an opportunity to pick up high-yield fare at favorable prices. See Buying Yield: Bonds and Preferred Shares.

4. The conference calls hosted by the major oil services firms provide a treasure trove of information and have implications for a number of other energy-related sub-industries. Here’s a preview of some key trends to monitor. See Earnings Watch.

5. Although the recent volatility in the broader market offers value investors plenty of opportunities, the correction also stopped us out of three Gushers Portfolio holdings. See Stopped Out.

6. Want to know which Portfolio holdings to buy now? See Fresh Money Buys.

The Stocks

SandRidge Mississippian Trust I–Buy < 24
Oasis Petroleum’s 7.25% Bonds Maturing in 2019 (CUSIP: 674215AA6)–Buy < 100
Chesapeake Energy Corp 4.5% Preferred D (NYSE: CHK D)–Buy < 105
Valero Energy Corp
(NYSE: VLO)–Stopped Out for 31% Gain; Hold in Energy Watch List
Spirit AeroSystems (NYSE: SPR)–Stopped out for 33% Loss
Tenaris (NYSE: TS)–Stopped out for 21.9% Loss; Buy up to 37

1. Buying Yield: Master Limited Partnerships

Our Portfolios currently include 11 MLPs, while the Fresh Money Buys at the end of this issue features three of our favorite MLPs for new money. The table below lists all of our MLP holdings, their current yields, distribution growth over the past year and my buy advice on each.


Source: The Energy Strategist, Bloomberg

Many of these MLPs are among steadiest and least commodity-sensitive stocks in the model Porctfolios. The vast majority of MLPs are involved in the transportation, storage or processing of oil and natural gas–not the production of these energy commodities.

Most MLPs sign capacity reservation deals with major oil or natural-gas producers before breaking ground on a new pipeline. Under such an agreement, the producer pays an MLP for guaranteed access to pipeline capacity–regardless of whether the customer uses the facility. These multiyear deals guarantee the MLP a return on its investment.

Pipeline operators also usually charge an additional volume-based fee. Some of these contracts include automatic escalation clauses that adjust the annual tariff based on a major index of inflation such as the consumer price index. When soaring energy prices inflate consumer prices, this structure can produce a substantial uptick in tariffs.

That being said, few MLPs are fully insulated from commodity prices and economic conditions. For example, if an MLP owns a network of gathering pipelines–small-diameter pipelines that connect individual wells–and drilling activity in that area declines, there will be fewer wells to hook up to the gathering system. This translates into lower throughput and a decline in volume-based fees.

The gas processing industry, which separates natural gas liquids (NGL) such as propane from raw natural gas, has varying exposure to commodity prices. Under fee-based processing arrangements, the processor receives a tariff that reflects the volume of gas passing through its facilities. This structure limits the processors’ direct exposure to commodity prices. Fixed-margin processing deals lock in the MLP’s margins at a fixed and predetermined level.

Percent-of-proceeds (POP) arrangements are a different story. Under these contracts, the MLP receives a designated percentage of the natural gas and NGLs it processes as compensation for its services. In other words, the amount of money the MLP receives depends on the value of the natural gas and NGLs.

However, most MLPs involved in processing book a range of different contracts to reduce risk. Others make significant use of oil and gas hedges to ensure that volatility in commodity prices doesn’t impair their ability to pay distributions to unitholders. In recent years, fee-based deals have increased in popularity–in part because strong processing economics mean that producers want to keep those profits for themselves. This shift isn’t necessarily a negative for MLPs because it adds visibility to their cash flow and distributions.

Wildcatters Portfolio holding Linn Energy LLC (NSDQ: LINE) technically isn’t an MLP, but limited liability companies are taxed in the same manner. A producer of oil and natural gas, Linn Energy hedges much of its output to lock in prices and guarantee cash flow. The firm has hedged 100 percent of its natural gas production through 2015 and 100 percent of its oil production through 2013. Moreover, Linn Energy has hedged about 80 percent of its oil output in 2014 and 2015.

Portfolio holdings Penn Virginia Resource Partners LP (NYSE: PVR), Natural Resource Partners LP (NYSE: NRP) and Alliance GP Holdings LP (NSDQ: AHGP) have varying degrees of exposure to coal prices. We discussed the MLPs at length in the previous issue of The Energy Strategist, Raked over the Coals.

Investors should also ignore earnings per share when analyzing an MLP’s quarterly performance. This popular metric includes a number of noncash charges such as depreciation–an accounting construct rather than an actual expense. MLP unitholders usually benefit from depreciation because these accounting charges reduce their tax liability.

Hedging causes another set of accounting discrepancies. Under generally accepted accounting principles (GAAP), Linn Energy must assess the value of its oil and gas hedges at the end of each quarter and book a charge or a gain based on their performance. All hedges must be marked to market–not just those hedges that apply to a particular quarter’s production.

