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Energy Plays

BTU - Peabody Energy

One energy opportunity I am going to discuss today is coal and specifically Peabody Energy. We have played it several times in the past but falling gas prices killed the coal sector beginning in May. That sector is beginning to rebound based in part on rising gas prices and the advent of winter. Coal demand is about to rise dramatically.

TXU Corp, a major Texas utility, has proposed a $10 billion plan to build 11 new coal fired plants. They claim by using current technology and repeating the designs at each location they can build them faster and cheaper than anyone else. TXU is not alone. There are 154 new coal fired plants currently on the drawing boards across the U.S. according to the National Energy Technology Laboratory. Illinois is the only other state with 10 plants are in the planning stages leaving 133 spread out across the country.

High gas prices and a very bearish outlook on future gas prices is driving utility companies back to coal even with all its emission problems. Gas production in the U.S. has peaked and Canadian production, our current gap filler, has also peaked and is already in decline. This projects a grim picture for cheap gas prices with $15 gas almost a sure thing over the next couple years.

Coal we have in abundance with enough reserves to last 200-250 years at the present rate of consumption. Even doubling or tripling the consumption leaves us many decades of cheap power. A coal-fired plant requires up to 5 years of lead-time due to the extensive permitting process. Many are already under construction and experts claim even more will be added to those 154 already identified.

Some proponents have suggested going the coal gasification route, turning coal into gas and removing the pollutants before it is burned, as a better way around the pollution problem. Building a gasification plant is +20% to +25% more expensive than a regular pulverized coal generation plant. American Electric Power, Xcel Energy and Duke Energy are already reviewing plans to implement this technology.

However those 154+ plants are built it will translate into significant new demands for coal. Several coal to liquids plants are also in the works to convert coal to fuel that can be burned as gasoline or diesel. One money plant run by Satoil (STO) in Africa converts 120,000 tons of coal per day into 160,000 bbls of liquid fuel. There are various price points for this technology depending on the process and the scale but the average seems to be around $40 per bbl as breakeven. Since I doubt we will see those prices ever again these plants should begin to proliferate thus adding to the demand for coal.

Peabody reported earnings on Thursday of 53 cents per share, up from 42 cents in the year ago period. Analysts were expecting a 44 cents profit. Sales were up on higher volumes and on rising prices in all of the company's producing regions. Peabody said prices rose on average +6% in the US and +7% in Australia. BTU spiked from $40.85 to $44 on the news and I thought we had missed the boat. Fortunately Arch Coal warned on Friday that transportation problems would force it to lower production in 2007. Getting coal to buyers is a major problem and even more a problem for the smaller producers. This is why railroads like our current play CSX are doing so well. They do not currently have enough capacity to ship all the coal needed and are adding cars and track as quickly as possible. With 154 new plants in the works this will only become more of a profit center for the railroads and more of a problem for the smaller producers. Peabody, as the biggest in North America can contract for more capacity and can afford to pay more than the rest. The railroads want BTU for a customer because size does matter in the shipping business. Peabody still faces transportation constraints and said it was slowing growth plans for its Powder River Basin production by -7 million tons in 2007. They will still produce record volumes but the rail capacity will not be up to full speed until late 2007 or early 2008. Peabody also said it was deferring the startup of its planned School Creek mine to 2009 or beyond. Analysts liked this news saying the planned additional 45 million tons of production could drive prices lower. By waiting until later to bring this production online it would force power plants to stock up on coal in fear of a shortage of supply.

The Peabody President said the country was finally working its way out of the effects of the mild winter and they anticipate a tighter supply-demand picture going forward assuming weather patterns return to normal. He said coal stockpiles at U.S. power plants had fallen by -10 million tons during the quarter.

Peabody also said its growth will be accelerated by the $1.5 billion purchase of Australia's Excel Coal Ltd. The purchase will triple Peabody production in Australia from 9 million tons per year to 29 million. This coal is delivered to the fast growing Asian markets. Peabody purchased more than 500 million tons and three working mines from Excel. Much of this coal has already been committed under long-term contracts to Asia.

Based on the current trend, the number of new plants under construction and 150+ on the drawing board the future looks bright for Peabody. I believe this is a company we should be invested in for the foreseeable future.

Buy Jan-2009 $50 LEAP Call ZZT-AJ currently $8.70

No insurance put at this time with $35.

