Melissa Davis

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Buckling Up to Ride the Oil Roller Coaster

Melissa Davis

Investors are mining the energy sector like old-fashioned wildcatters.

They know there's money to be made, what with the war looming in Iraq and potential production shortages driving prices skyward. Still, most people have been stymied trying to figure out where the next big gusher will be.

Indeed, they've hit some big dry holes. Stock prices for the three oil majors have languished this year, despite soaring energy prices and rising company profits. And while most analysts continue to view these companies as great long-term prospects, hungry investors are looking for ways to hit pay dirt now.

Industry experts caution that with prices where they are, there's no shortage of risk in chasing the energy sector right now. But after examining the possibilities -- ranging from volatile energy futures to stable royalty trusts to obscure niche players -- observers settled on a few pointers for treasure-hunting investors.

Decent Exposure

There's only one real way for investors to fully exploit $40 oil and $8 natural gas: fully expose themselves to the risks -- and rewards -- of volatile energy prices.

"One of my clients is an oil trader," says David Edwards, president of Heron Capital Management and a contributor to RealMoney.com. "If the prices are volatile, he just hauls it in."

Edwards himself doesn't trade energy futures -- and doesn't necessarily recommend that others do it, either. But for retail investors who can stomach the risk, the New York Mercantile Exchange offers just the vehicle for betting on energy prices. The exchange, which caters primarily to professional energy traders, began reaching out to retail investors last June by offering mini futures contracts. But so far, the contracts have yet to catch on.

"We do a little better with the crude oil contracts than the natural gas ... because the oil markets are more visible," said NYMEX spokeswoman Nachamah Jacobovits. "But the volatility makes [both] somewhat challenging."

Even investment experts shy away from energy futures. Some of them believe investors could profit handsomely by shorting near-term contracts that look expensive, and snatching up long-term contracts that look too cheap. But they generally view energy futures as too risky for both their clients and themselves. That might be especially true in the current scenario, which seems even more unstable than usual on account of rising tension surrounding Iraq.

So the experts tend to recommend open-end commodity funds -- rather than specific futures contracts -- to those who insist on heavy exposure to volatile energy prices.

The Real Asset Fund, launched six years ago by Oppenheimer, is the oldest and best-known of the bunch. Although it includes other commodities, such as precious metals and livestock, the Real Asset Fund is currently dominated by energy futures.

Fueled by soaring energy prices, the fund has rocketed 21% in what has so far been a down stock market year. But even Oppenheimer cautions against putting too many eggs in this tricky basket.

"We pretty much advocate that investors can benefit from a 5% exposure to commodities," says Oppenheimer spokesman Gregg Stitt. "This was never meant to be a full portfolio."

Jeffrey Saut, chief investment strategist at Raymond James, says that commodity funds are "probably the way to go" for retail investors seeking high exposure to volatile energy prices. But most investment experts, Saut included, see better ways to capitalize on the current energy environment.

Royal Flush

Low-key royalty trusts -- passed over for years by growth-hungry investors -- are getting a second look these days.

Energy experts now view this quiet group of companies as an attractive vehicle for investors looking to profit from high energy prices with little downside risk. The companies basically own mineral rights that generate cash from energy discoveries made by outside producers.

A hike in energy prices often leads to a hike in energy production, both of which benefit companies in this group.

"It's an interesting way to play" the current energy market, said Les Childress, an analyst at the independent research house J.M. Dutton.

Childress is particularly fond of Panhandle Royalty (PANRA), a small Oklahoma company with an "enviable track record" for delivering strong dividends and financial results to investors. Childress believes that Panhandle, which is heavily leveraged to natural gas reserves in its home state, has positioned itself to profit handsomely from the surge in energy prices.

Childress triggered a 20% jump in the stock when he strongly recommended it in December. The stock, up 28 cents to $18.27 on Monday, continues to handily outperform the broader market with its 20% gain this year.

