Energy Stocks for Three Different Time Frames

In a column last week I wrote that "figuring out what stocks to buy for this kind of vicious long-term dollar/energy cycle is actually pretty easy." I still stick by those words, but for the record, I'd add, "It's when to buy them that's likely to drive investors crazy."

So in this column, I'll begin by giving you a way to figure out when to make your investments in energy shares so that you don't either buy high and sell low, buy too early and grow old waiting for your investment to pay off, or buy too late and risk being the greater fool.

And I'll end with a list of what to buy as well: 10 energy stocks for the short-, intermediate- and long-term periods.

Break Down the Trend

First, start by breaking down the trend of rising oil prices and the falling dollar into three time frames.

In the short term, there's the truly scary volatility of oil prices. The January futures contract for light sweet crude is trading near $41 a barrel. That's more than 30% off October's high. We're talking about a 30%-plus move in two months.

In the intermediate term -- say five years -- there's the very tricky transition as the market stumbles around searching for alternatives to high-priced oil and gas. The mix will include contributions from coal, ethanol, wind, nuclear, other sources and conservation -- as well as continued reliance on high-priced oil and gas. But the profitability of investing in any one of these will hinge on how quickly the market moves to find substitutes for oil and gas and how big the move is toward any particular substitute.

In the long term -- say one to two decades -- we can list the technologies that are likely to be part of the energy fix. But it's devilishly hard to point to specific products and predict their relative market share, or even to ballpark the point at which any of these products will hit the sweet spot in the growth curve. And given what we don't know about global supplies of oil and gas, putting a price on energy stocks in this time frame takes on even more uncertainty.

Of course, while all of this is happening in the energy marketplace, the dollar will be dancing its own jig. At times, the U.S. currency seems headed for the dustbin of history. But that very pessimism is likely to produce short-but-significant rallies in the dollar.

Strategize by Time Frame

The next step is to develop a stock-picking strategy for each time period.

In the short term, for example, recognize that although the prices of energy stocks are trending upward, the short-term volatility in oil and gas prices will spill over into the price of energy-company shares. Your choices:

  • Ignore this volatility and stick to the long-term trend;
  • Buy on the dip to add to existing positions in the sector; or
  • Trade in (on the dip) and trade out (on the peak).

Combining the first and third strategies above will work best for most investors. Not all energy stocks react with the same volatility to changes in oil prices. As a general rule, the bigger the energy company, the less volatile its stock is to swings in the price of oil.

Holding a big-cap energy stock such as ExxonMobil ( XOM) or BP ( BP) through these kinds of short-term dips and dives makes sense. The volatility isn't enough to make active trading profitable or necessary.

Short-Term Volatility Can Aid Smaller U.S. Stocks

If you want to try to use short-term volatility to increase your energy-sector returns, I'd go with smaller U.S. companies. This makes sense particularly if you believe, as I happen to, that the market is overestimating the risk in these stocks.

The ups and downs of the Organization of Petroleum Exporting Countries' production plans and price bands aren't nearly as important to these U.S.-based oil companies as the spread between the price they get for their more easily refined light sweet grades of crude and what the Saudis and the Venezuelans get for their more difficult-to-refine, heavy sour crude.

The much-quoted OPEC target price is really a price for a basket of the grades of crude that OPEC sells. Most of this oil tends toward the heavier and sourer side of the crude spectrum, and it sells at a lower price than West Texas Intermediate, the benchmark lighter grade of crude that is traded. The difference has been huge lately, rising to as much as $15 a barrel between West Texas crude and some grades of Saudi crude, and about $8 a barrel between West Texas crude and the OPEC basket of crude.

Right now, the market fears a reduction of this premium for West Texas and similar sweet grades of crude. That would cause a huge reduction in the income of these small domestic producers.

But I think the market has got it wrong. The extra oil now flowing from Saudi Arabia and the rest of OPEC isn't a replacement for these lighter, sweeter domestic grades. And the heavier OPEC grades still run up against the same problem: There isn't enough refinery capacity to handle the heavier grades.

If you look out a few months, greater flows from OPEC will not do much to reduce the premium for lighter grades of crude, although extra refinery capacity that might begin to come on line in late 2005 could. After a period of weakness, the shares of smaller producers will rebound strongly, especially when OPEC begins its attempt to cut production in 2005.

In the short term, my list of stocks to buy would include BP and ExxonMobil among the majors, and Swift Energy ( SFY), St. Mary Land & Exploration ( SM) and Penn Virginia ( PVA).