For example, Linn Energy must factor in changes to the value of its 2015 hedges to its third-quarter earnings, even though the firm doesn’t have to pay any cash or post any margin on these hedges. In other words, if oil prices sank to $80 per barrel and Linn Energy had hedges in place at $100 per barrel, the gains from these hedges would artificially boost cash flow in that particular quarter.

Investors should tune out any articles about MLPs missing earnings estimates and focus on distributable cash flow (DCF), a measure that strips out these non-cash charges and more accurately reflects the cash a partnership has available to funds its distribution. Linn Energy’s DCF only factors in hedging contracts for that quarter.

Although MLPs as a group have comparatively little sensitivity to commodity prices or macroeconomic environment, units of publicly traded partnerships aren’t immune to weakness in the broader stock market. When fear rules the ticker, equities of all stripes trend lower. On certain trading days in September, the correlation among the top 50 stocks in the S&P 500 approached 95 percent. To put this number in context, a reading of 100 percent would indicate that stocks moved in lockstep.

In addition, regulations restrict institutions’ MLP holdings to a percentage of their investable assets; most MLPs have an ownership base that skews toward individual investors. Units of smaller MLPs also trade in relatively light volumes, exacerbates the upswings and downswings in bull and bear markets.

Investors who set stop-loss and trailing stop orders with their brokers can inadvertently lock in sizable losses. Check out this price graph of Linn Energy’s units.


Source: Stockcharts.com

The low price circled on this graph occurred on May 6, 2010, a day when the Dow Jones Industrial Average briefly plummeted by 9.2 percent before quickly recovering. During this flash crash, Linn Energy tumbled to a low of $12.60 per unit, from its previous close of more than $25 per unit. The stock remained at depressed levels for less than 10 minutes before bouncing back to finish the trading day at $23.69.

Stop orders accounted for much of this sudden wave of selling pressure. Investors who were stopped out of Linn Energy that day undoubtedly sold the stock at unfavorable prices only to watch the stock rebound once again into the close.

Investors should never place a stop-loss or trailing stop order on the MLPs in the model Portfolio. Although the May 2010 flash crash is admittedly an extreme example, units of Linn Energy and other MLPs occasionally sell off inesxplicably over a one- to three-day period before quickly recovering.

Rather than setting stops that are likely to get picked off by savvy institutional traders, investors should take advantage of the inherent volatility in MLPs by purchasing these stocks on dips. We advocated this strategy in the Aug. 8, 2011, Flash Alert, Opportunities Abound. Here’s a refresher course.

In early August, Linn Energy dropped to $31.50 per unit before rebounding to $39 per unit a few days later. Investors who jumped on this opportunity booked a 20 percent gain in a matter of days.

Earlier this week, the stock fell to an intraday low of $31 before rallying into the mid-$30s the following day. If you were nimble enough to grab units of Linn Energy at their low this week, you would have locked in an almost 9 percent yield and snagged a 15 percent capital gain in only two trading sessions.

Even units of the safest and most conservatively run MLPs are prone to occasional downdrafts. Enterprise Products Partners LP (NYSE: EPD) has increased its distributions in 29 consecutive quarters, but that track record didn’t prevent the stock from plummeting to a low of $36.25 in early August. At this level, units of Enterprise Products Partners–arguably the safest MLP in my coverage universe–yielded about 6.7 percent.

To increase your odds of purchasing our favorite MLPs at bargain prices, set a limit buy order with your broker that’s roughly 10 to 15 percent below the units’ recent trading prices. A limit order instructs your broker to buy the stock at the limit price or better. For example, if you set a limit order to buy Linn Energy at $33 per unit, your broker would only buy Linn if they can get a price of $33 per unit or lower. This strategy can pay off handsomely in a volatile market.

2. Buying Yield: US Royalty Trusts

High-yielding Canadian royalty trusts have been tremendous moneymakers over the years, though most converted to regular corporations because of an unfavorable change in the tax code.

Despite the change in tax treatment, many the former Canadian trusts still offer high yields and significant growth potential. My colleague Roger Conrad covers the group in great detail in Canadian Edge.

Investors often ask about the prospects for high-yielding US-listed trusts, especially BP Prudhoe Bay Royalty Trust (NYSE: BPT). Since this royalty trust began trading in 1989, it has generated enormous wealth for investors.


Source: Bloomberg

If you purchased this security for $26 per share in 1989, you would have collected more than $95 worth of distributions over the ensuing 22 years. If we factor in capital gains and assume you reinvested the distribution to buy additional units, you’d be sitting on a roughly 5,000 percent return–an annualized gain of almost 20 percent in a market that has gone nowhere over the past decade.

Outperformance of this magnitude merits a second look.

US-listed royalty trusts aren’t subject to corporate taxes. The trusts pass through the income and profits earned to individual unitholders who pay tax on their share of the income. This prevents the double taxation that occurs when the Internal Revenue Service (IRS) taxes dividends at the corporate and individual level.

