Oil: High Prices, Cheap Stocks

Oil and natural gas stocks rank among this year's best performers, as rising energy prices have keyed better-than-expected earnings and lifted expectations for full-year 2004 and 2005. Yet amid the latest move to all-time highs in oil prices, energy stocks have slumped. Investors are concerned that higher oil energy prices will halt the world economy, reducing energy demand in 2005. Moreover, many are convinced that industry fundamentals do not support today's oil prices, that the move to all-time highs reflects speculation and fears of a disruption in supplies. The longer prices stay artificially high, argue the oil bears, the longer OPEC and others will produce at capacity--and the greater the risk of a hard landing for prices if fears of a supply disruption ease.

The world's oil producers have very little spare capacity, and the risk of a disruption in supplies from Russia or Iraq seems very real. Still, with U.S. inventories of crude oil and refined products in line with five-year averages, and 6% above last year's levels, oil prices are likely to fall unless supplies are disrupted. Natural gas prices, though likely to remain well above historical norms, have already retreated about 15% since June. With oil and gas prices more likely to fall than rise, should you be selling your energy stocks? While the group could pull back, having some energy exposure in your portfolio makes sense, for several reasons.

The stocks already reflect expectations of lower prices. According to Thomson First Call, the average Wall Street analyst expects the price of West Texas Intermediate crude oil to average $30.21 per barrel in 2005--well below the current price near $45. Profits for oil companies are expected to fall sharply in 2005, with predicted declines ranging from 15% to 40%. Energy stocks help to diversify a portfolio. If prices remain high through the winter, energy stocks are likely to deliver market-beating returns. Energy stocks represent 7% of S&P 500 Index's value, while Forbes' Buy List and Long-Term Buy List have about 11% in energy.

A return to $25 per barrel oil prices seems unlikely. The threat to the global economy seems overblown, as energy prices are well below previous highs when adjusted for inflation. With energy demand growth likely to remain healthy, expectations for 2005 pricing and oil-industry profits seem more likely to rise than fall. Also, energy stocks are reasonably valued. Several quality energy stocks are trading at attractive valuations relative to historical norms.