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Ride the Oil Boom

The potential for more chaos in the Middle East means oil and natural gas prices aren't going to stay down for long. Take advantage of the selloff in this sector -- now.

The subprime mess has spread to surprising corners of the markets. The price of oil, which peaked at more than $77 a barrel at the beginning of August, has fallen to $71 as of August 27. Before rebounding a bit, energy stock indexes had declined, too -- by almost 10%.

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It's easy to understand the decline. The credit crunch awakened fears on Wall Street of a recession. Any economic slowing, of course, would mean less consumption of oil and result, perhaps, in lower oil prices.

That makes this an ideal time to buy. A recession seems unlikely, and other forces are pushing up energy prices relentlessly. What's more, brokerage analysts are basing their company earnings forecasts on estimated oil prices of roughly $55 a barrel -- so the stocks look cheap.

My favorite fund to invest in this volatile sector is T. Rowe Price New Era (symbol PRNEX). Manager Charles Ober had cooled a bit on energy when I last talked with him, in March. He predicted that the price of oil would fluctuate between $55 and $65 a barrel over the next two or three years. Obviously, he was wrong. But he had previously been right on target in his energy forecasts, so I place a lot of value in what he says.

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His new bottom line: roughly $70 to $80 oil "for the foreseeable future." What has changed his thinking are increased dangers in the Middle East, where so much of the world's oil is produced.

Political unrest

I agree with Ober that Congress may force meaningful troop reductions in Iraq by next year. But Iraq's problems will hardly vanish just because we scale back, or even end, our presence.

Not only could Iraq's oil production of 2 million barrels a day disappear, but other countries could also be at risk. Turkey, Iran and Saudi Arabia all have axes to grind with different factions in Iraq.

And Israel, impatient with U.S. inaction on Iran's nuclear bomb development, could precipitate a conflict with Iran, Ober says. The U.S. could easily be drawn in.

It's hard to bet against more trouble in the Middle East. "I'm fearful of the situation getting out of control," Ober says.

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Even if production capacity in that dangerous neighborhood is unaffected, Ober says, supply and demand will keep oil prices at $65 a barrel. But he's not willing to bet on peace breaking out. I couldn't agree more.

Venezuela's production is also falling, following the pullouts of ExxonMobil and ConocoPhillips from that country.

Absent a serious recession then, it's hard to see how oil prices decline much from here, Ober says.

A good value

For some time I've been recommending putting 5% of your stock money into a fund such as New Era. Energy already makes up 10% of Standard & Poor's 500-stock index and maybe 5% of the index is in other commodities. I don't think it's too much to have 20% of your stock money in this sector today.

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Despite a runup in prices, energy stocks remain reasonably valued. Energy stocks are, of course, cyclical. When the economy tanks -- and sometimes even when it doesn't -- these stocks crater. Nevertheless, I'm comforted somewhat by price-earnings ratios on the big oil companies that are in line or lower than that of the S&P 500.

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New Era has 67% of its assets in energy; the rest mainly in other commodities.

Over the past five years through August 27, New Era returned an annualized 25%. Of course, it hasn't been a steady ride. The fund plunged 15% between July 19 and August 16.

Commodities offer insulation against inflation, which is still a worry even though the U.S. economy appears to be slowing.

I'd avoid pure commodity funds -- those that directly invest in commodities through futures and other instruments. Yes, you get more diversification from owning commodities themselves. But if prices of oil and other raw materials flatten out, you probably won't make a dime in futures. Companies -- and their stocks -- can profit even with level or slightly declining commodity prices.

Energy stock picks

For stock investors, ExxonMobil (XOM) and Schlumberger (SLB) are blue chips that Ober still likes. Among the major oil companies, he also likes France's Total (TOT) and England's BP (BP).

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He also recommends energy service firms Baker Hughes (BHI) and BJ Services (BJS). Both fell recently on bad earnings reports, so these are only for patient investors.

Ober says he'd avoid pure alternative-energy stocks. He thinks their prices are too high. Huge conglomerates such as General Electric (GE), Siemens (SI) and Mitsubishi will play a huge role in this area, as will the major oil companies, which Ober says have gotten serious about alternative energy, particularly biofuels other than ethanol. The difficulty here is that they are far from pure plays on alternative energy.

Instead of overpriced alternative-energy stocks, Ober has bought Quanta Services (PWR) and InfraSource Services (IFS), which Quanta is acquiring. These are among a tiny handful of firms that build the high-voltage transmission lines required to bring alternative energy to where it's needed.

Conservation, as well as alternative energy, will be part of the solution to the energy problem and global warming, Ober says. But for conservation to work, Congress must put in place a clear set of regulations for industry to follow on capping and trading or taxing carbon emissions. As it is now, utilities, especially those that rely heavily on coal, are afraid to act for fear the rules will change. "They need a road map," Ober says.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.

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