The rising tide in energy prices has lifted share prices across the sector, from the tiniest drillers to the largest integrated oil companies. Unfortunately, it has also made the water murkier for natural resource fund managers drilling for winners.

The average natural resources fund is up close to 50% over the past year, according to Morningstar, paralleling oil's climb into the low $60-a-barrel range. In other words, energy fund managers really didn't need to do much exploring to hit a gusher.

Now that the easy gains are behind them, energy fund managers looking to keep pace will be forced to be far more discerning in their stock-picking. Robert Shearer, portfolio manager for the $267 million

(MAGRX) - Get Report

Merrill Lynch Natural Resources fund, says oil services and natural gas issues are the best plays in this increasingly crowded field -- not necessarily the smaller stocks, which will be hit with higher expenses. This year, Shearer's fund is up 38.6%, while the

S&P 500

is up just 0.59%.

Shearer chatted with

TheStreet.com

about his search for the best energy stocks and the direction of oil prices.

I'll start out with the $64,000 question. Which way are oil prices headed?

Inventory has been adequate in the past, but there is so little spare capacity in the world now that I think the bias is to the upside rather than the downside. That will continue until OPEC or non-OPEC countries can bring on additional production of crude oil.

Where will that supply come from? The usual pumper of last resort has been Saudi Arabia, but rumor has it that the Saudis are running at full capacity due to the extra China business.

The Saudis are probably producing fairly close to capacity. They do have some spare capacity, but that additional supply is low quality or heavy crude, which does not refine into light product easily.

So if the Saudis are tight, where can we find that extra capacity?

There is no doubt that the industry is struggling with this problem. People in the oil industry are saying that we need access to new areas, which include the eastern Gulf of Mexico and western Africa, which has light crude. And companies like

Murphy Oil

(MUR) - Get Report

have discovered light crude in the deep waters off Malaysia. But all these projects take very long lead times to bring onstream.

Do we have enough rigs out there?

A lot of these deep water projects are now in the development phase, so rather than tying a rig up for a few months while they are exploring, the companies need a rig for a longer period of time to develop the field. Currently, we are bumping up against the capacity limit for rigs that can drill in deep waters. It's going to take several years given the tight shipyard capacity to construct new deepwater rigs.

In terms of stocks, who would that favor?

That would favor companies like

Transocean

(RIG) - Get Report

,

Noble

(NE) - Get Report

and

Global Santa Fe

(GSF)

.

We own all those companies. I'd say the best of the group is Noble, since they have the best ability to take hulls of rigs and upgrade them into deepwater drilling rigs for very low costs. They also have additional rigs that they can upgrade to deepwater capacity.

Are the drillers the best play? Or is it the refiners, oil services or integrated oils?

Exploration and production companies have the best leverage to increased oil and natural gas production. However, they are facing the rising cost of oil service activity. So right now we are looking at the service industry -- the drillers and companies that make equipment to put on the rigs, like

National Oilwell Varco

(NOV) - Get Report

, which makes much of the equipment that will be put on new rig construction.

OK. Let's talk about refining capacity. We keep hearing that the U.S. has serious capacity issues. How bad is it?

We are pretty much running full out, and the U.S. is actually importing much of its light product from Europe and the Far East when transportation allows. We had excess refining capacity after Asia had a recession in the late 1990s. Back then there was excess refining capacity where we could import product. But with growth in China, that excess capacity has been absorbed.

We are going to need new capacity, which may potentially arrive from Eastern Europe.

ConocoPhillips

(COP) - Get Report

and

Lukoil

are said to be building and upgrading refineries to move product to western markets. Since it is a global market, any new capacity would help.

Which do you prefer: the huge integrated oil companies like Conoco or smaller, more specialized oil providers?

As I alluded to previously, smaller companies might be hurt because they are bearing the full impact of rising service costs, whereas the integrated companies can see profits from both the upstream and the downstream refining area. In addition, much of the new petrochemical capacity was going to be built in the Middle East, but due to security concerns that capacity is coming on slower than predicted. So we might actually see a situation where all three legs of the stool are working for integrated oil companies.

How do you view Chevron (CVX) - Get Report shares now that the Unocal( UCL) battle is over?

Chevron and Unocal is an attractive combination. Unocal gives them an attractive asset base in Thailand and other Asian markets. Both Chevron and Unocal had been on the leading edge of some deepwater developments including the Trident field, which I believe is the deepest well discovered in the Gulf of Mexico.

Your fund's largest holding is EnCana (ECA) - Get Report. Is that a play on getting oil out of the sand now that the price is high enough to make it worthwhile?

EnCana has some oil sands operations in Foster Creek and Christina Lake, which are some of the better sites for that type of production. But we like them more for the natural gas production. They were early to see the potential in unconventional natural gas, so they acquired huge acreage for that type of play. They have the most attractive acreage and basins for gas production.

The fund started focusing on natural gas five years ago when we saw that rising drilling activity was not resulting in an increase in natural gas production. And that's still going on despite record high rig activity. We intend to continue to focus on natural gas since we think that will be a tight supply/demand situation.

Where are we in terms of natural gas supplies?

We have above-normal natural gas supplies right now due to last year's mild winter. But currently those supplies are being drawn down due to the shortage of coal at some utilities this summer. So utilities are being forced to burn natural gas instead of coal to maintain those supplies for the winter.

The real test for natural gas will be this winter. Most of the houses constructed during this multiyear housing boom are heated by natural gas. We'll have a real test if we get a normal winter this year. Then we'll see how much gas will be consumed by all these new houses.