Betting on the Energy Boom With Mutual Funds

NEW YORK ( TheStreet ) -- News reports have hailed a shale energy boom. Industry analysts predict that the U.S. can achieve energy independence in the next decade. But so far, the optimism has not translated into outsized gains for investors.

During the past five years, energy funds lost 7.0% annually, compared to a gain of 6.9% for the S&P 500, according to Morningstar. Weakening oil prices and sluggish global demand have held back the stocks.

Now some fund managers argue that the shares have become undervalued. William Riley, co-manager of Guinness Atkinson Global Energy ( GAGEX), says that energy stocks have sometimes sold at a premium to the overall market. But in recent years, the sector has traded at a discount.

A basket of major oil and gas companies that Riley tracks has a price-to-earnings ratio of 10.9, vs. 16.0 for the S&P 500. The discount is wide because many investors expect oil prices to sink. "We think the size of the discount is unwarranted," Riley says. "In the emerging markets, demand for energy is pretty robust."

To bet on a revival in the sector, consider a solid-performing energy fund. Sound choices include Fidelity Select Energy ( FSENX), Guinness Atkinson Global Energy, and Ivy Energy ( IEYAX). During the past five years, all three funds outdid their average peers.

William Riley of Guinness Atkinson Global Energy favors natural gas producers. He says that the outlook for gas prices is improving. In recent years, prices sank as shale production increased and excess supplies plagued the markets.

During the past year, companies have started reacting to market forces, reducing the number of rigs that are producing gas. At the same time that supplies have been falling, demand has grown as some big users switched from high-cost coal to cheaper gas. Gas futures recently reached $3.56 per million British thermal units, up 31% from a year ago.

Riley likes Ultra Petroleum ( UPL), which produces gas in the Marcellus field of Appalachia. "They will be rewarded as the gas price continues to recover," he says.

Riley also likes BP ( BP). The shares have been unloved since the Gulf oil spill made headlines in 2010. He says that the company has the resources to cover the costs of the spill.

Fidelity portfolio manager John Dowd is investing in companies that stand to benefit the most from the new shale fields. So far, margins of shale exploration and production companies have been skimpy, he says.

But Dowd argues that the weak showing is about to change because of declining costs. When shale development began several years ago, gas production outfits moved slowly, going through the expensive process of drilling a few individual wells. Gradually the number of wells increased, and producers began running massive operations that could deliver gas more efficiently.

As the facilities expanded, engineers have improved techniques through trial and error. All the efforts will soon result in healthy margins, says Dowd. "When the wells are extremely efficient, then the industry returns can be good," he says.

As an example of an efficient producer, Dowd cites Cabot Oil & Gas ( COG), a longtime holding of the fund. A leader in exploiting the Marcellus gas fields, Cabot managed to cut its costs sharply and improve profit margins even during times when gas prices were falling. "The productivity of their wells has been improving in virtually every quarter," he says.

Dowd also likes EOG Resources ( EOG), which produces oil in the Eagle Ford shale region of Texas, and Pioneer Natural Resources ( PXD), an oil producer in the Permian Basin of Texas.

David Ginther, portfolio manager of Ivy Energy, says that operators of pipelines stand to enjoy growing profits. Pipeline owners charge fixed fees based on the volume of the material they transport. As volume increases in the shale fields, the pipelines should report improved sales and profits. A favorite pipeline holding is MarkWest Energy Partners ( MWE), a master limited partnership that yields 5.0%.

MarkWest is increasing its facilities in the fast-growing fields of the Marcellus region and the Utica shale fields that extend from New York through Pennsylvania and West Virginia. "The company is in the right areas," says Ginther.

At the time of publication, Luxenberg had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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