Don't bet against the long-term energy cycle.

The recent swoon and volatility in both energy commodities and equities have unnerved many. However, instead of worrying, your time is better spent developing a plan to play defense before the next opportunity arises to play offense in the energy space.

Fundamentals suggest there's still plenty of game left in the sector.

Temporary Fumble

High prices in the oil patch may slump temporarily, but demand for crude oil and products remains robust.

In fact, demand continues to creep higher from a base of 84 million barrels per day.

Without additional supply in the coming years, this trend will push the current limits of global production, now in the range of 85 to 86 million barrels per day.

Some have argued that gasoline demand dropped as a result of high prices in recent months. In fact, the data indicate otherwise.

When gas prices rose from $2 to $3 a gallon in the U.S., consumer demand remained surprisingly strong. Recent declines in demand are the result of typical seasonal patterns, namely a slowdown in driving as the summer-vacation season winds to a close.

Demand for crude, both domestically and globally, remains firm and should stay brisk for the foreseeable future.

Developing countries like China and India remain wild cards, but most signs point to increased consumption.

China's demand for crude may fluctuate from year to year, but continued infrastructure development will make it difficult for current supply patterns to satiate China's growing appetite for crude. Countries like India and many of the states of the former Soviet Union are also likely to need additional crude oil, albeit from a much smaller base than China.

That said, the decline in crude prices remains unsettling to some.

In fact, seasonal patterns, combined with the "dormancy" of geopolitical tensions around the globe -- have changed the short-term momentum in crude prices. As a result, the argument that Jim Cramer and others have made -- that the energy rally is over -- seems prescient.

Yet the longer-term fundamentals have not changed.

Supply and demand are roughly in balance, and existing crude oil production is rapidly declining. Moreover, the costs to find new production are ever increasing.

For example, the

recent discoveries in deepwater Gulf of Mexico -- the Jack II success by

Chevron

(CVX) - Get Report

,

Devon

(DVN) - Get Report

and

Statoil

(STO)

-- occurred with oil well above $50 a barrel.

In fact, all of the deepwater activity in the Gulf of Mexico was spurred by high oil prices. Conversely, when oil hovered in the $20-to-$30 range, there was little economic incentive to explore new hydrocarbon horizons.

The message should be clear: With supply growing tighter by the year, the economic incentive to discover new sources of oil is the only path to future supply-and-demand balance.

As a result, the broad bias will be toward higher -- not lower -- energy commodity prices. If prices drop to a level where drilling incentives wane, then activity will slow.

Assuming stable to incrementally higher demand, supply depletion will create shortages that will only be resolved through higher prices.

It's simple supply and demand at work.

Take Two: Natural Gas

A similar phenomenon is occurring in the natural gas markets.

While the unwinding of major speculative positions in the natural gas markets helped accelerate the past week's price decline, the shoulder season -- when demand historically falls -- has accentuated the focus on storage levels, creating a picture of abundant natural gas.

That's true today, but supply challenges are as daunting for natural gas as they are for the crude markets.

Natural gas decline rates -- the average annual decline rate for existing natural gas production -- are as high as 35%, and climbing.

Thankfully, demand growth in the U.S. is slow and steady, about equal to economic growth.

However, demand is also somewhat seasonal, and a cold winter would create an even larger challenge for natural gas producers. Fortunately, last year's warmer-than-normal winter left plenty of natural gas in storage, giving consumers a reprieve from high gas bills so far in 2006. But that will change quickly if the coming winter is closer to normal.

Natural gas prices have also slipped because of the lack of tropical activity this year, which can disrupt production from Gulf of Mexico fields.

One reason for higher prices last winter was the lack of supply from that region.

While 5% to 10% of the Gulf supply remains offline (and may never return) because of Hurricanes Katrina and Rita, production has increased meaningfully in the past six months.

The lack of storm activity this summer has also helped to rebuild stockpiles.

Yet, like crude oil, exploration and production of natural gas have become more costly, as wells are drilled deeper and new reservoirs are more costly to bring to production.

As a result, the average marginal cost of production, including economic profit for producers, is estimated to be somewhere north of $4 per thousand cubic feet (mcf).

Like oil, any drop in price below that level would be short-lived, as new supply would slow to a trickle, decline rates would quickly impact existing supply, and price would again adjust to bring the markets toward equilibrium. Over longer periods of time, the base market clearing price will likely be in the $6 range.

Cautiously Energetic

The fundamental arguments certainly suggest the recent steep correction in oil and natural gas prices has taken the excess out of the system. Demand should remain solid at current price levels, underscoring the need for continued exploration activity.

In addition, the crude market could once again feel the impact of exogenous events.

Although the risk premium probably won't become as inflated as it was at the peak of the Israeli-Lebanese conflict, hot spots such as Iran, Iraq, Nigeria and Venezuela are far from resolved.

A meaningful amount of oil comes from parts of the world that are not particularly friendly with the U.S.

That said, the shoulder months can be volatile times. With this year's ascent in energy prices, it shouldn't be surprising that commodity prices have corrected quickly, taking energy equities along for a wild ride.

For equity investors, this is not the time to be a hero. It's important to stick to discipline and protect capital.

Yet, it also may be time to begin nibbling at longer-term positions in the space.

Begin to take small positions on weakness like that seen on Wednesday. Remember, third-quarter earnings are just around the corner, and results should be good.

The key will be outlooks from oil and gas companies for fourth-quarter activity. So far, the outlook should remain pretty optimistic.

However, don't expect the stocks to rally significantly in the coming weeks.

Trading will remain volatile until we see some signs of winter demand, which might not come until December. To protect yourself, consider a number of risk-mitigating strategies:

  • Buy the best-in-class, top-quality names, and pair those long positions against relatively weaker players in the same subsector. In the land-drilling space, if demand for rigs weakens, the companies with the highest-quality fleets should outperform those with lower-powered rigs. Therefore, consider owning the leaders like Nabors (NBR) - Get Report and Helmerich & Payne (HP) - Get Report. Take those with smaller-horsepower fleets on the other side of the trade. As the market perks up, inch out of the short positions, increasing your overall long exposure.
  • Buy liquidity. There are a number of great small-cap exploration-and-production names with cheap multiples, but they aren't cheaper than the big names like Chesapeake (CHK) - Get Report and Anadarko (APC) - Get Report. Buy high-quality, liquid names that have much less price volatility.
  • Consider using covered calls to create income while you wait. If you have longer-term positions and believe that the market will remain relatively flat in the coming weeks -- lots of volatility but little meaningful price direction -- consider writing calls against your eligible long positions. In the worst-case scenario, the calls will hit the strike and you'll be taken out of your position. In that case, in this market, you'll likely have a chance to repurchase your position. If the call expires worthless, you'll collect the premium -- a nice payment to wait.
  • Keep your perspective in a difficult tape. Know your tolerance for risk, and don't underestimate your biggest challenge: the need to remain patient and focused on your discipline.

Now is the time to exercise that patience. It will pay to wait. While the biggest downdraft may well be over, the short-term sway in the markets won't necessarily produce quick profits -- at least until the weather gets cold.

At time of publication, Edmonds had no positions in any of the stocks mentioned in this column, although holdings can change at any time.

Christopher S. Edmonds is partner and managing director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he appreciates your feedback;

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