Fill 'er Up?

By Daniel Kadlec

Just because you'll be paying a lot more for heating oil and electricity this winter doesn't mean you'll reap a windfall by investing in stocks of companies in those businesses. Most energy-related stocks have doubled over the past few years, fed by soaring oil prices. For them to move much higher, oil--which has been edging lower of late--would have to resume its upward trend. Which it may. Wall Street heavyweight Goldman Sachs raised the specter of oil at $100 per bbl. even before hurricanes Katrina and Rita disrupted supply lines and briefly pushed oil past $70 at summer's end. Some investors clearly believe Goldman's story: cash flowing into energy-related stock mutual funds this year has reached $6 billion--already more than twice last year's total. These funds now have assets of $21 billion, up from $3 billion just three years ago, according to fund-research firm AMG Data.

"At a recent energy conference in New York, the place was overflowing," says Charlie Ober, manager of the T. Rowe Price New Era natural-resources fund. He views the crush of interest as a sure sign that investors have pushed up energy stocks too far. He has been paring back. But Ober still views oil and gas as a good long-term bet (increasing demand for a finite resource). The stocks he is sticking with are oil-services firms, including Schlumberger, which has key relationships with foreign producers, and oil companies with accessible reserves, including French giant Total.

Higher oil prices seem likely over the long haul. Yet they are anything but certain over the next few years. Any dramatic rise from here would almost certainly trigger a global economic slowdown that would cut demand and send energy prices--and energy stocks--sharply lower. Ed Maraccini, portfolio manager with Johnson Family Funds, says he will get interested again when oil drops below $50. At that level, he says, global demand is sustainable, and economies can grow.

New investment in exploration and production will lead to greater supply in coming years. "There's more than enough reserve base," says Craig Pennington, energy analyst at Schroders. By 2010 crude will average $36 per bbl. as new technologies and new fields in formerly unreachable regions of Russia and the Middle East add more than 3 million bbl. a day to global supply, he predicts.

You can still make money in energy if you're careful, and you should be exposed to this sector for the long term anyway. Warren Buffett said earlier this year that "the energy field is the single most likely area" where he "can find places to put significant capital" to work. He said he expects his Berkshire Hathaway to be making power-related acquisitions for 20 years.

Buffett is in no rush, though, and you shouldn't be either. Wait for energy stocks to come down another 10%. What looks best? Pennington favors refiners like Valero and Marathon, which he believes will be running at full capacity for the next five years. He also likes natural-gas firms such as Quicksilver and Nabors because he expects natural-gas prices to trend higher even as oil falls. Natural gas is more difficult to transport. It will take years to build enough transportation capacity to meet demand without higher prices in the U.S., where gas fields are losing steam, he says.

But the best approach may be a steady, 10% energy allocation through proven, diversified energy funds. With those in hand, filling the tank won't seem quite so painful.

GUSHING ENERGY MUTUAL FUNDS Average annual total return

[This article contains a table. Please see hardcopy of magazine or PDF.] Fund Name 1 year 3 years 5 years Guinness Atkinson Global Energy 62% New New Fidelity Select Energy Service 56% 34% 14% Fidelity Select Energy 54% 40% 9% Profunds Ultra Sector Oil & Gas 50% 38% 14% Fidelity Select Natural Gas 50% 28% 12% Vanguard Energy 46% 38% 22%

Source: Morningstar; data through Nov. 9