Energy Mutual Funds Power Up

Energy mutual funds have trailed the S&P 500 this year. With oil stocks trading at bargain prices and spot commodity prices rising, funds could get a push.
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NEW YORK (TheStreet) -- Investors have been cool toward energy stocks. During the first quarter, the average energy mutual fund gained 0.5%, trailing the S&P 500 by 5 percentage points, according to Morningstar.

Analysts cite a variety of reasons for the lack of interest. Investors worry that the big integrated oil companies have become sluggish giants, unable to find new reserves. In addition, natural gas and coal companies seem to be plagued by excess supplies.

But some fund managers argue that energy stocks have gotten too cheap, especially after oil prices surged to a 17-month high yesterday on a brighter outlook for the U.S. economy.

Chevron

(CVX) - Get Report

sells for eight times this year's earnings estimates, a modest price at a time when the S&P 500 has a multiple of 15. Other blue chips with single-digit multiples include

Exxon Mobil

(XOM) - Get Report

and

ConocoPhillips

(COP) - Get Report

.

"The integrated companies sell at significant discounts to the S&P 500," says Tom Nelson, an analyst with

Guinness Atkinson Global Energy Fund

(GAGEX) - Get Report

. "Over the years, there have been extended periods when energy stocks traded at a premium."

To bet on a revival of the sector, consider an energy fund. If oil prices climb this year, as some analysts expect, the funds could outdo the S&P 500 by a wide margin. In addition, an energy fund can help to diversify a portfolio, since the industry sometimes rises when most other stocks are falling.

Keep in mind that energy funds follow a variety of strategies. Some funds focus on blue chips, while other managers emphasize smaller companies that promise to deliver higher returns -- and more risk.

An aggressive choice is

BlackRock Energy & Resources

(SSGRX) - Get Report

, which has returned 10% annually during the past five years, outperforming 70% of competitors and topping the S&P 500 by 8 percentage points. Managers Dan Rice and Denis Walsh favor smaller companies. When they spot an energy subsector that's undervalued, they overweight the bargains.

The fund currently has a big weighting in coal stocks. Holdings include

Massey Energy

(MEE)

and

Peabody Energy

(BTU) - Get Report

. Those stocks have fallen out of favor because demand for coal is flat in the U.S. Environmental concerns could hamper coal sales for years. But Rice says coal prices are bound to climb because of increasing demand in developing countries. He says China and India alone will need to import 70 million tons of coal in the next year.

To satisfy their needs, the Asian countries will have to buy U.S. coal. "Inventories in the U.S. will get to critically low levels next year, and that will send prices up," Rice says.

To hold a mix of big integrated oil stocks and smaller exploration companies, consider Guinness Atkinson Global Energy, which has returned 12.4% annually during the past five years, beating 99% of competitors. Integrated oil companies in the fund's portfolio include Chevron and ConocoPhillips.

Guinness Atkinson's Nelson says oil shares are depressed because investors believe integrated companies aren't finding enough new reserves to replace old production. That is a recipe for slow growth. But Nelson says the top companies are enormously profitable, and they're using some of their spare cash to buy back shares.

As the number of shares is reduced, the amount of oil reserves per share increases. "Total production is growing slowly, but the production per share is growing quite quickly," Nelson says.

For a fund that taps into faster-growing companies, consider

Waddell & Reed Energy

(WEGAX)

, which has returned 3.4% annually during the past three years, exceeding 79% of competitors. Manager David Ginther owns a few integrated companies, but he favors exploration and service stocks that can show long-term growth.

Ginther says that when oil prices dropped below $40 a barrel late in 2008, exploration activity slowed. But now that prices are back above $80, exploration is increasing. The growth should continue as global demand for energy rises in coming years.

Ginther is particularly keen on service companies, which provide software and equipment that integrated companies use to produce oil. A holding is

Schlumberger

(SLB) - Get Report

, the largest oil-service company.

"They invest heavily in research, and that will enable them to increase their market share in the Middle East and other areas," Ginther says.

Another oil-service holding is

Halliburton

(HAL) - Get Report

. The company has a strong position in North America.

Cautious investors may prefer

Franklin Natural Resources

(FRNRX) - Get Report

, which has returned 10.3% annually during the past five years. The fund keeps about two thirds of its assets in blue chips with the rest in smaller companies with growth potential.

A mid-cap holding is

FMC Technologies

(FTI) - Get Report

, which is developing equipment for deep-water drilling. Another holding with growth potential is

Noble Energy

(NBL) - Get Report

, an exploration and production company that has achieved large discoveries in deep water. The company has been producing natural gas off the coast of Israel, a country that has long faced problems obtaining energy. "This is a major growth market because Israel needs energy security," manager Fred Fromm says.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.