ENERGY investors are going to have a hard time duplicating their success of the last five years.
The Energy Select Sector SPDR, an exchange-traded fund that tracks a diverse basket of energy stocks, returned 17.7 percent, annualized, in the five years through March, according to Morningstar. But many actively managed mutual funds that invest heavily in energy produced even better gains.
The U.S. Global Investors Global Resources fund produced an annualized return of 37.8 percent over the five years through March. Van Eck Global Hard Assets, RS Global Natural Resources and a few others returned about 25 percent a year, on average.
But, as the fine print warns, past performance does not guarantee future gains. Over the last five years, energy prices have generally soared because of stronger demand from developing countries. Global tensions, natural disasters and rampant speculation have also helped prices to climb.
“The easier money has probably been made,” said Evan Smith, a co-manager of U.S. Global Investors Global Resources.
But Mr. Smith and other energy fund managers said that further gains would most likely come from specific energy stocks, though they may be harder to find. “I don’t think we’ve seen the peak,” he said.
Fred Sturm, manager of the Ivy Global Natural Resources fund, which has climbed 22.3 percent, annualized, over the last half-decade, said there were plenty of opportunities for managers who could find good stocks.
“At some point this sector will be well enough understood and closely and passionately followed so that it will be difficult for experienced managers to add more value,” Mr. Sturm said. “We are not there yet.”
He favors companies that should benefit from the expansion of oil production in the developing world. “Seventy-five percent of incremental energy will be produced by nationalized oil companies” of developing nations, he said.
Much of that oil is offshore, and producing it will require the help of deep-water drillers like two of the portfolio’s holdings, Noble and Diamond Offshore, Mr. Sturm said. “Current share prices do not fully reflect the sustainability of profits for these companies,” he said.
Mr. Smith also favors offshore drillers. He expects that deep-water oil and gas production worldwide will triple by 2010.
“The majors are putting money into deep water,” he said. “There is an increasing allocation in exploration budgets to deep-water drilling.”
Equipment and labor shortages have led to a tripling in rates for some rigs, many of which now rent for $500,000 a day. Mr. Smith holds shares of Noble and Transocean in the fund.
He also likes the long-term prospects of several companies that extract oil trapped in sandy deposits in Canada, mostly in the province of Alberta. Such oil, he said, represented “one of the largest underexploited resources in the world.” At current production rates, he added, Canadian reserves should last for 50 years.
While the costs of extracting from oil sands are high, the rising value of a barrel of oil, along with technology advances, has made such production more lucrative. At $35 to $40 a barrel, producers can earn a 15 percent return on capital, Mr. Smith said. He said he believes that investors will eventually pay more for producers like Suncor Energy and Canadian Oil Sands Trust.
“Over the long run, a premium will be paid for these assets because they are in a politically stable area,” Mr. Smith said.
While some fund managers pick sectors, others look for stocks that fit a profile. Derek van Eck, lead portfolio manager of Van Eck Global Hard Assets, seeks companies that can steadily increase their oil and gas production, a capacity that he termed “increasingly scarce.” Mr. van Eck expects production at XTO Energy and Southwestern Energy, two of the fund’s holdings to swell at double-digit rates.
Mackenzie Davis, a co-manager at RS Global Natural Resources, said he was looking for companies that could “replace their current production at the lowest cost.”
One portfolio holding is Denbury Resources, an oil and gas producer based in Plano, Tex. Denbury specializes in tapping oil from old and abandoned fields.
Investors looking overseas might consider the ING Russia fund, which produced an annualized return of 39.7 percent in the five years through March and has just over 35 percent of its holdings in energy.
The oil and gas reserves of Russian companies are inexpensive, compared with those of Western producers, said Samuel Oubadia, the co-manager. “The reserves of large-cap Russian energy producers are valued at one-half or less those of large energy companies in the developed world,” he said.
POLITICAL risk is one likely reason for the low valuations, but in one case, changing government policies could help investors, he said. Government caps on natural gas prices are likely to be at least partially lifted in the next few years.
“It’s not if, but how soon, and by how much,” Mr. Oubadia said. One major beneficiary would be the giant gas producer Novatek, which represents 3.2 percent of the ING Russia fund’s assets.
Asked if he could produce over the next five years the nearly 40 percent annual returns that ING Russia has had over the last five, Mr. Oubadia replied, “not likely.”
He said if someone had asked five years ago whether the fund would have such large annual gains over the next half-decade, he would have been just as skeptical.