Like MLPs, trusts incur significant depreciation and depletion charges that provide a tax shield. The IRS considers part of the distribution you receive as a return of capital. You won’t be taxed on that portion of your distributions until you sell your units.

In contrast to MLPs and Canadian royalty trusts, US-listed oil and natural-gas trusts are finite entities that convey the right to unitholders to collect royalties from a specific group of wells, fields or geologic formations. The trust can’t add to these properties over time by acquisition or expansion.

As these wells mature, declining oil and gas output will force the trust to reduce the amount it pays out. Most trusts are set up with a pre-determined termination date, at which point the assets will be liquidated and the proceeds distributed to investors.

With about 15 publicly traded US energy trusts on the market, investors have limited options from which to choose. Investors most scrutinize each trust’s financial and registration statements to determine which names offer the best potential returns and payout schedule.  

We favor trusts that have launched more recently; they tend to have a longer life span ahead of them, and payouts often grow more rapidly in the early years. Many trusts are also structured with hedges and other safeguards that reduce immediate exposure to commodity prices and facilitate reliable distribution growth.

SandRidge Mississippian Trust I (NYSE: SDT) went public in April 2011 and owns royalty interests in 37 horizontal wells producing oil and natural gas from the Mississippian formation in Oklahoma and a stake in 123 additional horizontal wells to be drilled over the next few years by the grantor, SandRidge Energy (NYSE: SD). All of these wells are located on a 64,200 acre “area of mutual interest” (AMI) in Oklahoma’s Alfalfa, Garfield, Grant, Major and Woods counties.

Here’s how the royalty structure breaks down.

1. The trust is entitled to receive 90 percent of all proceeds from the sale of oil and natural gas associated with the existing 37 producing horizontal plays after deducting post-production costs and taxes. The remaining 10 percent is paid to SandRidge Energy.

2. The trust is entitled to receive 50 percent of the proceeds from the 123 wells scheduled to be drilled over the next few years, with the balance paid to SandRidge Energy.

Note that SandRidge Energy doesn’t own a 100 percent interest in all the wells covered by the trust. In these cases, trust’s share of a particular well’s proceeds will be adjusted according to its stake in the particular well.

SandRidge Energy is required under the terms of the trust to drill the 123 additional wells on the AMI properties by Dec. 31, 2014, though that deadline can be extended by one additional year under certain circumstances.

A horizontal well’s productivity depends in part of the length of the well’s laterals, or the horizontal segment that intersects the oil and natural gas reservoir. The terms of the trust stipulate that only wells with a perforated lateral segment–the portion of the well that produces oil and gas–of at least 2,500 feet will count toward the 123 wells. In addition, SandRidge must have at least a 57 percent working interest in each well.

The trust structure also includes offsets to these requirements. For example, SandRidge Energy could reduce the number of wells it must sink by drilling longer laterals and focusing on projects in which it has a higher ownership stake.

Note that the trust itself isn’t responsible for the costs associated with drilling these 123 new horizontal wells, limiting trustholders’ exposure to the rising cost of hydraulic fracturing and other critical production services.

However, the trust is liable for its share of the post-production costs, including gathering and processing fees. Administration expenses associated with running the trust also reduce trustholders cash receipts. In general, post-production and administration costs are significantly lower and far more predictable than operating and drilling costs.

This trust stands out because of two other risk-reducing features.

At the time of its initial public offering, the trust had hedged roughly 54 percent of its planned production and 60 percent of its estimated revenue between April 1, 2011, and Dec. 31, 2015. Management expects the trust’s output to be split evenly between oil and natural gas. The trust has hedged about 40 percent of its gas production and around 70 percent of planned oil output through 2015.

These hedges offer significant near-term protection from fluctuations in commodity prices, while offering exposure to oil and gas prices after 2015–a potential upside catalyst.

Although we expect oil prices to remain elevated over coming years because of rapidly increasing global demand and constraints on supply growth, our intermediate- and long-term outlook for US natural gas prices remains sanguine. This stance might come as a surprise to readers, as we remain bearish on domestic gas prices in the near term.

But the coming years will be kind to natural gas. With rising concern about carbon dioxide emissions, US utilities are increasingly turning to natural gas-fired power plants to boost baseload capacity. Meanwhile, nuclear reactors take far too long to build, while alternatives only generate power intermittently and can’t add baseload power to the grid.

The nation’s vast gas shale reserves also make it difficult to envision a world in which domestic demand for natural gas doesn’t improve over the long term.

In short, the trust’s structure ensures a reliable income stream in the early years and the potential for additional upside after 2015. We also like that SandRidge Energy has retained ownership of 3.75 million shares in the trust, equivalent to a 17.8 percent stake. The parent company will receive the same distributions as individual holders.

