Energy Stocks with Room to Run

The surge in energy prices has been so rapid and relentless—particularly since the beginning of this year —that investors may think it's too late to grab a piece of the action. Of course, they may have thought that when oil was at $80, or $100, or $125 a barrel. But now many forecasters think that oil prices could be headed higher than the low $130s reached in the past week—maybe toward $200 a barrel over the next year. On May 16, Goldman Sachs (GS) raised its average price estimate for the benchmark West Texas Intermediate grade of crude for the second half of 2008 to $141 from $107 per barrel.

There are dissenters, however, such as a Bloomberg analyst composite forecast of $97 per barrel for WTI crude. Some economists think the prices aren't sustainable, as they are being driven more by speculation among traders than a worsening supply-and-demand outlook. Mark Gilman, an analyst at the Benchmark Co. in New York, attributes the price runup to money flows from big institutional investors who have suddenly decided that commodities are a valid asset class.

One thing everyone on Wall Street can agree on: The gains in prices of energy-sector stocks have lagged far behind the underlying commodities, due to prevailing skepticism in the market that the energy price hikes can be sustained. Valuations in the energy sector are considerably below historic medians, says Rob Mackenzie, an oilfield service analyst at Friedman Billings Ramsey (FBR) in Arlington, Va.

Goldman Sachs Raising Forecasts

That's good news for investors who think fuel prices will continue to push higher and are eager to participate in those gains.

In a May 5 research note, Goldman Sachs analyst Arjun Murti raised his earnings forecasts for the integrated oil producers—the big outfits that have soup-to-nuts operations in oil exploration, production, and refining—and trimmed his estimates for refiners, although he said he'd continue to buy industry players Valero Energy (VLO) and Frontier Oil (FTO) at their current prices.

Tim Guinness, chairman and chief investment officer of Guinness Asset Management in London, pointed out that energy equities, as represented by the MSCI World Energy Index, are up just 25% since the end of June, 2007, while the WTI crude price has jumped 84%, from $70 to $130, over that same period.

Gauging the Impact of a Correction

Based on the supply-and-demand evidence, Dan Rice, who co-manages the $1.47 billion BlackRock Global Resources Fund (SSGRX), believes $100 oil is defensible but says there isn't enough information yet about demand at higher prices for him to gauge whether or not they can be sustained.

If there was a substantial decline in oil prices, integrated oil stocks would certainly get hit, probably harder than the oil price correction might warrant, given the oversized reaction in equities to significant downward moves in corresponding commodity prices in recent months, says Clay Hoes, subadviser of the $145 million AmEx Global equities Energy Fund.

But since it takes a few months for oil price hikes to flow through to earnings, integrated oil producers will certainly revise their earnings higher, which "could make for another leg of investable opportunity if prices go up," says Minneapolis-based Hoes. Any pullback in oil stocks would also scare out the momentum players—those whose invest based on price moves—giving longer-term investors the chance to buy on the dip, especially if they expect a positive earnings surprise, he says.

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