Coal Fuels My Intermediate-Term Strategy

A brief version of my intermediate-term analysis would go like this: It's hard to tell what alternatives to high-priced oil will prosper as investments over the next five years with one exception: coal. All of the others depend on favorable government regulations, subsidies and tax breaks for growth in the near term.

It's hard to tell when, or indeed if, technologies such as ethanol or nuclear power or wind will make the turn to standalone growth. Also clouding the picture is the dearth of pure plays in most of these technologies. For example, General Electric ( GE) is a sure leader in any nuclear renaissance, but the revenue from that business will be a relatively small part of total revenue for the company.

The price of coal lives under an umbrella provided by the rising price of oil: As oil prices go up, the use and price of coal goes up. And because the U.S. has huge domestic supplies of coal, this part of the energy sector doesn't face the threat of supply disruption from terrorist activities that oil does. Finally, because coal is produced domestically and costs are denominated in dollars, a weaker dollar won't drive up domestic prices for coal, and it will make U.S.-mined coal even more competitive in international energy markets.

Stocks to buy in the intermediate term include Penn Virginia, which produces coal and oil, Peabody Energy ( BTU), Natural Resource Partners ( NRP), Alliance Resource Partners ( ARLP) and Fording Canadian Coal Trust ( FDG).

With the exception of Penn Virginia and Peabody Energy, all of these carry yields of 3.9% or better. In the intermediate term, the 4.5% yield of Fording Canadian Coal Trust is especially attractive to U.S. investors because the Canadian dollar is likely to keep appreciating vs. the greenback.

Long-Term, Think Like a Venture Capitalist

And in the long term?

The uncertainties inherent in predicting what technologies will turn into real products 10 years out begs for something like a venture-capital portfolio strategy for this time period. In other words, try to get in early when the stock of any potential winner is cheap and buy a basket of the most promising companies you can in hopes that a couple of big wins will pay off and offset your losers.

I can think of two ways to do this: You can buy shares of BP, which is the major oil and gas company furthest along in its own transition into an energy company instead of a petroleum producer. Otherwise, you can buy shares of Harris & Harris ( TINY), a venture capital pool that specializes in nanotechnology companies.

With BP, you'll get exposure to coming technologies such as wind and solar, with a guarantee that the petroleum portfolio at BP means you won't lose your investment. But you won't make a killing, either.

Harris & Harris is at the other end of the risk spectrum. If some of its very early-stage investments pay off, you could be looking at returns like those from Internet pioneers. On the other hand, the whole portfolio could go belly up.

I think Harris & Harris is a reasonable bet because the rising price of oil -- and the inherent difficulty in getting people to change habits or pay for new infrastructure -- means technologies like nanotechnology that can produce radically lighter materials for use in energy-gobbling products such as cars and airplanes are a likely winner in the search to make high-priced energy go further.

Finally, Look for Overlaps

To complete this strategy, put the three lists from the three different time periods together and look for overlaps, places where buying one stock gives you a potential winner in different time periods. That's a good way to make sure you're not buying something at a peak that won't pay off if you hold it for a few years, or that you're not buying a stock that won't go anywhere until years after you've lost patience and sold it.

Overlap stocks in this list include BP (short term and long term) and Penn Virginia (short term and intermediate term). You'll find different overlap stocks because, I assume, you'll put different stocks on your lists of short-, mid- and long-term candidates.

I'm going to add Penn Virginia to Jubak's Picks with this column.

Changes to Jubak's Picks

Buy Penn Virginia. Penn Virginia hasn't had a great 2004. Most of the company's reserves of oil and gas lie along the Gulf Coast and in the eastern U.S. Thanks to a long hurricane season, this hasn't been a great year for Gulf Coast oil production. Some pipeline problems in the East hurt as well. Third-quarter production was up only slightly from 2003.

Still, total revenue still climbed 22% in the year's first nine months, and the company expects production to pick up in the fourth quarter and into 2005. With Penn Virginia, investors also get major coal exposure because the company owns Penn Virginia Resource GP, which serves as the general partner in Penn Virginia Resource Partners, a limited partnership that owns the coal assets spun off by Penn Virginia in 2001. Penn Virginia's coal royalties grew 47% in the third quarter from a year earlier. Wall Street expects earnings per share to grow 40% in 2004 and 17% in 2005. As of Dec. 13, I'm setting a target price of $48 a share by June 2005. (Full disclosure: I will buy shares in Penn Virginia on Dec. 17.)

At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jubak at jjmail@microsoft.com.

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