In addition, SandRidge Energy owns 7 million subordinated shares that will pay out a regular distribution only if the trust generates sufficient cash flow to disburse at least 80 percent of the targeted quarterly distribution. If quarterly cash flow falls short of this threshold, the subordinate shares will forego part or all of their contingent distribution, until common shareholders are made whole.

These 7 million subordinate shares account for 25 percent of outstanding shares (21 million common shares and 7 million subordinated shares), providing a substantial cushion against shortages in cash flow.

However, SandRidge Energy does receive a carrot for providing this cushion. When distributions exceed 120 percent of their targeted quarterly amounts, the subordinated shares entitle SandRidge Energy to a 50 percent bonus on all amounts over this threshold. The subordinated units will convert into common units four calendar years from the date that SandRidge Energy completes its obligation to drill those 123 wells.

Although these subordinated units limit potential upside when quarterly distributions are high, the downside protection that this structure provides in lean times is a welcome offset. In addition, the size of SandRidge Energy’s bonus should incentivize the company to exceed the 120 percent distribution threshold as often as possible by accelerating drilling activity.

Let’s look at the trust’s targeted quarterly distributions.


Source: SandRidge Mississippian Trust I Form S-1/A Registration Statement

This graph tracks the targeted quarterly distributions for the SandRidge Mississippi Trust I through to the final quarter of 2016. The upper line represents the 120 percent threshold; the lower line represents the 80 percent payout threshold.

Note that the trust’s registration statement calls for the distribution to rise through the end of 2014 and decline thereafter. That’s because the terms of the trust require SandRidge Energy to drill these 123 new wells by 2014; production should increase as new wells come onstream, boosting the payout. Once new drilling ceases, oil and gas output will begin to decline until the trust expires in 2030, at which point it well sell its remaining assets and distribute the proceeds.

The potential upside comes from better-than-expected drilling results and/or higher-than-expected commodity prices.

Since the initial public offering in April, SandRidge Mississippi Trust has paid out one distribution–$1.068461 per unit, disbursed on Aug. 30, 2011. This amount is above the scheduled target distribution, but a bit shy of that 120 percent threshold. Based on this early performance, the trust appears on track to meet or exceed the targeted levels.

Assuming the trust manages to pay out according to its scheduled target over the next year, the common shares yield roughly 12 percent. The equivalent 80 percent and 120 percent payout thresholds would result in yields of 9.5 and more than 14 percent, respectively.

In addition to the incentives associated with the subordinated shares, SandRidge Energy plans to spin off other assets as a means of funding its drilling programs. If this initial foray generates solid returns for investors, the company should have little trouble raising capital via a similar trust.

For these reasons, we expect the trust’s distributions to meet or exceed 120 percent threshold more often than not. The potential returns in this scenario are impressive. Between now and 2016, the trust could disburse between $16 and $19 in distributions per unit. Elevated oil prices and rapid distribution growth could also drive up the price of the common shares. Energy trusts and MLPs often post their best returns in their first few years of public trading because rising distributions tend to drive capital appreciation.

SandRidge Energy’s production estimates for the 123 wells it will drill in the Mississippian appear reasonable. This play has been in production for decades, so the geology is well-known. Previous activity in this formation focused on vertical wells, but horizontal wells have given the play a new lease on life.

Although not enough horizontal wells have been drilled in the region to produce reliable production and decline curves, SandRidge Energy is an experienced operator and thus far drilling activity has yielded consistent results. SandRidge Energy may have low-balled the trust’s production potential slightly to generate above-average distribution growth,

The stock has pulled back from its early August high amid volatility in the broader market and shouldn’t drop below $19 to $22, assuming a barrel of West Texas Intermediate (WTI) crude oil doesn’t tumble into the low $70s. When WTI claws its way back to $90 per barrel, the stock could rebound into the high $20s.

SandRidge Mississippian Trust I is a more aggressive income play than Linn Energy, which boasts a more robust hedge book and continues to grow through acquisitions. But the significantly higher yield offered by the trust offsets these risks.

Note that SandRidge Mississippian Trust is taxed as an MLP, so you will receive a K-1 form at tax time. Part of your income will be considered a return of capital and will not be taxable until you sell the trust. The rest will be considered ordinary income and taxed at your marginal income tax rate. For more details, on the K-1 forms and the tax treatment of MLP-like structures, check out MLPs and Taxation: A Quick Refresher from Tax Season

A high-yield play on a rebound in WTI prices SandRidge Mississippian Trust I rates a buy up to 24 in the Wildcatters Portfolio.

3. Buying Yield: Bonds and Preferred Shares

Preferred stocks and bonds are two additional high-yield safe havens. In the Nov. 19, 2008, issue, High Income with Upside, we initiated a long position in Chesapeake Energy Corp’s 6 3/8% bonds slated to mature in 2015. In summer 2010 we booked a tidy profit when Chesapeake Energy Corp called the bonds at a substantial premium to our entry price.

