Energy Sector Shows Promising Vital Signs

The rally in the energy sector Wednesday offered some overdue relief for a downtrodden sector. The first good news in nearly two months sparked renewed interest in the sector, but energy stocks still need to heal before they can power forward in a healthy way.

First, the Good News

Both Schlumberger (SLB Quote) and Halliburton (HAL Quote), two energy-service giants, reported solid earnings. They exceeded expectations in the second quarter and, more importantly, didn't express the level of pessimism that many investors expected. In fact, Halliburton admonished analysts that third-quarter estimates were about 20% too low. And both companies suggested North American natural gas weakness could be offset by the growth in international demand from oil drilling. So far, with the exception of ExxonMobil (XOM Quote), energy earnings have generally exceeded expectations, and the third-quarter outlook -- while not wildly optimistic -- is certainly far from moribund.

The American Gas Association noted a lower-than-expected increase in natural gas storage last week: 84 billion cubic feet vs. estimates of nearly 100 billion cubic feet. While one week doesn't make a trend, natural gas prices reacted to the news, suggesting demand still exists for natural gas. A pattern of shrinking storage over the next several weeks would be key to supporting a rally.

OPEC's decision to cut oil production by a million barrels a day beginning in September indicates that the cartel is serious about keeping oil at or above its $25 per-barrel target price. The current prices of many of the exploration and production, or E&P, and energy-service stocks suggest investors think crude oil prices will be much lower than the cartel's $25 price target in the coming months. The American Petroleum Institute report Tuesday, which showed crude stocks tightening in the past week, and the additional OPEC cut should support prices at or above the $25 target.

The Federal Energy Regulatory Commission's decision Wednesday to accept the judge's recommendation that a hearing be held on refund calculations in the California power debacle brings the issue a step closer to closure. The FERC appears to agree with the judge that refunds due are in the hundreds of millions -- as opposed to California's claim of nearly $9 billion -- and that's a positive for the independent generators, which were trampled earlier this week on news of a Salomon Smith Barney downgrade.

Can the Rally Last?

With a series of good data points, an overly depressed market rallies. That's not unusual. And, frankly, it's not unusual for that type of rally to quickly slip away as the excitement of the moment dissipates.

In a recent missive, I penned a checklist of possible signs of a turn in the energy markets. Key among them were earnings, which appear solid with decent outlooks, and natural gas and oil-storage data, which are not yet conclusive or trend-setting but provided some hope for investors this week.

Yet, a number of E&P companies are still slated to report, including Apache (APA Quote) Thursday morning as well as Devon (DVN Quote) and EOG Resources (EOG Quote) in the coming week. They should all exceed estimates, but their outlook for the natural gas markets and any adjustments to their capital budgets will be watched closely. EOG's report could be particularly telling, as it started the year with little of its gas exposure hedged, meaning that falling gas prices could have a more significant impact on the company's earnings and cash flow.

Among the power producers, Calpine (CPN Quote) reports Thursday. Given the quick correction in power prices, especially in California, its second-half outlook will be carefully watched.

With the psychology of the sector so fragile, one slip would quickly erase the unsteady base of confidence that began to develop Wednesday.

It's too early to suggest that a firm bottom is in place, but Wednesday's news is a start. A return to recent lows is a buying opportunity, and a further spike up is likely a trading opportunity. However, for longer-term investors, Wednesday's rally suggests that it's time to think about establishing a core group of positions in the sector. Absent a major economic debacle, they should provide nice returns as demand and commodity prices stabilize and heat up as winter approaches.