Why Oil Is Overpriced

Speculation in commodities seems out of control. In the not-too-distant-future, investors will discover that oil prices -- like the prices of everything else -- go down as well as up.

A central pillar for commodity bulls was synchronized global growth. With the U.S. almost certainly mired in recession and economies in much of the developed world slowing, too, that pillar is gone.

True, emerging markets are likely to continue growing robustly, albeit at a slower pace than they have been -- and it's surging demand from countries such as China and India that has fueled most of the commodities boom.

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Even so, the price of oil and other commodities has gotten well ahead of supply and demand. In fact, after hitting a high of $111.80 during the day March 17, oil prices plunged to a close of $105.68 per barrel. "At least in the United States, fundamentals continue to point to weakness in oil markets," James Crandell, an energy analyst at Lehman Brothers, said in a recent note to clients. "Product demand in every fuel category is suffering this year on account of the dual blow of economic slowdown and high prices."

Just as Americans learned to conserve energy during the oil shocks of the 1970s, we're learning now. The Energy Department reports that gasoline demand is down 1% compared with a year ago. Meanwhile, U.S. inventories of crude oil continue to build.

Charles Ober, the veteran manager of T. Rowe Price New Era (symbol PRNEX), has done a good job predicting oil prices since the energy bull market began. He sees the price of crude oil falling to $85 a barrel by year's end, then rising toward $100 over the next two years.

Of course, oil isn't the only commodity on a tear. Inflation fears and demand from emerging markets have pushed up the price of everything from corn to gold. "All of these commodities have been dramatically affected by inflows into commodity funds," Ober says. "Last year, only about $22 billion flowed into commodity funds compared with $20 billion to $30 billion in the first two months of 2008. I suspect that this wave has pushed prices above a sustainable level in the short run."

Commodity funds have been all the rage of late. Pimco Commodity Real Return D (PCRDX), which tracks the Dow Jones AIG Commodity index, has surged an annualized 19% over the past five years-including a 26% gain so far this year through March 13.

For my money, I'd rather invest in stocks or stock funds. If Ober is right and the price of oil falls and then climbs over the next two years to a point at which it is 10% lower than the current level, investing directly in the commodity will be a bad bet.

Many experts argue that an investment in pure commodities is a better diversifier for a long-term portfolio. That's because commodities don't rise and fall with stock prices, while share prices of commodity-related companies do have some correlation with other stock prices.

But I'd much rather make money than worry about assembling a perfectly diversified portfolio. And if oil and other commodity prices stabilize, you'll still be able to make money by owning good companies in those industries.

The managers of RS Global Natural Resources A (RSNRX) -- McKenzie Davis, Ken Settles and Andy Pilara -- see it the same way. They don't make predictions on the price of oil or other commodities. In the energy sector, they hunt for companies that can produce oil at low costs -- for years to come. That means traveling around the world to inspect oil and gas fields.

A huge advantage of investing in stocks instead of pure commodities is that savvy managers, such as the trio who run the RS fund, can identify attractive companies and bargain-priced stocks.

One prime example: XTO Energy (XTO), which explores for and produces natural gas and oil. With huge holdings in gas fields in the Southwest U.S., XTO is able to sell its products at healthy profit margins -- and reinvest increasing amounts in other projects.

At the March 17 close of $59.19, the stock trades at 11 times estimated 2008 earnings of $5.38 a share. And it sells at just 8 times estimated cash flow (earnings plus depreciation and other non-cash charges).

Another favorite stock of the RS managers is Eastman Chemical (EMN), a turnaround candidate. With new management, the company is expanding the use of its sophisticated technology to convert coal into gas. Davis expects earnings to double by 2012, from the $4.98 per share that analysts expect the company to earn this year. Meanwhile, Eastman is buying back 20% of its stock. It closed at $63.64, or about 13 times estimated '08 earnings.

The RS fund is a superb one. It has returned an annualized 31% over the past five years through March 17. On the negative side, it sports a 4.75% sales charge and annual expenses of 1.49%. T. Rowe Price New Era, meanwhile, has produced the same five-year return, has no sales charge and boasts expenses of just 0.63% annually. Note that the five-year returns for both funds leave that of the Pimco commodity fund in the dust.

Should you invest in commodities at all -- even a stock fund? First look at your other stock holdings. Standard & Poor's 500-stock index has 12.5% of its holdings in energy stocks now, and many fund managers have been adding to their energy holdings in recent years. Until recently, I had been advocating placing an extra 5% of assets in T. Rowe Price New Era. I'm not so sure anymore.

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