Five Funds That Tap Energy's Potential

It's high time to give your portfolio an energy boost.

A large contingent of the smart-money set is concluding that the energy sector, after years of neglect, deserves an overweighting in 2004 -- for several reasons. First, energy demand continues to rise while supply remains tight. Second, energy companies' earnings growth has been among the most impressive of all sectors and looks poised to continue in 2004. Third, the energy sector has tightened and (pardon the expression) refined its operations in the painful past two decades after the energy bubble burst, taking the sector from a 40% weighting in the S&P 500 to about 8% today. Last, energy stocks on average are dirt cheap compared with other sectors -- in part because the stocks don't reflect the higher oil prices that the market continues to discount.

"One of the big surprises for 2004 is that oil and natural gas prices are going to average much higher than anyone expects," said Leigh Goehring, co-manager of the Jennison Natural Resources fund.

After lagging frothy tech stocks and the broader market for most of 2003, Wall Street has recently cottoned to energy stocks -- the sector's 13.8% return for December was tops among S&P 500 sectors -- and energy's bull run appears far from extinguished. Individual investors looking to tap the sector's strength have plenty of solid options, including a handful of top-shelf energy and natural resources funds as well as some low-cost exchange-traded funds. Today's column offers five offerings worthy of consideration.

But first, let's briefly examine why the sector looks poised to boom in 2004 and beyond.

Oil Prices: Oil prices have remained above $30 a barrel since before the war in Iraq, and energy watchers are growing increasingly convinced that prices won't slide to the $18 to $25 range anytime soon. The Department of Energy's Energy Information Administration projects average oil prices of $28 to $30 a barrel for 2004. Boston-based energy research firm Cambridge Energy Research Associates expects oil prices in the high-$20s for the year. However, "major oil stocks have not been reflecting $25 oil," said Charles Ober, manager of the T. Rowe Price New Era fund, in his recent outlook.

Jennison's Goehring expects oil prices in 2004 will average over $30 a barrel because OPEC should have the ability to retain pricing power, thanks to a slowdown in the growth of oil supply from non-OPEC nations. The skipper, whose fund has averaged a 22% annual return over the past five years, said 2004 may be the year the gap between the perception and the reality about oil prices closes. If the perception is $18 to $25 a barrel and Goehring is right that the reality will remain around $30 a barrel or higher, "anything energy-related is going to be a superb performer in 2004."

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) 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) more than doubled in the three weeks since it announced a deal with ConocoPhillips ( COP) 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.

For those who buy the case that energy is a smart place to overweight in 2004, here are five ways to play the sector. One final caveat: Sector fund bets are best in smaller doses. A 5% to 10% allocation should suffice for more aggressive investors who feel comfortable making a sizable sector bet.

1. Vanguard Energy

The $2.1 billion ( VGENX) Vanguard Energy fund, managed by Karl Mandtel of subadviser Wellington Management, is a great way to tap energy's potential. Returns have been impressive over the short and long haul -- 11.01%-a-year average over three years, 12.43% a year over the 10 years -- besting three-quarters of its peers, according to Morningstar. Meanwhile, the actively managed fund is dirt cheap -- the 0.4% expense ratio is actually cheaper than some of the exchange-traded funds in the energy sector. Mandtel, who replaced longtime colleague Ernst von Metzsch at the helm in December 2002, focuses almost exclusively on energy stocks and applies a contrarian bent in hunting for out-of-favor stocks. ExxonMobil, BP ( BP), Total SA ( TOT) and other giant global diversified oil companies turn up prominently in the portfolio.

2. Jennison Natural Resources

( PNRZX) Jennison Natural Resources isn't a pure energy fund. Skippers Leigh Goehring and Mark DeFranco dip into many natural resources pools -- metals, agriculture, forest products and, yes, energy, which the managers like enough currently to have the sector make up roughly two-thirds of the portfolio. While the $145 million fund's expense ratio of 1.39% is considerably higher than the Vanguard fund, it remains well below the 1.92% category average, according to Morningstar. Returns have been strong: The three-year average annual return of 16.57% ranks it in the top 20% of its class. Among the fund's biggest holdings are energy-services providers such as BJ Services ( BJS) and Smith International ( SII).

3. T. Rowe Price New Era Fund

The ( PRNEX) T. Rowe Price New Era fund, with $1 billion in assets under management and managed by Charles Ober since 1997, is also a natural resources fund -- energy constitutes about 60% of the portfolio these days. Ober and his staff look for undervalued stocks that they can buy and hold; the 11% turnover helps keep the expense ratio to a trim 0.72% a year. The fund's conservative approach to the sector has meant it trails some of its peers during the heady bull runs, but it has helped keep losses in check during the rough stretches -- Ober's worst year at the helm was a 9.9% loss in 1998. Schlumberger ( SLB) and ExxonMobil turn up among the big holdings at the T. Rowe fund.

4. Energy Select Sector SPDR

The cheapest, purest and potentially most volatile way to tap the energy sector is through this exchange-traded fund, which is a basket of the 23 energy stocks in the S&P 500. As one might expect, the names that turn up are the well-established multinationals such as ExxonMobil, ChevronTexaco ( CVX) and ConocoPhillips, which combined make up 40% of the ETF, making it a top-heavy offering. On the plus side, the fund sports an expense ratio of 0.27%. But if you want a straight market capitalization-weighted exposure to the sector and don't feel you need the expertise of an active manager (which comes at a higher price tag), this SPDR (called "Spiders") is worth a look.

5. iShares S&P Global Energy Sector Index Fund

This exchange-traded fund sports an expense ratio of 0.65%, more then double the previous option. Why consider it above the Energy Select Sector SPDR? Unlike the U.S.-only SPDR, this ETF does offer global diversification.

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