Our investment thesis in fall 2008 was simple: The global credit crunch that followed Lehman Brothers’ bankruptcy in September 2008 had scared investors away from bonds issued by Chesapeake Energy and other relatively stable companies. When we initiated the position, the bonds offered a yield to maturity of more than 12 percent and traded at levels that offered plenty of room for price appreciation once investors came to their senses.

The ongoing EU sovereign debt crisis has led to some attractive opportunities in the high-yield market. That being said, the bond markets aren’t as beaten down in 2011 as they were in 2008.

Check out this graph of the yield spread between the 10-year, BBB-rated bond of an industrial company and a 10-year Treasury bond. When this spread spikes, BBB-rated companies are paying more to borrow money relative to what the government pays to borrow money.


Source: Bloomberg 

As you can see, the yield on BBB-rated bonds has ticked up in recent weeks, reflecting a flight to safety Treasury bonds and concerns that the EU sovereign-debt crisis could touch off a global credit crunch. However, bond yields aren’t even in the same ballpark as they were in 2008.

Income-seeking investors will need to look to high-yield bonds for value plays, as the yields on these junk-rated bonds have spiked in recent weeks.

Oasis Petroleum 7.25% 02/01/2019 (CUSIP: 674215AA6), issued by Gushers Portfolio holding Oasis Petroleum (NYSE: OAS), carry a B- rating from Standard & Poor’s.

In late July 2011, this bond traded well above its par value of $100 and offered a yield of less than 7 percent. Today, the bonds trade at a discount to par value and offer a yield to maturity of more than 8 percent. 

Oasis Petroleum’s fundamentals remain strong. Despite the recent dip in the price of WTI, the company’s wells in the Bakken Shale remain profitable. Most operators in this region estimate that wells offer a positive return on investment even with oil prices at $70 per barrel or slightly lower.

The stock and bond could rally after the company reports quarterly earnings on Nov. 8, 2011. In the first half of 2011, Oasis Petroleum missed production targets on its Bakken properties because of weather-related delays. But operators have reported little downtime in the third quarter, so a rebound in oil production should improve sentiment toward the company’s bonds and common shares.

In addition, Oasis Petroleum has little debt. The company has a $600 million revolving line of credit that matures in 2015 and carry a variable interest rate indexed to the London interbank offered rate (LIBOR) plus 2 percent. Despite worries about the EU financial system, LIBOR have yet to take off. The firm also has $400 million worth of bonds maturing in 2019. With a market capitalization of more than $2 billion and more than $400 million in cash, Oasis is far from overleveraged.

The bonds currently yield 8 percent and could appreciate in value once EU policymakers formulate a plan to stabilize Europe’s banking industry. Oasis Petroleum 6.75% 02/01/19 bonds rate a buy up to 100 in the Proven Reserves Portfolio. Note that bonds are quoted as a percent of par, so a bond trading at 100 actually costs $1,000. Buying bonds isn’t as easy as buying stocks. You may need to call your broker and provide the following CUSIP number: 674215AA6.

Wildcatters Portfolio holding Chesapeake Energy Corp 4.5% Preferred D (NYSE: CHK D) remains our favorite preferred stock and has pulled back from almost $100 to the low $90s–an outstanding buying opportunity.

At the current price, the preferred stock yields about 4.9 percent–compared to the less than 1 percent yield offered by Chesapeake Energy’s common stock. In addition, each preferred share is convertible into 2.2727 shares of the common stock. This option is good through 2049, so the preferred shares tend to follow the common stock higher over time. Buy Chesapeake Energy Corp 4.5% Preferred D up to 105.

4. Earnings Watch

Services Stocks

Schlumberger (NYSE: SLB)

Conference Call: Oct. 21, 2011 at 9:00 a.m. EST

Wildcatters Portfolio holding Schlumberger is the largest of the BIG Four services firms; the breadth of the company’s services portfolio and geographic footprint make management’s earnings conference calls a must-listen for all energy investors.

Like most investors, we will scrutinize management’s take on the strength of the North American market and recovering demand in international markets.

Thus far in 2011, robust activity in US shale oil and gas plays has driven earnings growth for the Big Four. But questions remain about whether economic weakness or capacity growth will stunt demand or erode service providers’ pricing power.

Schlumberger Chairman Andrew Gould had been somewhat bearish on the sustainability of the bull market for pressure pumping and other services related to shale oil and gas plays. But Gould changed his tune during Schlumberger’s conference call to discuss first-quarter earnings. CEO Paal Kibsgaard likewise noted that pricing power had extended to services other than hydraulic fracturing during the conference call that followed the release of the company’s second-quarter earnings. We’ll see whether a decline in the price of WTI has dampened his outlook for activity and pricing power in the nation’s liquids-rich shale fields.

