Manager thinks oil prices and energy stocks look ready for further gains.

Consumers can expect oil prices to be relatively tame for the rest of the year but they'll need to tighten their belts in 2008 and 2009, according to veteran energy sector investor John Segner, who sees good times ahead for the companies in the energy industry that are positioned to benefit from increased demand and limited supply.
"People are underestimating demand and overestimating supplies," says the manager of the AIM Energy Fund. "The energy industry will continue to be a good performing sector for the foreseeable future, and present solid investment opportunities for investors."
Soaring oil prices began rewarding investors a few years ago, as energy replaced technology as the U.S. market sector to beat. AIM Energy's total return was 23%, 36.4% and 54% in the three years from 2003 to 2005. But last year the sector and the fund trailed the S&P 500 Index, as above-normal temperatures and benign weather with few supply-disrupting hurricanes helped spark a decline in oil prices from a peak of $77 a barrel in July to the mid-$50s by November. In the ten years Segner has been running the fund, there have been only two calendar years, including 2006, that it did not outperform the S&P 500 Index.
The question now is whether a bubble has deflated, or are energy stocks just marking time in anticipation of further gains. Segner believes favorable supply-demand characteristics make the latter scenario more likely, particularly when the world begins to feel the pinch of tight supplies in a year or so. He says that world demand averages 86 million barrels of oil a day, up from 84.6 million barrels last year, while average world production capacity is about 88 million barrels. That means the industry is operating at nearly a 98% demand-to-production capacity, the tightest levels since the 1970s.
Non-OPEC production growth during 2007 will meet increased worldwide demand, so 2007 could be a relatively flat year for oil prices, he contends. "But we see little to no new non-OPEC production coming on line in the 2008 to 2009 time frame. These are going to be good years to be invested in energy, as oil and natural gas markets are going to be tightening up." The much-anticipated start of new deepwater production, especially in the Atlantis platform in 2007 and the Thunderhorse platform in late 2008, "will make a nice dent, but it won't come near to making up declines in production elsewhere." At the same time, oil is becoming more difficult and expensive to extract from the ground, and readily available sources are being depleted at a surprisingly high rate. China and India have a large and growing thirst for oil, which shows little signs of abating. The steady growth of world economies will also help spur demand.
Segner says that while pricing blips created by international tensions and weather are likely this year, they really are just short-term noise against a longer-term backdrop of slower production growth and higher demand. "We may have some warm winters, but there are also going to be some cold ones. In some seasons hurricanes may disrupt supplies, and in others they may not. But the fundamental supply-demand equation is not going to go away."
One of those blips occurred in early spring, when oil stocks rose sharply after nearly a year of trading in a narrow range as concerns mounted that strained relations between Iran and the West would jeopardize oil exports. Oil shipments that move through the Strait of Hormuz bordered by Iran account for about one-fifth of the world's total oil production, according to the Energy Information Administration (EIA), making what happens in the region a pivotal factor in the direction of oil prices. Those tensions followed several weeks of rising prices due to declines in U.S. gasoline inventories. Through early April, natural resource funds were up 9.35% for 2007, with most of the gain coming from the previous month.
Some analysts disagree with Segner's view that oil prices will remain tame in 2007 and rise over the following two years.  In a report issued in March, the EIA predicted oil prices will average $62 a barrel this year, and tick up just slightly to an average of $63.75 per barrel in 2008. 
Moody's senior economist Rakesh Shankar expects oil to drop to $55 a barrel by the end of 2007, and says prices could drop as low as $45 a barrel in 2008. "As the predicted market oversupply broadens in 2007, the price outlook becomes increasingly bearish," Shankar wrote recently on the Web site economy.com. "The loosening fundamentals imply escalating inventories and a widening of the previously tight spare capacity buffer ... Global crude oil supplies should continue to exceed demand despite the best efforts of OPEC, the oil-producing cartel." He sees robust growth in supply this year from West Africa, Eastern Europe and the Middle East.
Analysts on the opposite side of the oil price debate include Lehman Brothers chief energy economist Ed Morse, who believes that growing demand from Asia's expanding middle class will help push the average price of oil to $74 a barrel this year. Lehman analysts estimate that crude oil use in the U.S. is one million barrels a day higher than it was a year ago, and predict that demand in this country will rise about 300,000 barrels a day. The U.S. accounts for 25% of the world's oil use.
The fund has an obvious stake in where oil prices are headed. Integrated oil and gas companies, oil and gas exploration and production companies, and oil and gas equipment and service providers each account for roughly 25% of equity assets. Another 16% of assets is invested in oil and gas drillers, storage and refining companies.
