Major equity markets enjoyed their strongest first quarter in more than a decade, with the S&P 500 climbing 12.6 percent and the Bloomberg European 500 returning 8.6 percent. The financial and tech sectors were the big winners in the first three months of 2012, with the S&P 500 Financials Index gaining 22.1 percent and the S&P 500 Information Technology Index returning 21.5 percent.

Although the S&P 500 Energy Index eked out a 3.9 percent return during the first quarter, the stocks in my Best Buys List gained 6.5 percent with our hedges and 7.4 percent without these short bets. Over an equivalent holding period, the S&P 500 Energy Index returned 3.24 percent and 3.36 percent, respectively.

Source: Bloomberg, The Energy Strategist

We’re never pleased when our picks lag the S&P 500, but the Best Buys List faced an uphill battle because of the huge rally in financial stocks. Nevertheless, we take solace in the fact that the average yield offered by the stocks in the Best Buys List is triple the dividend yield of the S&P 500. Our top picks also exhibited slightly less volatility than the S&P 500 as a whole.

What We Got Right

Allocation shifts based on our outlook for the stock market and commodity prices enabled the Best Buys List to outperform during the first quarter. In the Jan. 5, 2012, issue of The Energy Strategist, Reading the Tea Leaves, we made five key big-picture calls:

• Cautiously bullish on the global economy. US economic data steadily improved in the final quarter of 2011, and our view that the economy would not re-enter recession proved correct. In addition, we maintained that the EU sovereign-debt crisis, though a concern, wouldn’t morph into a global credit crunch akin to the 2008 meltdown.
• Bullish on equities in the first half of 2012. Our forecast called for stocks to rally in the first half of the year in response to an improving US economic backdrop and encouraging developments in Europe.
• Elevated oil prices. We expect West Texas Intermediate crude oil to trade above $100 per barrel and Brent to fetch more than $110 per barrel. Our projections also called for these benchmarks to retest their 2011 highs at some point in the new year. 
• US natural gas prices remain depressed. We expect US gas prices to remain depressed for the foreseeable future, though our near-term outlook for international gas prices remains sanguine.
• High-yielding fare remains in vogue. Starved for yield, investors continue to flock to names that offer elevated yields, including integrated oil companies, US royalty trusts and master limited partnerships.

As we predicted, a strengthening US economy and the capitulation of overly bearish investors who called for a recession in late 2011 extended the S&P 500’s year-end rally into the first quarter of 2012. Sentiment toward Europe also improved in the first quarter, with yields to maturity on bonds issued by the Italian and Spanish governments receding.

These developments supported an ongoing rally in oil prices, which came close to retesting their 2011 high because of solid economic growth and Iran’s saber-rattling about disrupting shipments from the Middle East. This price backdrop enabled the oil-focused exploration and production names in my Best Buys List to post solid returns during the quarter: Shares of EOG Resources rallied by almost 13 percent, while Oasis Petroleum (NYSE: OAS) returned 6 percent and GeoResources (NSDQ: GEOI) gained 5.3 percent.

The high-yielding names in the Best Buys List also furnished some of our biggest winners. Units of Chesapeake Granite Wash Trust (NYSE: CHKR) returned almost 13 percent in the first quarter; SandRidge Mississippian Trust I (NYSE: SDT) gained 9.5 percent; Eni (Milan: ENI, NYSE: E) was up 13.5 percent; and Mid-Con Energy Partners LP (NSDQ: MCEP) climbed 9.5 percent.

The stocks that you don’t buy are equally important to q portfolio’s overall return. Not only have we assiduously avoided exposure to exploration and production names with exposure to US natural gas production, but we also sold short First Trust ISE-Revere Natural Gas Index (NYSE: FCG), an exchange-traded fund (ETF) focused on North American gas producers. This positioning proved prescient: The ETF gave up 2.8 percent in the quarter despite a broad-based rally in the stock market. Meanwhile, with already weak natural gas prices dropping to less than $2 per million British thermal units, this bearish bet should do well in coming months. Short First Trust ISE-Revere Natural Gas above 15.50.

Our bets on the growing international market for liquefied natural gas (LNG) also paid off during the quarter. Units of Teekay LNG Partners LP (NYSE: TGP), which owns and manages a fleet of LNG tankers booked under long-term contracts, rallied more than 20 percent during the quarter, while BG Group’s (LSE: BG/, OTC: BRGYY) American depositary receipt (ADR) returned roughly 8 percent.

The Feb. 23, 2012, issue of The Energy Strategist, Sticking to Our Values, contained perhaps our most important call of the quarter: to take some profits in many of the income-oriented names that investors had bid up well beyond our buy targets.

With units of Chesapeake Granite Wash Trust (NYSE: CHKR) up more than 50 percent since we added the position to the Growth Portfolio in November 2011, we suggested that investors sitting on sizable gains sell at least half their positions.

By the end of the quarter, Chesapeake Granite Wash had pulled back to $26 per unit and on April 18 dropped to $23 per unit during the trading session. As I explained in a Flash Alert issued that day, the latter correction marked the first time in a while that the units had traded below our buy target. Chesapeake Granite Wash Trust rates a buy under 25; do not let the stock’s high current yield lure you into paying more than our buy target.

