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The well has run dry for energy funds
High oil and natural-gas prices won't last, which will lead to lower profits for oil companies and tougher times for funds that focus on them.
By Timothy Middleton
These should be the best of times for the oil patch. With OPEC holding down production, crude oil is trading above $30 a barrel, and natural-gas prices have tripled to nearly $6 per thousand cubic feet.
But energy stocks are languishing. The sector rose just 3.3% through the end of July, according to Standard & Poors, compared with a 12.6% spurt in the S&P 500 Index ($INX). A cool, wet summer and SARS-related travel fears have depressed consumption, and the industrys declining yield on producing fields creates anxiety about the future.
Lisa Svensson, manager of Putnam Global Natural Resources Fund (EBERX), says the market is concerned that the huge, integrated oil-and-gas companies that are the sectors backbone will need to spend more for each incremental barrel that they find.
The crunch on energy stocks has created price-to-earnings ratios that are half the market average, and yields that are rising correspondingly -- to more than 5% in the case of at least one Big Oil stock.
But sometimes stocks are cheap for good reason, and this is such a time for the oil business, which doesn't bode well for natural-resources funds. Sam Stovall, S&P's chief market strategist, notes that the sectors first-quarter earnings soared 142% from a year earlier. By next years first period, Were seeing a 34% decline, and in all four quarters of 2004, were expecting negative percent changes.
In a commodity-driven sector such as energy, earnings forecasts beyond one year rapidly approach pointlessness. Prices of the groups raw materials are too volatile. As surely as energy will enjoy a renaissance at some point, it cant be foreseen now.
Volatile swings in supply, demand
The sector has had some turbulent times recently. Inventories fell after an unusually cold winter in North America and falling oil exports from Iraq, Venezuela, Indonesia and Nigeria, and that boosted prices. But fears of SARS battered air travel, reducing demand. Then OPEC in April announced output cuts of 2 million barrels a day.
Shortages of gasoline were muted by weak demand in the wet summer, but they did materialize. October futures of unleaded gasoline are trading at a 75-cent premium to crude itself, as refineries were slow to switch from production of home-heating oil and power-plant fuel to gasoline.
But the swift conclusion of the Iraq war and resumed operations in Venezuela dampened the group's outlook; OPEC abandoned further production cuts. And while prices of natural gas surged during last years cold winter, investors expect more-normal conditions in the future.
What were seeing, going forward after 2004, is earnings (of natural-gas producers) actually coming down, so thats not an encouraging sign to us, says J.C. Waller, an analyst on the investment team of ICON Energy Fund (ICENX).
Climbing back to the base
Travel is rebounding; New York City is experiencing a surge in hotel bookings. But after three years of recession, that's taking bookings to only near-normal levels. Worldwide, travel is off so steeply that travel agencies are advertising week-plus trips to Asia for $1,000 and to Europe for half that.
Historically, natural-resources funds have benefited from inflation, which has been virtually absent in recent years. In the United States, both fiscal and monetary authorities are expansionary, feeding fears of rising prices. Prices of Treasury Inflation Protected Securities have risen even as conventional Treasurys have declined in price.
In the United Kingdom, continental Europe and Japan, however, fiscal and monetary policy remains constrained by inflation obsession. Even China is alarmed and has raised reserve requirements on its banks to dampen the nations rapid economic growth.
So to the extent the United States generates inflation, the rest of the world is leaning the other way. That leaves investors in beleaguered natural-resources funds with little to cheer about.
Such funds have shown only one positive attribute in recent years, which is stability. They resisted the bear market, with average gains in those three years of 3.1%. Their five-year annualized returns have been 6.5%, and over 10 years, 7.7%.
Protected by diversification
They're buoyed by the high dividends paid by the sectors giants, the integrated oil-and-gas companies. Exxon Mobil (XOM, news, msgs) yields 2.7%, BP (BP, news, msgs) 3.9% and Royal Dutch Petroleum (RD, news, msgs) 5.9%. Even with declining earnings, these payouts are well-protected by operations thoroughly diversified by geography as well as industry.
Last week, I wrote about utility funds, which are also delivering lush yields. But whereas that group can expect modest earnings gains, Big Oil is poised to deliver lower profits. P/E multiples in the range of 12 to 15 (compared with the markets 25) are correspondingly weak.
Natural-resources funds invest in other commodities-driven sectors, like base and precious metals, but they put an average of 70% of assets into the oil patch. Even with economic recovery, therefore, they cant eke out enough returns from paper companies and aluminum producers to overcome the energy drag.
If youre worried about inflation, buy TIPS or perhaps gold, which is an inflation hedge that also is denominated in dollars and therefore benefits from a weaker greenback.
But avoid energy. It has run out of gas.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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