Veteran energy analyst Kurt Wulff is touting his own "discovery" in this sector. He has zeroed in on the San Juan Basin Royalty Trust (SJT), which set a new 52-week high during last week's spike in natural gas prices. Since Wulff first recommended San Juan in late 2001, the company's stock has surged 50% to $15 -- and promises to soar higher as quarterly profits grow.

Wulff, who owns the stock himself, favors royalty trusts over master limited partnerships, which are similar in nature. Both types of companies distribute all their free cash flow to investors. But royalty trusts like San Juan pay out no hefty management or financing fees before they do so.

In general, Wulff also tends to prefer Canadian energy companies over their American counterparts. He singles out EnCana (ECA) as a particularly strong prospect.

"EnCana has had a remarkable record of new discoveries in just the past two years -- even in the U.S.," said Wulff, who personally invests in the stocks he recommends. "They had a big discovery in Wyoming, right under the noses of the U.S. companies. And they've discovered the biggest oil field in the North Sea in the last 10 years."

The stock, which dipped 52 cents Monday to $32.31 a share, is roughly $1 shy of the 52-week high it set last month.

Bob Howard, publisher of the investment newsletter Positive Patterns, is also extremely bullish on Canadian energy stocks. In addition to Encana, Howard strongly recommends Imperial Oil (IMO) and TransCanada Pipeline (TRP).

"Take your pick," said Howard, who has no vested interest in the companies he covers. "Canadian [energy] stocks have outperformed U.S. energy stocks handily in the last few years.

"To me, it's one of the few really cheap asset bargain areas around."

Howard believes that Canadian companies benefit from deeper reserves, fewer drilling restrictions and cheaper currency than their American peers. But he's pretty excited about some energy companies stateside, too.

Like most industry experts, Howard is directing investors to hunt for winners among the energy majors -- the same place where they've struck it rich before.

The Usual Suspects

Meanwhile, most investment advisers warn against longshot gambles in the sector.

Yes, big oilfield firefighters like Superior Energy (SPN) and RPC (RES) -- and even near-bankrupt Boots & Coots -- could heat up if Saddam Hussein starts blowing up his oil wells in a war with the U.S. But that's a big "if."

Experts instead recommend more traditional sectors. Saut favors drillers, which also would benefit from oil well blowups but don't need them in order to succeed. And Edwards is big on oil services companies, Baker Hughes (BHI) in particular.

Edwards says the big oil services firms, which also include Halliburton (HAL) and Schlumburger (SLB), will stay busy no matter how an Iraqi conflict pans out. If the war goes well, as most expect, the companies are looking at lucrative contracts to rebuild Iraq's dilapidated infrastructure. And if the war goes badly, Edwards says, the companies will enjoy increased business from customers chasing after the high energy prices that result.

Edwards likes Baker Hughes best because it's unburdened by the asbestos taint of Halliburton or the financial problems of Schlumberger.

"It has no radiation hanging over it," said Edwards, whose firm owns stock in the company.

Still, the clear favorites of most energy analysts are the biggest names in the sector -- companies such as BP (BP ADR), ExxonMobil (XOM) and Royal Dutch/Shell (RD), all of which boast pristine balance sheets and more profits than they can reasonably spend. The share prices of all three majors have been punished by investors betting on a fall in energy prices. But experts believe the stocks will recover -- as they always do -- with the overall economy.

In the meantime, they recommend parking money in the majors for their dividends alone. All three of the big oil giants pay dividends that fly past those offered by S&P companies in general.

"Everybody has been trying to come up with ways to play the price of higher oil, and the stocks just haven't cooperated," said Dan Gillespie, manager of the energy fund at Rydex. "If I were an individual investor, I'd be looking at this dividend yield as a good play."

Fadel Gheit, an energy analyst at Fahnstock, agrees. He believes the big three -- in addition to ChevronTexaco (CVX) -- represent solid, long-term investments. And he urges investors to take their eyes off of rocketing energy prices so they can see the values before them.

"It's like driving down the highway," said Gheit, who owns stock in all the majors. "You don't put your nose in the dashboard if you want to see what's coming ahead."