We pursued a similar strategy with SandRidge Mississippian Trust I (NYSE: SDT), which had returned a whopping 54 percent between Oct. 6, 2011, and Feb. 9, 2012. On that day, we issued a Flash Alert advising investors to sell one-third to one-half of their position. In Sticking to Our Values, we cut the stock to a “Hold” and reiterated that investors should sell at least half their initial position to book gains. SandRidge Mississippian Trust I continues to rate a Hold. SandRidge Mississippian Trust II (NYSE: SDR), on the other hand, rates a buy up to 23 (see Trust IPO).

Readers who adhered to our buy targets on Conservative Portfolio holdings Kinder Morgan Energy Partners LP (NYSE: KMP), Enterprise Products Partners LP (NYSE: EPD) and Sunoco Logistics Partners LP (NYSE: SXL) avoided overpaying for these high-quality but overvalued names.

What We Got Wrong

Investors who refuse to admit their errors, evaluate what went wrong and adjust their strategy accordingly are doomed to failure in the long run. Any analyst, pundit or investor who claims to be 100 percent accurate in predicting market moves and trends in individual stocks is either delusional or an outright liar.

We made several tactical mistakes during the first quarter.

Coal-related names Peabody Energy Corp (NYSE: BTU), which gave up 12.3 percent, and Penn Virginia Resource Partners LP (NYSE: PVR), which gave up 12.8 percent, were among the biggest losers in my Best Buys List.

There are two types of coal: steam coal burned in power plants and metallurgical coal used in steelmaking. At the beginning of the year, we argued that Peabody Energy and other companies with exposure to international coal markets should beat weak expectations because of China’s solid economic growth. We also avoided US-focused names with concentrated exposure to weakening US thermal coal prices.

Although we remain convinced that China’s economy is in for a soft landing, metallurgical coal prices tumbled amid concerns about Chinese steel output and recovering supplies in Australia. Coal prices in the US remain challenged because of weak natural gas prices; utilities with the flexibility to switch feedstock are burning more gas and less coal. Seaborne thermal coal prices also eased somewhat because of rising production in Australia and elsewhere and concerns a weakened global economy would sap demand.

At its current stock price, Peabody Energy appears to have bottomed and represents an outstanding value for investors. Buy Peabody Energy Corp up to 45.

Units of Penn Virginia Resource Partners LP (NYSE: PVR) have surged off their 2012 low, bolstered by the transformational acquisition of privately held Chief Gathering LLC for $1 billion.

After the deal closes, midstream operations will account for roughly 75 percent of Penn Virginia Resource Partners’ distributable cash flow in 2013, up from 37 percent in 2011. Based on producers’ current drilling plans and the number of wells shut in because of insufficient midstream capacity, management expects throughput on these systems to exceed 1,500 million cubic feet per day.

Even if development and throughput falls short of these expectations (some analysts are calling for a roughly 15 percent decline), the newly acquired gathering systems will still generate a huge increase in distributable cash flow. We also like the long-term growth prospects for these assets as the Marcellus gradually becomes the primary source of natural gas for urban centers in the Northeast. Buy Penn Virginia Resource Partners LP up to 29.

Our Best Buys in the oil services and equipment industries posted mixed returns in the first quarter. Although Growth Portfolio holdings Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT) managed to eke out slight gains in the first quarter, both stocks lagged the S&P 500 Energy Index and have pulled back since the beginning of April.

The table below tracks how shares of the Big Four oil-field services firms–Baker Hughes (NYSE: BHI), Halliburton (NYSE: HAL), Schlumberger and Weatherford International–have fared in recent months.

Source: Bloomberg

Shares of Baker Hughes and Halliburton–both of which have heavy exposure to North America–have underperformed Schlumberger and Weatherford International, two names that stand to benefit from recovering margins and demand in international markets. We discussed this dichotomy in the Feb. 2, 2012, issue, Pockets of Strength.

We remain bullish on Schlumberger and Weatherford International: Both stocks have suffered because of concerns about weakening profit margins in North America–a headwind that’s more of a concern for Baker Hughes and Halliburton. In recent years, the market increasingly regard stocks as baskets; in this instance, investors have failed recognize the Big Four’s different emphases and upside catalysts.

Weatherford International, for example, offers superior exposure to oil-focused services, has little exposure to activity related to North American natural gas and boasts a rapidly growing international business. The company’s move to replace its CFO and vice president of tax should eliminate any future earnings restatements. At these levels, the stock is too cheap to ignore and could be a takeover candidate. Buy Weatherford International up to 17.50. Schlumberger continues to rate a buy up to 100.

Besides Weatherford International and Schlumberger, our picks in the oil services and equipment industries fared well in the first quarter, especially names with exposure to accelerating activity in deepwater exploration and development. We discussed this growth trend at length in the March 8, 2012, issue of The Energy Strategist, Into the Deep.

Seismic services specialist Petroleum Geo-Services’ (Oslo: PGS, OTC: PGSVY) ADR rallied more than 34 percent during the first quarter, while contract driller SeaDrill’s (NYSE: SDRL) high-yielding stock returned more than 15 percent, in part because of tightening supply-demand conditions for deepwater rigs. Buy Petroleum Geo-Services’ ADR up to USD17.50. SeaDrill rates a buy under 45.

After gaining almost 11 percent in the first quarter, shares of Core Laboratories have returned 57 percent since we added the stock to the Growth Portfolio in December 2010. At these levels, the stock is priced for perfection and could pull back at the slightest disappointment; investors should sell at least one-half their position in Core Laboratories, turning paper profits into real wealth. Core Laboratories now rates a “Hold.”