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Markets

How to Play the Energy Sector Now

Middle East politics may have contributed to the recent drop in oil prices, but the long-term trend is still up.

Look no further than the pump prices at your neighborhood filling station for evidence of why energy stocks seem to be fizzling. But don't cut back on your energy holdings. In fact, this is a good time to add energy stocks, even if the short-term direction of crude is a muddle. Odds are that prices -- for both the commodity and the stocks -- are headed higher over the long haul.

Crude's performance has been like a roller coaster. Oil hit $77 a barrel in July, prompting some seers to declare that $100 was imminent. Instead, crude plunged to $50. Then, as sentiment grew more bearish, oil reversed course and jumped 20% before settling at $60 in mid February.

Explanations abound for the 22% decline since summer. Near the top of the list is the freakishly warm weather we had in early winter. On the geopolitical front, there is conjecture that Saudi Arabia wants to keep the price of oil at $50 to $55 a barrel to hobble regional rival Iran by cutting its petro profits. And then there is the law of supply and demand: The International Energy Agency reports that oil use by industrialized nations fell 0.6% last year, most likely in response to high prices.

As oil prices have dropped, analysts have trimmed their 2007 profit estimates for energy companies. For example, they expect ExxonMobil, which earned a record-breaking $39.5 billion in 2006 (a figure that tops the gross domestic product of Slovenia), to make a mere $36 billion (about the same as Ecuador's GDP).

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For investors, though, one number may trump everything else. Even as crude prices have tumbled, the American Stock Exchange Oil index has dipped just 6%. The reason for the divergence is simple, says John Dowd, manager of Fidelity Select Energy fund: "When you have stocks that are very cheap, they don't go down as much when the commodity goes down."

And oil stocks are cheap. Most big-oil shares trade at nine to ten times estimated 2007 profits. By contrast, the price-earnings ratio for Standard & Poor's 500-stock index is 16. Energy-stock P/Es may be so low because investors worry that oil will dip below $50 -- and stay there.

Don't bet on it. Tim Guinness, London-based manager of Guinness Atkinson Global Energy fund, says he believes that oil will trade at $50 to $70 a barrel for the next few years -- and then head for greater heights. Dwindling supply is the main reason. Guinness says companies operating in West Africa, Mexico, the Caspian Sea and Brazil are having "huge problems" getting oil out of the ground. Fidelity's Dowd observes that the number of U.S. drilling platforms has almost tripled since 1999, but oil and natural-gas production remains about the same.

The problem appears even more serious when you look longer term. Charles Maxwell, senior energy analyst at Weeden & Co., says that although non-OPEC countries produce 60% of the world's oil, most such producers, including the U.S., have hit peak output. In a few years, non-OPEC production will start to decline. "If the U.S. and Europe cooperate to bring their demand down so that we can accommodate demand in emerging markets, good. But that isn't going to last very long." By 2010, Maxwell says, we may face an Oliver Twist scenario, in which we'll go begging to OPEC, "Please, sir, I want some more."

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Maxwell is bearish on energy stocks for 2007. Such caution isn't surprising in light of the sector's phenomenal run -- over the past four years, the Amex Oil index is up 178%. But given the supply situation and strong worldwide economic growth, which pushes up demand, oil should head higher over the long term. And once investors realize that $50 a barrel is the floor, not the ceiling, energy stocks should resume their ascent.


Cheap energy

Well, some stocks. Exxon, the world's biggest oil company, is well run, generates gobs of cash and regularly raises it dividend. But at $75 in mid February, the stock (symbol XOM) trades at 12 times estimated 2007 profits. That's well above the group average.

Among big-oil companies, you won't find a better value than ConocoPhillips (COP). Although its main reserves are waning, it's tapping new sources in the Middle East and Asia. ConocoPhillips' 20% stake in Russian oil giant Lukoil has great potential. Analyst Jacques Rousseau, of Friedman Billings Ramsey, says the stock, recently $67, is a "great value" at six times his 2007 earnings forecast of $10.60 a share.

Drilling through the ocean floor is getting tougher as explorers look for oil-and-gas deposits in deeper and harsher seas. Oil companies now pay dearly for this expertise, and Noble (NE) is an industry leader in know-how. Noble can earn $180,000 a day from new contracts on one of its "jackup" rigs -- platforms that are supported by legs that lower like jacks. That's twice the rate it was getting late last year. At $73, the stock is 16% off its 52-week high and trades at eight times the average analyst earnings estimate for 2007 of $8.98 a share.

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Three outstanding energy funds

For a low-cost fund that focuses on giant companies, it's hard to top Vanguard Energy (symbol VGENX; 800-635-1511). At last report, the $10-billion fund's biggest positions were ExxonMobil, Chevron and ConocoPhillips. On average, the fund, run by James Bevilacqua and Karl Bandtel, of Wellington Management, changes only 10% of its holdings every year. Over the past five years to February 1, it gained an annualized 26%, beating the typical energy fund by an average of nearly four percentage points a year. Annual expenses are low at 0.28%. One drawback: a $25,000 minimum investment.

For just $2,500, you can buy into Fidelity Select Energy (FSENX; 800-343-3548). John Dowd has managed the fund only since 2006, but he has years of experience following energy stocks, at Fidelity and elsewhere. He says he doesn't buy stocks based on energy-price expectations, but on share-price value. He sleeps well at night, he says, because the energy companies he buys are priced at 70% of their replacement value. The fund returned 21% annualized over the past five years, trailing the category average by one percentage point per year.

Among exchange-traded funds, iShares Dow Jones U.S. Energy (IYE) is a fine choice. Note that big companies dominate the index this fund tracks; ExxonMobil and Chevron account for 37% of assets. The ETF gained 19% annualized over the past five years.