Oil prices could continue
rising for the long haul,
benefiting energy companies

NEW YORK » The Middle East is much more stable than it was last year, but the so-called terror premium on oil prices remains. Some analysts blame hedge speculators, while others say the soaring costs are justified by short supplies and rising demand from Asia.

One thing that is clear: While they may not like it, stock investors are learning to accept sky-high prices, drivers are getting used to paying more at the pump and so far, the economy has been able to withstand the pressure. Light, sweet crude rose 21 cents to settle at $53.78 on the New York Mercantile yesterday Friday, and the Dow Jones industrial average soared 107 points.

Despite worries that lofty oil will eventually lead to higher consumer prices, businesses have been very good at squeezing energy costs out of each unit of production, and inflation remains in check. Consumer spending patterns are on track, as well, with data showing brisk sales for retail goods, homes and even cars -- though General Motors Corp. and Ford Motor Co. saw declines due in part to the waning appeal of big trucks and SUVs.

For stock investors, the price of oil has become an excuse to sell on down days, said Bill Groenveld, head trader for vFinance Investments, and something they're "willing to overlook" when market fundamentals are strong, because "in the back of your mind you know it really hasn't hurt anything at this level."

Even as the stock market tries to get comfortable with the new economics of energy, oil remains a significant pressure, however. Given strong fundamentals, one could argue that stocks would be materially higher if energy prices had continued to abate the way they did during the last quarter of 2004, said Joseph V. Battipaglia, chief investment officer at Ryan Beck & Co. Instead, oil has been steadily rising since the first of the year.

"Now that (crude) prices have been up and stayed up, the market is moving sideways. If you drew a line through it all, you could say the stock market was held back by oil prices," Battipaglia said. "There's been not much progress in stocks at this point even though the fundamentals are decent, and I think you can lay that at the feet of costly energy."

While some market watchers argue that oil is overpriced, and likely to correct, Battipaglia is part of a growing camp that believes expanding global consumption -- partly due to rising demand in India and China -- will keep energy costs higher over the long term. Few things go up in a straight line, but over the next 10 years, that could put the average per-barrel cost of oil in the $35 to $45 range, as opposed to $20 for the previous decade, he said. That could mean a boomtime for energy stocks.

"That's a dramatic revaluation of the oil in the ground and the earnings of the companies in that industry, and the cash flows they generate," Battipaglia said. "The easy money has been missed if you're buying in now, but I'm not so sure that it's over yet either. The forward profile for energy stocks over the next five years shows their average price received will be higher, their margins will be higher and their cash flows will be up."

Such a trend would likely bring a wave of consolidation to the energy sector, as larger oil companies look to replace the reserves they're consuming -- a point underscored by reports that ChevronTexaco Corp., the second largest U.S. oil company, is considering a bid for smaller rival Unocal Corp.

An examination of price patterns going back to the 1970s by Merrill Lynch suggests the energy sector enjoyed an eight-year bull cycle from April 1972 until November 1980, during which its peak weighting in the Standard & Poor's 500 reached 40 percent. That was followed by a 20-year contraction that brought the sector's market cap to an all-time low in February 1999, and energy started a fresh bull trend in 2000. Now, the energy's sector weight in the S&P 500 stands at 8.5 percent.

In the short term, oil prices and oil stocks appear overextended, and may be heading for a correction, said Mary Ann Bartels, global equity trading strategist at Merrill Lynch. But over the long term, the relative outperformance of the sector is likely to continue. If there is a pause, Bartels said, it's likely to be only temporary; her research shows oil could rise as high as $70 per barrel if the current trends continue.

"When I look at the charts and interpret the price action, a move to $70 is supported by the charts," Bartels said. "I'm not looking at oil to trade at $70 this year, but it looks like oil prices are sustainable at these high levels and can possibly move higher."

As for hedge fund speculators? These large traders have gotten good at moving quickly to take advantage of price trends, and their actions often exaggerate moves already in progress. But while they can be influential, Bartels said they aren't responsible for the price of oil.

"The speculators aren't large enough to be the market, but they are large enough to move it at the margin, to be the next leg that comes in," Bartels said. "They accelerate the movements on the upside or the downside."

For investors, that means more volatility lies ahead.