At one point last week the S&P 500 was down almost 49 percent year-to-date. That would have put it on pace to be the worst year in the history of the index; the biggest drop for the index to date is a 47.1 percent decline in 1931, right in the teeth of the Great Depression.

As I’ve noted on a few occasions in this forum, there’s no doubt the US economy is in recession; based on the Index of Leading Economic Indicators, it’s likely the country has been mired in this downturn since late 2007. Moreover, I suspect that we’re currently experiencing the worst downturn for the US economy since the 1970s.

But no post-war recession in US history has lasted longer than 16 months; in all likelihood, we’ll begin to see signs of economic stabilization and recovery by the end of 2009. Of course, the market typically leads the economy by several months. While timing the turn precisely is next to impossible, it’s likely we’ll see a major low for the market sometime next year.

For a shorter-term perspective, it also appears that the year-end rally I’ve been looking for over the past few weeks has finally arrived. This rally will disproportionably benefit energy-related shares.

Energy stocks haven’t been immune to this downturn; as of this writing, the S&P 500 Energy Index is off about 34 percent for the year against a roughly 40 percent decline in the S&P itself. Clearly, most of that decline occurred in the second half of the year.

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The decline has been both broad and deep; in fact, there’s only one stock in the S&P Energy Index that’s positive for the year.

Source: Bloomberg, The Energy Strategist

There have also been some notable losers, such as refiner Tesoro Corp (NYSE: TSO), off more than 81 percent so far this year amid the decline in US demand for gasoline and other refined fuels.

This vicious bear cycle has left many fundamentally well placed energy stocks trading at valuations unseen since the late 1990s when oil was trading in the teens and natural gas under $2 per million British thermal units.

It’s clear the market has totally overreacted and has overshot the fundamentals to the downside. There will definitely be a slowdown in spending and activity in the energy patch, but, as I explained in the last issue of The Energy Letter, this isn’t 1998. Oil and gas prices are unlikely to challenge their 2008 highs for at least another year, but severe supply restraints will ultimately mean higher prices.

In this light, the obvious question is what sub-sectors and stocks within energy stand to benefit most in the current environment and which are vulnerable to more selling.

Here’s a quick rundown of three themes to watch as we roll into 2009.

Natural Gas Over Oil

The key focus of the crude oil market right now is demand and, in particular, how much US oil consumption will decline as a result of a weakening economy. I believe supply will ultimately be the bigger driver for the oil market, but for now demand is king, and declining consumption will remain a headwind for oil in the first half of 2009.

The primary fundamental driver for natural gas has been supply, not demand. Specifically, the fear has been that exploration and production (E&P) companies have figured out how to produce America’s unconventional gas fields effectively; some argue that strong production growth will result in a supply glut.

But fears of a natural gas glut are likely to dissipate in coming months for one major reason: Natural gas drilling activity is declining rapidly. Most of the larger gas producers have announced major cuts to their planned drilling budgets for 2009.

Even worse, smaller drillers are being hit hard by the credit crunch. Many of these smaller companies are private and, therefore, off investors’ radar screens.  But several public companies reporting earnings over the past month have remarked that the credit crunch has prompted many of the small fry to totally suspend drilling. This is beginning to show up in the rig count data published weekly by Baker Hughes (NYSE: BHI).

Meanwhile, gas demand is holding up well; tighter supplies and rising demand spells higher prices. There are two clear signs this theme is already beginning to unfold. First, note that of the 10 top-performing stocks in the chart above, six are heavily leveraged to natural gas.

And second, consider the chart below.
 
Source: Bloomberg

This chart show the relative strength of natural gas prices compared to oil. As you can see, natural gas prices have been outperforming crude since the beginning of September and that out performance is accelerating.

Income and Master Limited Partnerships

I offered a detailed look at the MLPs in the Oct. 29 issue, Three Ways to Reach for Yield. The MLPs haven’t performed well this year despite the fact that almost all of them have been consistently raising their distributions. Moreover, the MLP space is by and large the least levered to commodity prices of any of the groups in my coverage universe.

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The attraction of the bond market is simple: Investors can earn yields in the 7 to 11 percent range purchasing preferred and corporate bonds issued by energy firms. And there’s a kicker: These securities offer plenty of upside as the broader stock market and commodity prices recover. In a sense, bonds and preferreds offer a way of playing the long-term upside in the energy patch--and generate solid income while you wait.

Consider the chart below for a closer look at what’s happening in the corporate bond market today.

Source: Bloomberg

This chart shows the difference between the yield on a basket of 10-year corporate bonds for US industrial companies rated BBB and the yield on the 10-year government bond. Bloomberg created the index of BBB yields and offers historical data going back to 1991.

Most investors are familiar with bond ratings provided by companies such as Standard & Poor’s and Moody’s. These ratings are meant to help investors assess the risk that a particular issuer will default on their bonds; in theory, the higher the rating, the more financially secure the firm.

Here’s what S&P says about BBB-rated firms on its Web site:

An obligation rated 'BBB' exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

Another way of looking at BBB-rated firms is that this is the lowest rating still considered investment grade. Firms with a rating lower than BBB are called high-yield or junk bonds.

As you can see from the chart above, for most of the past seven years, 10-year corporate bonds rated BBB have offered a yield roughly 1.25 to 2.25 percent higher than US Treasuries of a similar maturity. One useful way to think of this spread is that it’s a sort of risk premium: The higher the spread, the higher the return investors are demanding to accept the risk of holding BBB-rated bonds rather than risk-free Treasuries.

It’s obvious what’s happened over the past six months; yield spreads have exploded to unprecedented levels of around 5 percent. That’s more than double the average level of the 2001 through 2007 period.

One key point about bonds: Do not assume that bonds are ultra-safe investments or inherently less risky than stocks. A bond is only as good as the company behind it. Therefore, it is absolutely crucial that investors evaluate the companies issuing the bonds they’re buying. A good rule of thumb: If you wouldn’t consider buying the stock, don’t buy the bond either.

Avoid Jackups

Jackup rigs are shallow water drilling rigs used in water up to a few hundred feet in depth. They’re bottom-supported rigs, meaning that jackups are supported by legs that actually touch the sea-floor.

Here’s the problem: Many smaller producers that operate in markets like the North Sea and offshore Africa are heavily leveraged. You’ll find many of these stocks trading on London’s AIM market.

These firms have been very active in recent years due to the easy credit available to them and sky-high energy prices. But with energy prices falling and credit drying up for smaller firms, these companies have been forced to suspend their operations or drastically scale back activity. In short, many firms are now forced to live within their means.

These very same companies have been using jackup rigs extensively in their operations. As drilling activity slows, I’m looking for day-rates charged for jackup rigs to get hit particularly hard.

The one possible exception is the US Gulf of Mexico. At current gas prices, there are enough rigs in the Gulf but if gas returns to the $9 to $10 level, there will be a shortage because so many rigs operating in this region have been moved elsewhere in recent years.