VALUE ADDED


Trim Your Energy Holdings -- Now

Steven Goldberg

Investing directly in commodities has become a dangerous momentum game. Some oil and coal stocks, however, still hold appeal.



The law of supply and demand is about to show its power. With crude oil selling for about $135 a barrel, look for energy companies to do all they can to churn out more supply. At the same time, expect consumers to consume less, something that's already happening in the U.S. as Americans cut back on driving and replace their gas-guzzling SUVs with Priuses, Corollas and the like. By the end of the year, crude should be selling for about $100 a barrel.

Investors should start trimming their energy holdings -- particularly direct plays on oil, gas and the like -- even though investing in commodities is one of the few strategies that has made money in the past 12 months. And most fund investors probably own more than they think they do -- and more than they should -- in stocks of companies tied to commodities.

It's impossible to quantify how much impact investors are having on the prices of oil and other commodities. But the effect is clearly significant.

Pension funds, hedge funds and ordinary investors, through mutual funds, have increasingly allocated more of their assets to direct investment in commodity futures and related products. The thinking is that because commodities often move in the opposite direction of the stock market, investing a percentage of your money in stuff will reduce your overall risk.

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Maybe so. But over the long term, commodities don't tend to rise much more than inflation. Stocks, meanwhile, have returned more than 10% annualized since 1926, or about 7% a year after inflation.

The supply of oil is slated to increase significantly in the second half of 2008, says Charles Ober, manager of T. Rowe Price New Era (symbol PRNEX). Saudi Arabia has 500,000 barrels a day of newly developed oil coming onstream. Other new supply will come from the Gulf of Mexico, Kazakhstan, offshore Nigeria and the tar sands of Canada.

At the same time, demand has already begun to weaken. In the U.S., which consumes roughly 25% of the world's oil, vehicle miles are down. Demand for oil in the U.S. and the rest of the developed world will be lower this year than last year, Ober predicts. Even China, which consumes 10% of the world's oil, will slow its consumption growth after the Olympics end and cleanup from recent earthquakes is complete.

Longer term, the price of oil and gas and many other commodities may well rise as demand continues to grow from emerging markets. Ober says prices will head higher again in 12 to 18 months as the global economy strengthens.

But longer-term forecasts are far murkier than shorter-term ones, particularly for oil. "The cure for higher prices is higher prices," says Ken Settles, co-manager of RS Global Natural Resources A (RSNRX). Higher prices have spurred consumers to reduce consumption and oil companies to increase their search for more oil. They have also dramatically boosted efforts to develop alternative energies.

None of this is to say you can't still make money in commodities companies. Brokerage analysts currently are assuming oil prices of $80 to $90 when estimating the value of energy companies. By this measure, many stocks will still be cheap even if the price of oil tumbles. Nevertheless, expect stock prices to sell off as the price of crude falls.

Longer term, though, prices of the best companies should rise. "The past five years, you could have owned any commodity and virtually any commodity company, and you would have made money," Settles says. You'll have to be more selective to profit in the future.

Settles and his co-managers say the most-expensive new oil coming to market costs between $80 and $100 to produce. That includes, for instance, oil from the tar sands of Canada. While prices fluctuate dramatically, Settles says, they tend to oscillate around the price of the costliest oil. The fund's managers then look for companies that can produce oil much less expensively or that sell at cheap prices relative to their assets. They do the same thing with other commodities.

Among oil stocks, Settles and Ober both like Schlumberger (SLB), the world's largest oil-services company, which helps other companies get oil and gas out of the ground and process it.

Ober and Settles are also fans of "clean coal." The U.S. has an abundant supply of coal. Both funds own Peabody Energy (BTU), which owns enormous coal deposits.

The two funds boast superb records. T. Rowe Price New Era returned an annualized 31% over the past five years through June 20. RS Global Natural Resources A returned the same amount over the same period. But RS Global is expensive: It charges a maximum commission of 4.75% and annual expenses of 1.45%. The no-load Price fund charges just 0.63% in annual fees.

Both funds have lagged pure energy funds in recent years. But they provide more diversification than you get in energy-only funds.

The question at this point is whether you need a commodity fund at all. Energy stocks alone account for 15% of Standard & Poor's 500-stock index, and other commodities firms make up another 4%. Diversified funds in your portfolio may hold even greater amounts of commodity stocks. Even 20% is too much.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.




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