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Now’s a good time to invest in energy

If you have wondered how you might profit from the rise in energy prices, you are not alone. As oil and gas prices have risen, the earnings and share prices of every sector of the energy industry have risen. I, too, have spent considerable time thinking about this sector, and whether it makes sense to add or increase exposure at this time.

I’ll review for you the process that I recommend for making this decision. I do not necessarily have clear answers of my own for many of these questions. What I hope to do is give you pause to take the time to sit and think through the questions and issues. In the end, you will need to make a decision one way or the other.

First, we must realize that any sort of outsized returns from most investments occur because some fundamental input is moving from one level to another. Once the input reaches and stabilizes at a new level, returns settle back down into mundane ranges. If corporate earnings rocket upwards, stock prices usually follow. As those earnings inevitably settle down into normal ranges, stocks go back to providing normal returns. It’s not so much whether earnings are high or low as whether they are on the move or not.

Any decision to move money into the energy sector must be accompanied by a point of view about the future of energy prices themselves. The stocks of energy companies have moved almost in lock-step with the price of oil. Do you believe that oil will stay at its current price above $65? Will it rise farther? Will it fall?

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The mere existence of high oil prices does not ensure that energy company earnings will continue to expand at super-normal rates. You should think about your outlook for oil prices over your investment horizon and consider energy stocks in that light.

The next step in my review is to think about what sorts of energy investments I want to make. Should we invest in mainstream oil companies, such as Exxon-Mobile or Chevron? There are also oil shipping companies to consider, as well as drilling companies, pipeline companies, refineries, and oil field operators. Do you want to invest in exploration risk or in companies that pump, process and sell oil that somebody else discovered?

There are a host of companies and partnerships that operate existing fields, and pay regular dividends and royalties to investors. Some of these offer quite attractive dividend yields. The trick is that these dividends can quickly turn into a return of principal, rather than income, if the oil fields’production begins to sputter. To make a wise investment of this kind, you would need to develop some expertise in analyzing the dynamics of reserves and the technology of oil harvesting.

All of this complexity highlights the fact that the energy business is not a simple one. I have a rather modest sense of my own complexity threshold. I can only understand so many things before I am in over my head. I’m not an expert in oil geology. Perhaps you are and can assess the prospects of a drilling project. For the most part, I believe that the energy sector as a whole will go the way of oil prices.

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Over the next few decades, I have a strong hunch that demand for oil will continue to push the limits of production capacity. I believe this will set the stage for the permanence of sustained high prices that grow faster than the inflation rate. However, it is entirely likely that prices could fall by half or more during a recession. This is the final element of your own review. Are you prepared to sit out the volatility? If you are getting in as a knee-jerk reaction, you are likely to get out the same way and lose money.

I have chosen to add a modest amount of exposure to the energy sector via specialty mutual funds. Given the enormous complexity of this industry, I have more confidence in the skills of a professional manager in picking these companies than in my own abilities. I have also made the decision that this investment is not tactical in nature, but is to be made with the portion of portfolios committed to very long-term investments.

Before you make a decision about any investment, you should take the time to sit and think through the reasons why it has done well in the past, and whether those conditions are likely to occur again in the future.

Rick Ashburn manages investments

for private clients. Write to him at rick@richardashburn.com or 7777 Fay Ave., Suite 230, La Jolla, 92037.