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Energy Space Still Has Value

A trio of mutual fund portfolio managers discuss sector trends at Morningstar.

The rising cost of commodities is just one of the challenges posed to investors in the energy space, but there is still value in the sector, a Fidelity portfolio manager told attendees of Morningstar's mutual fund industry conference in Chicago.

John Dowd, portfolio manager of the


Fidelity Select Energy Service Portfolio (FSENX), was one of three fund managers to speak Thursday morning about what they see as the major trends in the commodity markets and how they structure their funds to capture returns.

"Whether it was aberrantly low price for the past 20 years, or whether it's a structural shift in demand in certain countries, every commodity has been going up," said Dowd. "The cost of building a refinery has doubled, the cost of building copper mines has increased and all have seen underlying inflation. Do I incorporate that into my equation? Yes. Do I want to pay for it? No. I want the companies that will prosper, but won't see the rising costs."

The Fidelity Select Energy Service Portfolio isn't a diversified natural resources fund, but has a broad mandate that allows it to invest in giant-cap integrated oil company stocks. Morningstar gives the fund four stars and calls it the least expensive fund in its category, with an expense ratio of 0.89%. Last year, the fund returned 14%. Through May this year, the fund surged 22%.

Dowd says his fund invests in the stocks of companies in the energy sector rather than the hard assets, because he finds he can buy the equities cheaper than the underlying reserves.

"The market doesn't put a high multiple on a lot of these stocks, valuing them at about 70%," says Dowd. "We're looking for companies that are cheap and good and the management is smart."

Dowd says the frequent mention of commodities in the headlines has led many to think the sector is in a bubble, but he says that's not the case and he continues to find bargains. He says he's bullish on crude oil because much of the increase in Chinese imports of oil has been masked by an almost equal number of exports from Russia. But if Russian supplies can't keep up, an increase in Chinese demand will push prices higher.

And supply is already constrained, says Dowd. Companies are reconsidering plans to build new oil refineries because of the huge jump in the cost of construction, from about $6 billion to $16 billion. On top of that, the Organization for Petroleum Exporting Countries, is under-producing.

"That provides a healthy backdrop to stocks when the underlying commodity price is going up," says Dowd.

Among the stocks the fund currently holds, Dowd especially likes



, the Houston-based technology provider to the oil industry, because it has a good management team. He says the company has developed a suite of tools that differentiates it from its peers and shows where the industry is going.

Dowd said his big holding in the refinery space is

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Valero Energy


, because it is still "very cheap."

National Oilwell Varco


, the Houston builder of oil rigs, also takes a prominent place in the fund's portfolio.

Blackrock Global Resources Fund

Dan Rice, the portfolio manager for the


Blackrock Global Resources Fund (SSGRX), says his team does more macro analysis than company analysis when building its portfolio. Blackrock looks at how solar power, energy and gas interact worldwide. It's a broad approach that looks out about three years, rather than just three months. Over the course of the year, the fund may see turnover of just 25%.

For 2006, the fund returned 5%, and for the year to date through May, the fund is up 18%. The fund has an expense ratio of 0.75% and Morningstar gives it three stars.

"If you look back over the last 10 years, when China became a net importer of crude oil, that changed the landscape for crude worldwide," says Rice. "And the same with coal. China is the biggest producer of coal. But they just became a net importer. That will affect everything, including oil."

He says this is a good time to buy commodities overall. Rice explained the commodity bull market has been going on since 1992. Over that time, nothing inherent in the market has disrupted it, only three exogenous events. These was the Asian crisis in 1997, which took out demand; 9/11, which cut the demand for jet fuel; and the freakishly warm weather last year. During these disruptions, the industry underperformed and inventories were built up. But over a 12- to 15-month period, Rice says the industry would self-correct and resume what it's been doing for the past 15 years.

"We are almost past the 12- to 15-month self-correction phase," says Rice. "And once that happens, the cloud lifts off the stocks and the sector does very well. The bottom line is, always have part of this as part of you portfolio, about 10% to 15%. The upward trend is still there, but you have to be longer-term oriented. It may underperform for 12 to 15 months, but don't time the market, just allocate a certain amount."

Rice likes

Consol Energy


, a Pittsburgh-based provider of services to the electric power generation industry, and

Massey Energy


, a Richmond, Va.-based producer and processor of coal. He said he just halved his holdings of



, the Houston provider of offshore contract drilling services, and its cross-town rival,

Diamond Offshore



Oppenheimer Commodity Strategy Total Return Fund


The Oppenheimer Commodity Strategy Total Return Fund (QRAAX) doesn't hold stocks, but buys structured notes linked to the Goldman Sachs Commodity Index. It also uses other derivatives, such as futures and options. The fund returned a negative 13% last year, and so far this year, as of May, it's up 3.4%. Morningstar gives it one star.

Fund manager Kevin Baum said every dollar in the fund is invested in commodity prices themselves. He says his fund offers investors a way to get direct exposure to commodities, which will provide a negative correlation to equities and bonds.

The fund holds a strategic allocation of commodities, but never any equities. Energy is the dominant commodity in the market, in the way it impacts the economy. The fund doesn't offer exposure to coal or solar power or a variety of other energy sources.