Five Funds That Tap Energy's Potential

Earnings Strength: "Energy earnings have been phenomenal, as has [the sector's] positive earnings breadth," noted Merrill Lynch quantitative analysts Richard Bernstein and Lisa Kirschner in a Dec. 8 note. The analysts noted that third-quarter energy earnings rose 91% from the year-earlier period, best among all sectors; energy's 5% one-year return through Nov. 25 was the second-worst, according to the analysts. The earnings momentum is expected to continue in 2004.

Supply & Demand: One would be hard-pressed to find an industry that has a better supply-demand scenario than energy. On the supply side, crude-oil stocks are at their lowest levels since 1975. Meanwhile, supply growth from non-OPEC countries has slowed, which gives OPEC greater leverage in terms of controlling prices. On the demand side, the U.S. remains a steadily increasing energy customer, while China and other developing countries are becoming voracious hydrocarbon consumers. Vanguard Energy skipper Karl Bandtel, citing ExxonMobil's (XOM Quote) research, told the Houston Producers' Forum in November that oil demand is so strong that we will need to add 100 million barrels of oil equivalent a day -- "that requires $30 trillion to do so," said Bandtel, according to the Oil and Gas Investor Web site.

New Energy Initiatives: One of the hottest pockets of investing within the energy arena is liquefied natural gas, or LNG. LNG is natural gas cooled to minus-259 Fahrenheit degrees, which shrinks it to liquid form for easy transportation. The LNG is then regassified and fed into existing natural gas pipelines for distribution. Currently, the LNG makes up about 2% of gas use in the U.S., but experts project it will grow to 14% within a decade, and Europe is expected to push heavily into LNG as well.

"LNG imports to the U.S. doubled from last year, it's already starting to happen," said Robert Ineson, a director at Cambridge Energy Research Associates. Growth will be constrained between now and 2007 because of limited capacity, Ineson says, but companies are lining up to tap this growth opportunity. It isn't immediately clear who the big winners will be -- although shares of tiny LNG developer Cheniere Energy(LNG Quote) more than doubled in the three weeks since it announced a deal with ConocoPhillips(COP Quote) to develop an LNG terminal. Whether the big winners are the tiny outfits such as Cheniere or giants such as BG Group, LNG is a major net positive force for the sector over the next two decades.

Valuations: The energy sector of the S&P 500 sports a price-to-earnings multiple of 13.09, the lowest of all the sectors. Given the strong earnings environment, energy appears to be the one sector heading into 2004 as undeniably cheap.

The Antitech Diversifier: Energy stocks have a low correlation with the broader market in general, and in particular with the tech sector, which was quite frothy in 2003. For investors looking to hedge their bets and diversify away from some of 2003's highfliers, energy looks like a smart bet.