But according to its manager, his holdings' fortunes don't hinge exclusively on the price of oil, or even on the direction of the stock market. Instead, the two forces combine to produce investment returns with a low correlation to both. The fund's NAV correlation to the price of crude oil has ranged between .37 and .47 over the past three-, five- and ten-year periods. A .40 to .50 correlation to the S&P 500 Index over the same time frames is also relatively low. 
To help insulate investors from oil price shocks, Segner buys stocks of companies that he believes have some sort of competitive advantage, such as new technology, that can help increase production. He also likes to see free cash flow, evidence of cost controls, high returns on capital, a low price-to-earnings ratio within a subsector and greater-than-expected growth opportunities.  
There are no restrictions on company size, although he says the fund has a mid-cap bias because companies in that space represent a good balance between growth potential and the stability to execute their business plans. According to Lipper, the fund has 53.3% of its assets in companies with market capitalizations above $14.5 billion, 35.3% in companies with between $3.6 billion and $14.5 billion in market capitalization, and 11.4% in small companies that fall below those thresholds.  On the sell side, he may reduce or eliminate exposure to a stock when it reaches its price target or appreciation falls short of anticipated upside potential. He may also cut back if a stock position becomes too large, including when it hits more than 5% of total assets or represents more than 10% of the company's float.
The concentrated fund portfolio of 30 to 40 companies sells at a median of 12 times forward earnings, and is expected to see earnings growth of 13% over the next year. The top ten holdings generally account for 35% to 40% of assets, with the largest, National-Oilwell Varco, weighing in at 4.6%.
While the concentrated approach allows top picks to shine, it also courts issue-specific risk in what can be a volatile sector. Last year, fund holding Peabody Energy, the world's largest coal provider, slid after an unusually warm winter doused demand for coal. Segner remains wary of coal mining companies, citing pollution concerns as a reason those stocks may face tough times in the future.
He has a more optimistic view of the prospects for some oil companies, including top ten holding Occidental Petroleum, which he says is attractively valued, has been able to grow production and has a good relationship with Middle Eastern countries. Natural gas distributor Southwestern Energy should benefit from a significant presence in Arkansas, where it discovered natural gas-bearing formations in early 2002. The company's quick acquisition of the land at favorable prices should help it expand its drilling capacity at a reasonable cost.  French oil giant Total SA is growing production at a healthy rate thanks to its early presence in western Africa. The company also has good relations with Iran and Iraq, a claim no American companies can make, and sells at a very reasonable ten times forward earnings.
To help insulate investors from oil price shocks, Segner buys stocks of companies that he believes have some sort of competitive advantage, such as new technology, that can help increase production. He also likes to see free cash flow, evidence of cost controls, high returns on capital, a low price-to-earnings ratio within a subsector and greater-than-expected growth opportunities.  
There are no restrictions on company size, although he says the fund has a mid-cap bias because companies in that space represent a good balance between growth potential and the stability to execute their business plans. According to Lipper, the fund has 53.3% of its assets in companies with market capitalizations above $14.5 billion, 35.3% in companies with between $3.6 billion and $14.5 billion in market capitalization, and 11.4% in small companies that fall below those thresholds.  On the sell side, he may reduce or eliminate exposure to a stock when it reaches its price target or appreciation falls short of anticipated upside potential. He may also cut back if a stock position becomes too large, including when it hits more than 5% of total assets or represents more than 10% of the company's float.
The concentrated fund portfolio of 30 to 40 companies sells at a median of 12 times forward earnings, and is expected to see earnings growth of 13% over the next year. The top ten holdings generally account for 35% to 40% of assets, with the largest, National-Oilwell Varco, weighing in at 4.6%.
While the concentrated approach allows top picks to shine, it also courts issue-specific risk in what can be a volatile sector. Last year, fund holding Peabody Energy, the world's largest coal provider, slid after an unusually warm winter doused demand for coal. Segner remains wary of coal mining companies, citing pollution concerns as a reason those stocks may face tough times in the future.
He has a more optimistic view of the prospects for some oil companies, including top ten holding Occidental Petroleum, which he says is attractively valued, has been able to grow production and has a good relationship with Middle Eastern countries. Natural gas distributor Southwestern Energy should benefit from a significant presence in Arkansas, where it discovered natural gas-bearing formations in early 2002. The company's quick acquisition of the land at favorable prices should help it expand its drilling capacity at a reasonable cost.  French oil giant Total SA is growing production at a healthy rate thanks to its early presence in western Africa. The company also has good relations with Iran and Iraq, a claim no American companies can make, and sells at a very reasonable ten times forward earnings.