In North America, Schlumberger historically has focused on the Gulf of Mexico. Last year’s acquisition of former competitor Smith International, a leading producer of drilling fluids, further enhanced the firm’s competitive position in the deepwater Gulf. In the second quarter, Gould noted that an incremental recovery in the Gulf of Mexico serve to tighten capacity for certain services in international markets. Through the first nine months of 2011, the Bureau of Ocean Energy Management, Regulation and Enforcement (BOEMRE) had approved 48 deepwater permits, 26 of which were for exploratory wells. Over the same period in 2009, BOEMRE approved 106 deepwater drilling permits, 66 of which were for exploratory wells.

We expect Kibsgaard to maintain a positive outlook on the gradual recovery under way in the deepwater Gulf of Mexico, though some additional color on the pace of permitting and its implications for the global market in deepwater services would be welcome.

Kibsgaard was particularly bullish on recovering demand in international market during his comments on Schlumberger’s second-quarter performance. As with most investors, we’re keen to hear whether the company’s operations in the Eastern Hemisphere were able to maintain their momentum from the end of the first quarter. During a Sept. 7 presentation at the Barclays CEO Energy-Power Conference, Gould noted “we have not yet seen any impact on the activity plans of our customers but we continue to monitor the situation closely.”

We’ll also pay close attention to the performance of the company’s WesternGeco subsidiary and any of Kibsgaard’s comments regarding the outlook for this business unit. WesternGeco is a leading provider of geophysical and seismic information, services that typically lay the foundation for exploration of deepwater fields.

Although WesternGeco accounted for only 7.2 percent of Schlumberger’s revenue in 2010, this unit’s performance and management’s commentary could have implications for shares of Gushers Portfolio holding Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY), which reports earnings on Oct. 28.

Robust spending on seismic services in the Gulf of Mexico and in international markets would also presage an uptick in exploratory activity–a development that would play to Schlumberger’s strength. At the same time, investment in seismic data doesn’t feature an immediate payoff and remains leveraged to prevailing oil prices.

Weatherford International (NYSE: WFT)
Conference Call: Oct. 25, 2011 at 8:00 a.m. EST

Shares of Weatherford International have underperformed considerably this year, stung by an accounting restatement and a failure to manage expectations. After the second quarter, management raised its forecast for full-year revenue growth to 25 percent from 20 percent, citing ongoing strength in the North American market and an anticipated rebound in demand and profit margins in the international market.

After Weatherford International’s first-quarter earnings fell short of management guidance from a month earlier, investors will pay close attention to whether North American revenue and margins improved measurably in the third quarter. A lack of weather-related disruptions to its Canadian operations should account for much of this improvement.

We’ll also focus on the performance of Weatherford Internationals artificial-lift business, a suite of services that focuses on increasing production from wells where natural geological pressure has declined. During a conference call to discuss second-quarter earnings, CEO Bernard Duroc-Danner noted that this business line tends to recover later in the cycle, after primary drilling has occurred.

We’ll look for further detail about when management expects this segment to work through a backlog of lower-margin contracts that were inked before the company pushed through two price increases. We like Weatherford International’s exposure to the business line in the event that economic uncertainty prompts producers to rein in spending on exploration and development; artificial-lift technologies represent a relatively inexpensive way to boost output from existing wells.

The firm’s international revenue and profit margins will also be in the spotlight, with analysts looking for improvement commensurate with a 25 percent increase in total. Analysts will also likely look for an update on the timing of delayed projects and awards in Algeria, as well as Duroc-Danner’s outlook for the Mexican market.

Baker Hughes (NYSE: BHI)

Conference Call: Nov. 1, 2011 at 8:30 a.m. EST

By the time Wildcatters Portfolio holding Baker Hughes–the third-largest of the Big Four services firms–releases its third-quarter results, its peers will have reported their earnings already. At that point, the shares will likely reflect any positive or negative read-throughs related to the North American or international markets. In particular, investors should focus on Halliburton’s (NYSE: HAL) third-quarter results and outlook for the activity and pricing in North American shale oil and gas plays.

Baker Hughes generated about 53 percent of its second-quarter revenue in North America. Accordingly, we’ll focus on the company’s outlook for the pressure-pumping market and pay particular attention to new capacity additions. Baker Hughes tends to book shorter-term contracts than its competitors, so its results and management’s comments could provide early signs of a slowdown in that market. We’ll also look for any comments about the potential effect of lower WTI prices on drilling activity.

Note that CEO Chad Deaton didn’t foresee any fundamental weakness in the North American market during his Sept. 9, 2011, presentation at the Barclays Energy-Power CEO Conference:

North America we’re–it’s still strong, activity is still there. You just don’t know, it could turn on you fairly quickly in North America, we have seen that in the past. We see no indications of that happening, because our clients still are very active and still submitting their projects and we’re still short of people and equipment.

