Energy stocks are soaring,
but be careful before jumping
on the oil bandwagon

NEW YORK » As the rest of the equity market founders this year, energy stocks are surging, propelled by steadily rising crude prices that have climbed along with terror fears and unrest in the world's oil-producing regions.

Some analysts see the sector's strong performance as a signal to trim energy holdings and take profits, while others think the oil stock sprint has only just begun. Either way, it's probably a good idea to maintain some exposure to the best performing sector in the Standard & Poor's 500. The exchange traded fund that tracks the 27 energy companies in the index has soared 13 percent so far this year, far outpacing the 4.8 percent rise in utilities, the next best gainer. The index as a whole has sagged 4.3 percent since the start of 2004.

For small investors looking to benefit from this run, the biggest, most-diversified energy stocks may provide the least bumpy ride over the long term, because the breadth of their business models make them less vulnerable to oil price fluctuations. Substantial dividends add to their appeal.

"Bigger is better in the oil industry," said Paul Larson, stock analyst with Morningstar Inc. "The bigger companies tend to have a lower cost-per-barrel, so they have higher profits."

Large integrated oil companies, such as BP PLC, Exxon Mobil Corp., the Royal Dutch Shell Group and ChevronTexaco Corp., are insulated from risk because their operations cover everything from exploration, drilling and refining to marketing at the corner gas station. When one segment of their business isn't doing well, they can make up for it elsewhere.

In contrast, the performance of more specialized companies, such as oil field service providers Schlumberger Ltd. and Halliburton Co., is likely to be more closely correlated with crude prices. Smaller exploration and production concerns, such as Burlington Resources Inc., Anadarko Petroleum Corp. and Apache Corp., might have a hard time competing with the big integrated oil companies if prices fall. And independent mining and marketing businesses are the riskiest bets -- their fortunes could rise sharply if oil prices continues to go up, or plunge if they head lower.

Stocks across the energy sector have soared as crude oil futures jumped to a new record high this past week, settling at $46.58 per barrel yesterday. But with Wall Street looking for an average per-barrel price between $25 and $30, now might not be the best time to raise your investment in energy stocks.

Nervous traders drive crude prices higher whenever anything seems to threaten oil production -- whether it's a pipeline attack in Iraq, a threatened strike in Nigeria, political turmoil in Venezuela or a court battle over back taxes owed by Yukos, Russia's largest oil producer. Even Saudi Arabia's assertion that it could raise its daily output by 1.3 million barrels if necessary failed to stop prices from marching higher.

While supplies are tight and global demand is on the rise, few on Wall Street believe current oil prices are justified. The market has added a $10 to $15 "fear premium," said Dean Junkans, chief investment officer for Wells Fargo Private Client Services.

"With oil prices up 42 percent over the last year, and the energy sector up 40 percent over the last year, we think it's time to take some profits," said Junkans, whose firm recently trimmed its recommendation on energy stocks to underweight. "It's starting to look like a bubble -- and one driven by fear rather than greed."

How aggressively you choose to invest in such a market depends on what you believe will happen next, and how well you trust your crystal ball. Stephen Leeb, president of Leeb Capital Management and co-author of "The Oil Factor," thinks crude prices will strike $100 a barrel at least by the end of the decade, if not within the next few years. The fact that problems at Yukos, which produces roughly 1.7 million barrels per day, or about 2 percent of total global output, could significantly disrupt the market is proof that the world is running out of oil, he said.

Rising oil prices are nothing new, Leeb added: Crude futures were trading at about $12 a barrel at the end of 1998. But despite what he sees as a steady acceleration, no major Wall Street firms are projecting higher oil prices in the coming year.

"What that says to me is these stocks are priced as if oil is going to come down ... that no one has accepted that there is a shortage of oil, and these companies are undervalued," Leeb said. "So if I'm right, and oil prices continue to rise, you're looking at a home run. You're looking at massive gains."

The problem, of course, is that there is no way of knowing whether oil prices will retreat from their current highs or continue to climb. So for small investors, the safest course of action is not to make decisions based on current oil prices, but to maintain a diversified portfolio that includes exposure to the larger integrated oil stocks -- even though they may be overextended by some measures.

Of course, there's no indication that the so-called "terror premium" is going away anytime soon, said Richard A. Dickson, senior market strategist with Lowry's Research Reports in Palm Beach, Fla.

"They don't wave a flag or sound a horn saying, 'Hello, this is the high,"' Dickson said. "At this point you just really don't know. People may be thinking it's time to step back, but it's not a time to do a whole lot of selling, because the expectations are that these stocks will go higher."