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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).
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."
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.
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