Nevertheless, we expect North American activity to remain relatively stable; the focus in this region has shifted from natural gas–which trades in a closed, domestic market–to oil, which trades in a global market and commands a higher price. We also expect the wear and tear that pressure-pumping equipment goes through and extended downtime to somewhat mitigate the effects of new capacity additions.

With producers rushing to add acreage and ramp up drilling in the Utica Shale and other emerging plays, we’ll also look for any details on how these efforts will affect demand for hydraulic fracturing. Recent commentary has suggested that the Utica Shale will require a similar level of service intensity to the Eagle Ford Shale. Management will likely face the obligatory questions about its outlook for the Gulf of Mexico, though we wouldn’t expect an overly informative response.

Much of the focus will be on the company’s outlook for pricing and profit margins in its international markets. CEO Chad Deaton sounded incrementally more bullish on demand in these markets during his Sept. 9, 2011, presentation at the Barclays Energy-Power CEO Conference:

[I]t’s clear that the international is on its ramp back up again. And again…look at the Brent price, and you look at these economics of many of our customers; you see what Kuwait, Saudi, the Emirates, what they have announced we have seen no back-off of any of that. They are all going to–they are increasing their activity through the end of this year and early 2012….Resources are getting tight internationally, it’s not just us. It’s our competition as well. We can see it….So that all just leans towards, you could see the international side building, and I don’t see anything that’s going to slow that down that I can see out there right now….I think you will start seeing price movement. You see a little bit now towards the end of this year, and I think 2012 again as things get tight, I think you will see good improvement in pricing in 2012 internationally.

The big question is whether macroeconomic uncertainties have stifled the nascent recovery in international demand for oil and natural gas services. Improvement in the Russian market would also be a welcome develooment.

Although Baker Hughes won’t announce its 2012 earnings guidance until its conference call to discuss fourth-quarter earnings Deaton and the management team will likely field a spate of questions from analysts regarding their outlook for specific business lines or metrics.

5. Stopped Out

The late summer swoon that began in August stopped us out of three Gushers Portfolio holdings: Valero Energy Corp (NYSE: VLO), Spirit AeroSystems (NYSE: SPR) and Tenaris (NYSE: TS). Here’s a brief rundown on how these picks fared.

Valero Energy Corp, the world’s largest independent refiner, operates 15 petroleum refineries–seven on the US Gulf Coast, three in the Midcontinent region, two on the West Coast, one in Canada, one in Aruba and one in the UK–capable of processing a total of 2.9 million barrels per day.

On Feb. 27, 2010, we added Valero Energy to the Gushers Portfolio as a shorter-term investment that stood to benefit from improving fundamentals. (See A New Dark Age for Refiners.) After the stock ran up substantially, we sold half our initial position in the Jan. 19, 2011, issue for a roughly 42 percent gain and downgraded the stock to a hold. We also bumped the stop-loss order on the position to 22.50.

On Aug. 4, 2011, the stock dipped before our stop-loss threshold to an intraday low of $20.88. In this worst-case price scenario, investors booked a 20 percent profit on their remaining investment. In total, this amounts to a 31 percent profit on our initial investment.

Although we continue to regard Valero Energy as one of the best-positioned US operators because the flexibility of its refineries enables the firm to process less-expensive varietals of crude oil, the stock could struggle amid concerns that economic weakness will dampen demand for gasoline and other refined products. We will track the stock as a hold in the Energy Watch List.  

Spirit AeroSystems is the world’s largest independent manufacturer and supplier of commercial aircraft components.

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

Despite these headaches, securing these developmental contracts and seeing them through are essential to Spirit AeroSystems’ long-term growth. In an industry with so many single-source agreements, winning contracts held by competitors is almost impossible. Fortunately, Spirit AeroSystems holds a number of design-build contracts for the next-generation Boeing 787 Dreamliner and Airbus’ A350, revolutionary airplanes that rely on composite materials to improve fuel efficiency.

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

We added the stock to the Gushers Portfolio in the March 24, 2010, issue and set a stop-loss threshold of $15.50. On Aug. 8, 2011, the shares fell to an intraday low of $15.19. In this worst-case scenario, investors suffered a roughly 33 percent loss.  

At current levels, shares of Spirit AeroSystems trade at an attractive valuation. We continue to like Spirit AeroSystems’ post-2012 growth prospects and will consider adding the stock to the Alternative Energy Field Bet.

On Aug. 19, 2011, shares of Gushers Portfolio holding Tenaris breached our stop-loss threshold of $31 on their way to an intraday low of $30.88–a 20.9 percent loss from our entry point on Oct. 7, 2009. (See The Golden Triangle.)