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Non-Energy Plays

The earnings cycle should always give us an opportunity to step outside of the energy sector and pickup a couple bargains when they appear. Earnings surprises sometimes take on a life of their own and the magnitude of the reaction can be completely off the scale. Today we have a couple of entries that fit that scenario.

CAT - Caterpillar

The first play outside the energy sector this week is CAT. Caterpillar was hammered for a -$10 loss on Friday after warning that sales could slow in 2007 if the economy continues to soften. They also said they were hit by slowing sales in the housing sector and by a buildup of inventory at customer locations in the diesel engine business ahead of the new rules for low emission diesel.

CAT said its business was still booming especially the overseas segments. CAT posted earnings of +$1.14 for Q3, up from 94 cents, when the street was expecting profits of $1.35. CAT only lowered its full year outlook for profits of $5.05 to $5.30 from prior estimates of $5.25 to $5.50. Profit growth is still expected to be in excess of +10%. These are still stellar profits investors fled the stock.

CAT said if the economy does slow they expect sales of their expensive yellow metal to slow with it. The risk comes from dealers who may be less inclined to carry a lot of expensive inventory if sales are slowing. CAT said they only expected 2007 to be a slower growth phase for the current cycle and not the start of an extended downturn. CAT said if the Fed cut rates early in 2007 they could beat their current forecasts but they denied they were being purposefully negative in their outlook to drive down expectations. They claimed instead they were just being prudent. CAT said oil exploration, mining, infrastructure development were areas of strength around the globe.

I believe CAT was being purposefully gloomy. They have been punished before for small misses and they took the "economic slowdown" opportunity as a way to lower expectations just in case.

I believe CAT is a buy here as long as you have a long-term view. At Friday's close of $59 there is about $2 of risk and plenty of upside. The $59 low is about two days away from being the low from the year with a high of $82. If the economy does succeed in achieving a soft landing I believe CAT will be well rewarded.

With earnings already behind us there is little risk of another surprise.

BUY JAN-2009 $70 LEAP Call VKT-AN currently $7.20

No insurance due to strong support at $57.

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TEX - Terex Corp

Terex is a diversified global manufacturer of construction, road-building and mining equipment, shipping, transportation and refining industries. The Company operates in five business segments: Terex Construction, Terex Cranes, Terex Aerial Work Platforms, Terex Materials Processing & Mining, and Terex Road Building and Utility Products. Earnings in the June quarter jumped +94% to $198 million. Revenues came from improved performance from the Terex Cranes, Terex Aerial Work Platforms and Terex Materials Processing & Mining segments due to strong demand.

TEX has been growing by leaps and bounds with several acquisitions and greater acceptance of its cranes and aerial work platforms. Demand is currently stronger than TEX can supply with construction booming around the globe especially in Asia.

The analyst community can't say enough good things about Terex and they seem to touch all the booming construction areas. With a market value of roughly $5 billion and sales of nearly $8 billion and a PE of only 12 it is tough not to take this company seriously even though it is only about 1/5th the size of Caterpillar.

Their biggest customer is United Rentals, which buys their cranes, lift booms, and various other products. Profits are expected to rise by +10% annually over the next five years. Sales last quarter increased +18% profits +66%. In July they targeted sales growth for the full year at +17% to +22% and raised their earnings targets to $3.55 to $3.75 per share from $3.20 to $3.40. Return on invested capital is near +30%. Those are my kind of earnings increases.

In April Terex bought 50% of a crane maker in China in an effort to reduce costs for its future products. TEX spiked last week on news that Oshkosh Truck was acquiring JLG Industries for $3 billion. Citigroup said that although the deal had nothing to do with Terex it bode well for the industry that Oshkosh was willing to pay that kind of money at this time in the economic cycle for aerial assets. Terex Genie business is JLG's main competitor and the two dominate the market. Genie accounts for 50% of Terex earnings.

After more than doubling in price last year TEX has spent six months consolidating between $40 and $50 after a 2:1 split. TEX broke out over $50 a week ago but the Caterpillar warning knocked it back to earth after a promising sprint.

The key here is that TEX has nothing to do with the Caterpillar story. It has no exposure to housing and business is booming. It was simply caught in the CAT downdraft and that gives us an opportunity to enter the position cheap.

BUY Jan-2009 $60 LEAP VXQ-AL currently $10.90

Insurance Put:
Buy Jan-$45 PUT TEX-MI only is TEX trades at $48.

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