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Have Energy Stocks Run Out of Steam?
What to do with bulging energy holdings

Check out the top mutual fund performers over the past twelve months and you're likely to see a list dominated by funds filled with energy stocks. As is always the case with hot sectors, the big recent returns are often accompanied by continued optimism for industry fundamentals. The energy sector is no exception, with many analysts calling for continued strength in energy prices due to high demand. So, what does that mean for your portfolio? Should you let your holdings go, or is it time to take some profits?

SUPPLY AND DEMAND

On a shorter-term basis, OPEC's monthly statistical review illustrates their expectation of crude oil demand to remain relatively flat for the remainder of this year, while supply is schedule to gradually increase to the point where a small excess supply can be maintained. This implies steady (perhaps slightly downward trending) oil prices for the foreseeable future. On the home front, Natural Resources Canada did a report last year on the domestic energy market. Here are some of their longer-term projections from the year 2000 to 2010.

On Crude Oil and Equivalents

  • Canadian suppliers are expected to boost production by 24 per cent (2.2 per cent per year).
  • Domestic demand is expected to increase by 10 per cent (0.96 per cent per year).
  • Canada's net exports are expected to expand by 50 per cent (4.1 per cent per year).

    On Natural Gas

  • Canadian suppliers are expected to boost production by 20 per cent (1.8 per cent per year).
  • Domestic demand is expected to increase by 17 per cent (1.6 per cent per year).
  • Canada's net exports are expected to expand by 23 per cent (2.1 per cent per year).

    This long-term forecast is generally consistent with the ten and twenty-year projections prepared by the Energy Information Administration (EIA)'s 2001 industry review. They project world energy demand to rise by just over two per cent annually over the next twenty years, with demand from emerging markets and Latin America rising by about three per cent annually over the same period. The EIA estimates that natural gas will see the strongest demand growth, followed by crude oil. However, supply (and production capacity) of energy sources is expected to remain a step or two ahead of the rate of demand growth, thereby serving to provide some price relief for consumers.

    Overall, supply and demand fundamentals look strong for the world energy market both short and long term. If projections are even close, energy prices should fall gradually from today's levels but remain strong, thus allowing energy producers to reap financial benefits while giving consumers some relief.

    Another angle on this is to look at current energy prices and assess the feasibility of current prices. Oil prices, for instance, remain parked in the US$25 to US$30 range. However, George Morgan (manager of Templeton Growth) offered his thoughts in a conference call last week. (While George is a lead manager he also retains his analyst responsibilities, which focus on oil stocks.) He estimates that a more normal price range for oil, given current fundamentals, is in the US$18 to US$20 range. He said that oil prices that persist much above that range may draw excess supply and potentially cause a "boom and bust" effect. He's been surprised by how long oil prices have been sustained at this level. If he's right, revenues, profits and cash flows will fall to some extent from current levels. That's part of the risk in this sector.

    INDUSTRY CONSOLIDATION

    These days, buying energy companies is a cheaper expansion strategy than buying energy properties. Why? Because, quality properties can be had at a discount through a company, as compared to buying them outright. At least that's the trend identified by some of this country's most astute money managers. That's a trend some managers expect to continue among Canadian energy producers, starting with smaller companies and then escalating to acquiring the industry's bigger players. However, the latest deal involves one of Canada's biggest energy players - Gulf Canada Resources ("Gulf"). It was recently announced that Gulf Canada Resources was being acquired by Conoco Ltd. - the fourth largest oil company in the U.S. The offer was an all-cash US$4.3 billion deal, which represented a premium of about 34 per cent over Gulf's pre-announcement share price.

    RECENT PERFORMANCE & VALUATION

    The TSE Oil and Gas sub-index is up more than 43 per cent for the twelve months ending April 30, 2001. Longer-term performance is more "normal" in the 9 to 10 per cent range. However, the energy sector is deeply cyclical and can move at dizzying speeds. If returns remain strong for the rest of this year, 2001 will cap a third straight year of very strong performance for energy stocks - a rare occurrence for this volatile sector. While fundamentals look strong the million-dollar question becomes: are today's prices reasonable in relation to our expectations?

    Cyclical companies (i.e. automotive, resources, etc.) typically have very volatile revenues, profits and cash flows. This volatility means uncertainty to investors, which results in an unwillingness to pay rich prices for these stocks (extreme conditions excepted of course). Hence, today's price-earnings (P/E) ratio of about 10 for the energy sector may not be as attractive it looks. Just a few months ago, managers had felt that energy stock prices were behind the industry fundamentals (i.e. energy prices). While recent returns may have allowed market prices to play "catch up" to some degree, many of today's larger energy producers remain priced in historically normal ranges.

    RECOMMENDATION

    Valuation risk in commodity-sensitive industries is two-fold. Is the commodity over/under valued? Are stock prices over/under valued? These two questions are crucial to determining what action to take with your portfolio. In the case of energy, prices look as if they will strong but slowly trend downward over the next year or so. The long-term outlook for energy is positive, stock prices aren't unrealistic, and consolidation is alive and well. Overall, I remain positive on the sector and recommend maintaining a weighting in energy for most portfolios - no more than 10 per cent of the total portfolio or 15 to 20 per cent of the equity weighting for balanced portfolios.

    For those who did get in early and have made handsome profits, it may be a good time to take some money off the table and maintain your original energy allocation. Always remember, when looking at your energy allocation, don't just focus on specialty funds. Check diversified funds to keep on top of your exposure.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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    Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...