Energizing Your Portfolio

Higher prices at the pump got you down? Stressed out by steeper home heating oil and natural gas bills?

Well, don't call Ivy Funds Portfolio Manager Frederick Sturm to cheer you up. He'll just tell you that oil is "reasonably priced" even at today's prices, which recently touched a 13-year high of $38 a barrel.

Sturm manages the $270 million Ivy Global Natural Resources Fund (IGNVX), and by his math, the 40-year average price for a barrel of oil is $34.75 after adjusting for inflation, right in line with current market levels.

But Sturm says Americans don't need to look further than their driveways to realize that oil is properly priced.

"The simple gut check is to watch demand for cars. If oil was truly expensive, then SUVs would be traded in for today's Ford Pintos," says Sturm.

Sturm makes a strong point, but asking soccer moms to save money by swapping their SUVs for more fuel-efficient, smaller vehicles might stir up a revolution in some U.S. suburbs.

So, instead of trying to cut their energy bills, Americans might look to the other side of the personal accounting ledger to benefit from the rising price of energy: investing in energy stock funds.

The Search for Gushing Returns
Energy funds
Name/Ticker YTD (%) 3 Year (%) 5 Year (%) Top Holding Expense Ratio (%)
Fidelity Select Energy (FSENX) 3.95 1.89 10.44 British Petroleum (BP) 1.21
ICON Energy (ICENX) 5.49 9.43 25.27 Ultra Petroleum (UPL) 1.35
Ivy Global Natural Resources (IGNVX) 3.87 20.91 - Western Oil Sands(WTO)* 1.82
ProFunds Ultra Energy (ENPIX) 4.15 -3.9 - ExxonMobil (XOM) 1.95
Rydex Energy (RYEIX) 3.48 1.73 6.04 ExxonMobil (XOM) 1.39
Rydex Energy Services (RYVIX) 7.29 -9.93 4.61 Schlumberger (SLB) 1.39
State Street Global Resources (SGLSX) 5.1 21.13 30.95 Western Gas Resources (WGR) 1.30
UMB Scout Energy (UMBEX) 4.55 5.46 6.15 ExxonMobil (XOM) 0.85
Vanguard Energy (VGENX) 4.91 11.81 16.49 British Petroleum (BP) 0.40
Source: Morningstar (YTD as of 3/23) * Toronto Exchange

Low-Energy Energy Funds

Adrian Bachman, a portfolio manager at the Rydex Funds group, says the recent spike in oil prices has also piqued interest in his firm's two energy funds: Rydex Energy Fund (RYEIX) and Rydex Energy Services Fund (RYVIX).

Rydex specializes in sector funds that use widely recognized benchmarks as blueprints for its holdings. The Rydex Energy fund attempts to mirror the S&P 1500 Energy index, while the Rydex Energy Services Fund follows the S&P 1500 Oil and Gas Equipment Services index.

Rydex sector funds carry an expense ratio of 1.39 (see chart), which might seem high for what is essentially an index fund. But Rydex allows investors to trade in and out of its sector funds on a daily basis, something frowned upon as "market-timing" in other funds that like to protect long-term investors from short-term traders. Vanguard, by comparison, charges 0.4% for its actively managed Vanguard Energy Fund (VGENX), but tries to fend off market-timers with a 1% redemption fee for investors who sell the fund within a year of purchase.

Another energy sector fund, the ProFunds Ultra Energy Fund (ENPIX) has a similar design but a different benchmark, the Dow Jones U.S. Energy Sector index. This fund uses leverage to seek results that correspond to 150% of the daily performance of its benchmark. The fund's use of options to magnify its performance might also account for its higher-than-average expense ratio of 1.95%.

Bachman suggests that investors looking to benefit from higher energy prices veer toward funds dominated by integrated oil producers as opposed to other groups such as energy services or drilling companies.

"The integrated oil and gas producers have a much higher correlation between their stock price and the price of oil than the equipment services companies," says Bachman. "They are providing a finished product and can increase margins more easily."

In Rydex's case, that would mean opting for the Rydex Energy Fund, which holds names such as ExxonMobil ( XOM) and ChevronTexaco ( CVX), instead of the firm's Energy Services fund, which contains names such as Schlumberger ( SLB) and Halliburton ( HAL).

Drilling Down the Oil Sector

Not all fund families offer the same wide-ranging menus as Rydex when it comes to subsectors. And investing directly in a subsector fund like energy services is a risky strategy, coming as close to single-stock-picking as you are going to get.

Most fund managers, like J.C. Waller of the ICON Energy Fund (ICENX), allocate their funds across the five energy sector classifications: exploration and production; oil and gas equipment services; integrated oil and gas; refining, marketing and transportation; and oil and gas drilling.

For the ICON Energy Fund, which is up 5.49% this year (see chart), Waller sees the greatest value in the exploration and production category and has allocated 26% of his portfolio for companies like Ultra Petroleum ( UPL), the fund's largest holding. Waller says his valuation method -- a technique he calls a "modified Benjamin Graham style" of value investing -- shows that E&P stocks are undervalued in the marketplace.

Waller also likes the marketers and refiners subsector, in which he has a 16% weighting. Two of his favorite names there are Ashland ( ASH), which he sees as 10% undervalued, and Teekay Shipping ( TK), which he says is 33% undervalued.

Whether you agree with Waller's method for valuing energy stocks, there is undeniable chatter in the market about energy stocks being "overvalued." Nevertheless, Daniel Rice, portfolio manager for the $503 billion dollar State Street Global Resources Fund (SGLSX), does not see a valuation problem.

"I think if they market analysts are only discounting a $22 barrel crude price -- and we believe crude prices will be significantly higher than that -- then energy stocks are undervalued on a long-term basis," said Rice in an extended interview with TheStreet.com .(See related story.)

Rice is careful to warn investors that these are long-term projections and not ones simply based on spiraling prices at the local gas station. Rice says that although energy stocks typically do better when high oil prices start making headlines, there is not a direct correlation between today's commodity and equity prices, since "the stock market is a discounting animal and tries to guess where prices are going to be six months down the road."

Brian Cashman, portfolio manager at the UMB Scout Energy Fund ( UMBEX), echoes Rice, saying "high gas prices at the pump translate into higher prices for oil stocks for all the wrong reasons. Any pricing benefits are not realized until much later."

The China and Canada Syndromes

Ivy Fund's Sturm says another popular misconception among investors is that there is a growing supply problem because of increased demand for energy in China.

"There is no lack of energy. It just can't be produced for less than $10 a barrel anymore. The stuff that is easy to find and cheap to get has already been gotten," says Sturm.

Sturm says the increase in oil prices allows companies such as Western Oil Sands (WTO:Toronto) to increase exploration and production, because higher prices enable them to offset higher production costs. And Western Oil Sands -- Sturm's largest holding -- has much higher-than-average production costs because of its singular method of oil production: separating oil mixed with sand located in deposits across Canada.

"Canada has the world's second-largest oil reserve, second only to Saudi Arabia," says Sturm, whose fund is up 3.87% year to date. "But it's in oil sands. Oil mixed with sand. So when prices go up, it's finally cost-effective to produce oil this way."

Both Sturm and UMB's Cashman overweight refining stocks in their respective funds because of the high barriers to entry as well as the cheap valuations. Both pick Valero Energy ( VLO) as their top refining stock choice. Sturm calls the company "cheap at 10 times earnings." With no new refineries built in the U.S. since the 1970s, both fund managers believe Valero's position as the second-largest refiner in the U.S. will enable the company to increase margins for its product.

Then again, you could always buy a Ford Pinto.

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