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

Here’s a rundown of the company’s basic products and their applications:
  • Steel Casing sustains the walls of oil and natural gas wells during and after drilling;
  • Steel Tubing transmits oil and gas to the surface after drilling;
  • Steel Line Pipe conveys crude oil and gas from the well to refineries, storage facilities and loading and distribution centers;
  • Mechanical and Structural Pipes have a wide range of industrial applications, including the transportation of various liquids and gases under high pressure;
  • Cold-Drawn Pipe features diameters and wall thicknesses suitable for use in boilers, super heaters, condensers, automobile production and other industrial applications;
  • Premium Joints and Couplings are specially designed connections used to join tubes and pipes in high-temperature or high-pressure environments; and
  • Coiled Tubing is used for oil and gas drilling, well interventions and subsea pipelines.
However, Tenaris’ biggest growth opportunities hinge on a key investment theme that underlies many of the holdings in our model Portfolios: the end of easy oil. As production from established oil and gas reserves continues to dwindle, producers have sought to grow output by tapping expensive-to-produce reserves trapped in shale and other tight reservoir rock or located in deepwater fields around the world.

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

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

The Macondo oil spill served as a stark reminder that failure isn’t an option in deepwater drilling. Given the extremes of pressure and temperature in deepwater drilling environments, oil and gas producers are largely price takers when inventories of premium tubular goods are at normal levels.

Over the long term, Tenaris’ global reach, commitment to quality and close relationships with customers should ensure that the firm reaps the rewards of an improving product mix as spending on deepwater drilling activity increases. Despite the prevailing bearishness, Brent crude oil continues to command more than $100 per barrel–a level that should support ongoing investment in deepwater projects.

Shares of Tenaris are a bargain at current prices. We are reinstating the stock to the Gushers Portfolio as a buy up to 37.

6. 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

We are dropping the short play on First Solar from the hedges section of the Fresh Money Buys Portfolio. We booked a roughly 43 percent gain on half our short position in the Sept. 21, 2011, issue. Investors shouldn’t allocate any new money to the short sale of First Solar. We will issue a Flash Alert in coming weeks to cash out our remaining position. Instead, consider our short positions in Diamond Offshore and First Trust ISE Revere Natural Gas.
Although the risk of the US slipping into recession remains elevated, our proprietary Recession Radar indicates that a prolonged period of relatively slow growth remains the most likely outcome at this point.
In fact, recent data suggest the US economy has stabilized. Earlier this week, the Manufacturing Purchasing Managers Index (PMI) ticked up to 51.6 in September–an increase of 1 percentage point from the August reading. Monthly PMI numbers greater than 50 indicate that economic activity in the manufacturing expanded.
Automobile also sales surged to more than 13 million annualized units in September, while data from ADP Employer Services indicate that the US created 91,000 jobs last month–almost 20,000 more payroll additions than the consensus estimate.
In April and May, the stock market began to swoon when US economic data consistently fell short of expectations. A slew of better-than-expected economic data could support a year-end rally in US equities.
The EU’s ongoing sovereign-debt crisis remains a wildcard. Policymakers have moved slowly to address the problems in Greece, Italy and Spain, reminding voters of the downside of fiscal integration. Despite the popular outcry against bailouts, policymakers understand that an Italian or Spanish government default would devastate the global economy, strain the EU financial system and potentially touch off a global credit crunch.
Recent news flow suggests that the EU may announce a coordinated plan to recapitalize the region’s embattled banks and support fiscally weak national governments before the G-20 meets in early April.
In the near term, expect the uncertainty to roil equity markets and cap an upside. We continue to recommend a three-pronged investment strategy:
1.    Buy high-yield safe havens. Our top picks include master limited partnerships (MLP) and dividend-paying stocks such as SeaDrill (NYSE: SDRL). In this issue, I also take a look at US royalty trusts, as well as some high-yield bonds and preferred shares issued by US independents.
2.    Buy cheap growth. The recent selloff of cyclical energy names reflects the growth scare that began earlier this summer and intensified amid signs of an economic slowdown in the developed world and fear that the EU sovereign-debt crisis would yield a global credit crunch. In many instances, this downdraft doesn’t reflect industry fundamentals.

The previous issue of The Energy Strategist, /energy-strategist/articles/4622/raked-over-the-coals highlighted the discrepancy between the Peabody Energy Corp’s (NYSE: BTU) stock price and the tight supply-demand balance for seaborne metallurgical coal. Meanwhile, the dramatic pullback in shares of Weatherford International (NYSE: WFT) and Schlumberger (NYSE: SLB) belies the fact that Brent crude oil remains above $100 per barrel and is up 25 to 30 percent year over year. (See Outlook for Oil Services Stocks./energy-strategist/articles/4317/the-outlook-for-oil-services-stocks)
3.    Consider some shorts and hedges. We recently booked /energy-strategist/articles/4622/raked-over-the-coals a sizable profit on half our short position in First Solar (NSDQ: FSLR). Investors seeking to go short should consider Diamond Offshore (NYSE: DO) and First Trust ISE Revere Natural Gas (NYSE: FCG).

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