Many energy-related stocks have been pulling back over the past few weeks. This is nothing unusual. In the past year, there have been two major corrections in the energy patch, one last spring and another in October. Each of those selloffs turned out to be an outstanding buying opportunity; I expect the current selling to set up yet another golden chance to jump into the group at more favorable levels.

But I'm not yet convinced the downside is complete, at least not for all subsectors in the energy patch. Moreover, the energy sector is far from a homogenous group: Some energy sub-groups are actually benefiting from lower oil and natural gas prices while others will be hit particularly hard by the current selloff. And even within specific subsectors, there can be vast differences in companies' commodity exposure.

That spells plenty of profit opportunities for investors, even if oil and gas prices continue their downward tack for a few more weeks.

Check out the chart of the Philadelphia Oil Services Index below.

Source: Stockcharts.com

The longer-term chart shows that there's been a clear bull market in energy stocks over the past few years. As readers of this journal are well aware, this move is a secular rally. In other words, rising demand for energy-related commodities, especially in the emerging markets, is meeting increasingly constrained supplies. The result: higher prices.

However, the forces powering that secular bull market are long-term in nature and there will be short-term downside gyrations. This is nothing out of the ordinary--every great bull market in history has seen major corrections in the context of a multi-year move. For example, the Nasdaq saw several corrections of more than 20 percent in the 1990s and gold saw more than a few violent pullbacks during its 1970s run. All of these downside moves felt scary at the time; nevertheless, both the Nasdaq and gold offered tremendous returns for investors during those secular bull runs.

Energy is no different. In the chart above, I've highlighted several corrections in the group over the past three years. These selloffs have lasted a month to three months and shaved approximately 15 percent to 25 percent from high to low. The Philadelphia Oil Services Index hit a high on January 30 at 224.48. Yesterday's low was approximately 188, a 16.3 percent move to the downside, roughly in the middle of that historical range.

But other subgroups could get hit far harder. Specifically, this year's ultra-warm winter has actually produced a glut of gasoline and refined products inventories in the US market. Some refiners are exposed; refining margins for the weaker players are already dipping well into negative territory. Keep in mind that refining margins were near 30-year highs last year at this time. Analysts' consensus earnings estimates for 2006 still aren't reflecting the worst of that damage. There's more downside for select stocks in the group.

And while falling fuel costs are a big problem for the refiners, they're music to the ears of the airline industry. Last autumn I recommended US Airways in The Energy Strategist--the stock ultimately produced a gain of nearly 70 percent for subscribers. Several industry groups stand to benefit from the current pullback in energy costs. If timed correctly, such groups can offer huge gains for investors.

Cost, Not Demand

The other big takeaway from this quarter's earnings results is that costs are becoming a big factor for many energy firms. While demand was ultra-strong for everything from coal to uranium, some companies have had a rough time controlling their expenses. Cost control becomes even more crucial when there's a pullback in commodity pricing--higher cost producers tend to see their profit margins squeezed the hardest.

Coal mining firms offer an excellent case in point. In the western US, most coal mining is done using strip mining. This is a relatively cheap and efficient means of producing coal. Much of the actual work is done using large machines known as draglines that strip away the dirt and rock overburden that covers the coal reserves. Much of the labor used is relatively unskilled and requires little training.

Back east, where much mining is done underground, it's a different story. Mining companies there are more labor-intensive than their western counterparts. Disasters like Sago highlight the inherent dangers associated with underground mining--this is a major reason the eastern miners are seeing their labor costs and employee turnover rise so rapidly. Rising costs will crimp these companies ability to increase and/or maintain their production in coming years.

To truly understand coal mining companies, one must understand the quality and location of their reserves. This makes a huge difference to performance. For example, one of the big coal mining firms I recommend in The Energy Strategist is up nearly 30 percent from its October lows while some, such as Massey Energy and Alpha Natural Resources, are trading near their 52-week lows, despite the fact that coal prices continue to advance.

© 2006 Elliott H. Gue
Editorial Archive

A Preview In the upcoming issue of The Energy Strategist, I’ll be dissecting the correction in energy stocks, looking for some compelling opportunities. Specifically, I'll be highlighting a few sectors that have been and will continue to benefit from lower energy prices. I’ll also examine the various energy subsectors with an eye toward identifying the individual stocks most vulnerable to any further declines in oil and gas prices, and will recommend a few short positions and put options to play the most vulnerable sub-groups.