Investor's Business Daily
More Gas In The Tank For Oil Stocks?
Thursday November 15, 6:14 pm ET
Trang Ho


Being in a boom-and-bust sector, could energy stocks be on the verge of a bust after such a big boom?
Natural resource funds tracked by Morningstar are the top-performing sector this year, gaining 30.21% going into Thursday. They've cranked out an average annual 26.7% the past three years and 30.1% the past five years.

"Natural resources and commodities have seen a tremendous run over the last five years, but we still think this cycle could extend well into the next decade due to strong demand growth in emerging markets," said Evan Smith, co-manager of U.S. Global Investors Global Resources (NASDAQ:PSPFX - News). "The cost of producing oil is becoming greater, and access to easily produced oil is becoming more difficult."

China and India together are responsible for 45% of the increase in global energy demand, according to an outlook released last week by the Paris-based International Energy Agency. Their energy use is set to more than double between 2005 and 2030.

Oil imports for these emerging markets are expected to jump about 300% between 2006 and 2030 to 19.1 million barrels a day, surpassing the current combined imports of the U.S. and Japan. Most of the increase will come from the Middle East and Russia.

Worldwide demand for fuel is projected to rise 42% from 83 million barrels of oil a day in 2004 to 118 million in 2030, according to the IEA. That translates to a need for rampant increases in exploration and production.

"And (because of) a two-decade lack of investment in many natural resource industries, there's been a muted supply response despite rising commodity prices," Smith said.

Drillers and equipment makers stand to benefit from the need to put more holes in the ground in search of black gold.

Doubling Down?

John Escario, portfolio manager for the Rydex Energy Fund (NASDAQ:RYENX - News), is considering doubling his fund's weighting in such stocks.

"Oil has gotten to the price where oil companies are expanding drilling capacity," said Escario. "The shortfall in oil-refining capacity will double next year."

Top weightings in his fund are Schlumberger (NYSE:SLB - News), Halliburton (NYSE:HAL - News) and Transocean (NYSE:RIG - News).

But other money managers are more bullish on explorers than drillers and service providers. Tom Winmill, manager of the Midas Fund (NASDAQ:MIDSX - News), targets firms with reserves in the ground.

"Reserves aren't being replaced nearly as quickly as the increase in manufacturing capacity," he said.

His sector favorites are Chesapeake Energy (NYSE:CHK - News), CNOOC (NYSE:CEO - News) and EnCana (NYSE:ECA - News).

Smith's Global Resources fund has led the category for the past three, five and 10 years, with average annual returns of 38.4%, 50.2% and 15.8%.

Its biggest position is Schlumberger, the world's largest oil-field services provider. It digs wells, oversees construction and sells software to oil producers on nearly every continent.

"They'll continue to show double-digit revenue growth over the next decade," Smith said. "Valuation is reasonable, considering earnings and revenue growth."

The stock gapped down 11% -- the biggest hit in six years -- Oct. 19. CEO Andrew Gould said projects were delayed in Nigeria and the Caspian region because of equipment and labor shortages. Shares have been consolidating below the 10-week line ever since.

Earnings growth decelerated over the past four quarters to 35% from 88%. Sales growth slowed to 20% from 33%.

Lower refining margins, increased maintenance costs and closures because of hurricanes or other weather have shaved profits across the industry. Refiners have been caught in a margin squeeze since May as crude prices spiked 50%, but prices at the pump fell 10% over the same period.

Of course, investing in oil services involves many risks. Oil is highly sensitive to geopolitical events, such as conflicts with Iran over its nuclear program and instability in Afghanistan and Pakistan.

Slow-Growth Risk

"The primary risk," said analyst Mark Urness of Calyon Securities, "is slowing global economic growth, which would lead to reduced oil demand and potentially lower oil prices, causing oil companies to reduce their upstream capital expenditures."

In a research report, Deutsche Bank analyst Mike Urban said: "In this cyclical business, risks include both oil and natural gas commodity prices and the impact that changes have on the demand for oilfield services, assorted political risks to contracts, as well as unexpected events such as hurricanes, which can damage or destroy equipment."

Still, Urban recommends overweighting oil services. "We believe acceleration in secular growth internationally and rising exploration activity should help propel the group higher," he said.