Investing in the World’s Hottest Sector

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Energy is in the headlines once again.

The oil price has hit an all-time peak, at least in nominal terms. Record-high gas and electricity prices are being forecast for Europe this coming winter because of developing supply shortages.

In Canada, the oil majors are scrambling to get a stake in the immense tar sand resources, the latest move being Total's billion-dollar purchase of Deer Creek Energy. In Australia, the government has moved to open up one of the world's greatest undeveloped uranium resources. And in the US a mammoth energy bill has been signed into law that is more about "pork" and political posturing than about addressing the real issues.

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Is it too late to buy into energy, or time to bail out of stocks you hold?

Investing in energy is what my friend David Fuller calls "a supply inelasticity play" there's not enough of the stuff available to meet demand, and shortages are likely to persist for some time because it will take years to increase supply sufficiently. In the meantime, that means high prices and continuing good profit margins for companies in the business of supplying energy resources.

We've got energy shortages, which seem set to get worse, because:

a) Prices of energy resources were so low for so long that suppliers cut back sharply on exploration for new resources and abandoned expansion of refining and distribution facilities. (Oil sold for $10 a barrel less than seven years ago, compared to $65 currently).

Even now, fears about whether high prices for energy resources can be sustained are making companies cautious about taking the risk of investing in expansion. The amounts of capital required are enormous hundreds of millions, sometimes billions, of dollars for a single new facility. And it's years before payback time.

b) There are major political obstacles to increasing supply.

Most of the abundant cheap resources of oil and natural gas are in places such as Saudi Arabia, Russia and Iran, which are hostile to foreign firms that would like to develop them. Other locations such as Africa, Indonesia or Venezuela are politically risky.

Nuclear power avoids the supply location problem, as it can be generated anywhere it's needed. But since the Chernobyl disaster, few countries have been willing to allow building of new plants. Policies are starting to change in favour of them but slowly.

In the US, the biggest energy consumer, the powerful environmental lobby has blocked the opening-up of new resources. No new oil refineries have been built for 30 years. In both America and Europe, capital investment has been diverted from supply expansions to meet increasingly-tough cleaner-fuel regulations. It typically costs $400 million to make a coal-fired power station politically acceptable.

c) There are also natural obstacles to increasing supply. Much of the additional oil resources are in deep waters, or in difficult locations (Siberia, the Arctic). Natural gas deposits are in the "wrong" places, requiring long pipelines or very expensive liquefaction facilities to bring gas to where it's needed.

d) Global energy demand is expanding faster than supply because of high rates of economic growth in the emerging economies, especially China. One of the characteristics of such growth is that it's energy-intensive focused on production of cement, steel and other metals, and transportation, rather than the services and high-tech industries of developed nations that use relatively little energy.

Against this background, there is much promotion of the idea that the world is in danger of running out of energy resources.

That's complete rubbish, promoted by those seeking to advance their political or business interests.

Oil and natural gas reserves have been in a rising trend for most of the past century, not only in tonnage terms, but even relative to rising consumption.

Enough for thousands of years

Bjrn Lomborg writes in The Skeptical Environmentalist: "We have oil for at least 40 years at present consumption, at least 60 years' worth of gas, and 230 years' worth of coal. At $40 a barrel shale oil can supply oil for the next 250 years at current consumption All in all, there is oil enough to cover our total energy consumption for the next 5,000 years. There is uranium for the next 14,000 years."

Business Week reported recently how higher energy prices make various non-traditional sources of energy commercially viable, giving these examples:

:Mining the oil sands of Canada and Venezuela is profitable at $25-30 a barrel;

:Oil-from-coal (as produced in South Africa for many years) and making alcohol fuel from sugar (already a big business in Brazil) are profitable processes with oil at $35-40 a barrel;

:Oil from America's huge shale deposits becomes viable at $40 a barrel and higher.

:New nuclear power stations are already viable in the US, without any subsidies, at only two-thirds the level of current electricity prices.

Another source suggests that the huge gas-to-liquid plants being built in Qatar to convert natural gas into diesel fuel will be profitable at oil prices above $14 a barrel.

The global scramble for resources

High and still-rising prices have alerted the politicians to the increasing importance of energy.

Until very recently, the policy agenda has been dominated by the environmentalist lobby, whose concerns have been to curb generation of pollutants and greenhouse gases by power stations, factories and motor vehicles, prevent damage to the landscape, and divert production to "renewable" resources such as wind-power, solar energy and "biomass" (fuel made from crops).

Now there's a new factor starting to shape policy - fear of growing dependence on oil and gas imported from the Middle East, Russia and Africa.

The failure of the $20 billion bid by the Chinese oil company CNOOC for the American firm Unocal, because of political opposition, highlights the intensifying competition among major nations for control over supplies of energy resources.

China, now the world's second biggest importer of oil, is the most aggressive player, its companies roaming the world to buy oil and gas reserves. My guess is that they will target countries where they are unlikely to face political barriers, such as those in Africa, Canada, Southeast Asia and possibly Australia.

Energy is the world's biggest industry, encompassing thousands of companies involved in exploration, production, distribution, research and supply of capital equipment. This makes it difficult to offer more than a few random ideas for investing in the sector:

There are few mutual funds investing internationally in the energy sector. I particularly like the Investec Global Energy funds, which come in two versions: the Guernsey-based dollar-denominated offshore fund, and the sterling-denominated onshore UK fund. A virtually identical fund with the same manager is offered to US investors as Guinness Atkinson Global Energy.

These are great funds, but they're overwhelmingly in oil assets, giving you little or no exposure to natural gas, coal, nuclear power or electricity generation.

There are many listed oil producers, with the giants offering the stability that comes from size, heavyweight management and geographical diversity. I prefer those with little or no exposure to the Middle East such as the Canadians (especially Canadian Oil Sands, Suncor and Canadian Natural Resources), Australia's Woodside Petroleum, China's PetroChina, CNOOC and Sinopec, South Africa's Sasol and Brazil's Petrobras.

Gas, nuclear power and renewables

Natural gas has an even brighter future than oil, but listed companies investing mainly in it, rather than oil, are few. I prefer the North Americans such as Encana and XTO Energy to the UK's very expensive (but well-managed and globally diversified) BG Group, a prime mover in the fields of LNG (Liquefied Natural Gas).

There are a few opportunities in nuclear power. A handful of mines in Canada and Australia produce uranium as their primary product. Their listed stocks are Cameco Corp. and Denison Mines (Toronto) and Energy Resources of Australia (Sydney). Other nuclear energy securities include Areva, the French builder of power stations, and USEC, the world's leading supplier of fuel rods for commercial nuclear plants.

Renewable energy is spawning a lot of new companies. Perhaps the best-established is Denmark's Vestas Wind Systems, the world leader in wind turbines. Other suggestions are solar energy players Solarworld (Germany) and Evergreen Solar (US). Merrill Lynch has a Luxembourg-based mutual fund, New Energy Technology, which has started to do well after a very disappointing post-launch period.

Coal is a sector generally overlooked because it's so unfashionable polluting, clumsy to transport, dangerous to mine. Nevertheless, it's making something of a comeback as better ways are found to reduce pollution. Prices have been soaring in line with those of other energy resources. Indonesia plans to double its use of coal over the next ten years so it can halve domestic oil consumption. Unfortunately most of the major producers are owned by the mining groups.

Finally, let me answer the question I posed at the start of this report.

I don't think it's too late to invest in energy. In fact I think it ought to be a major element in your portfolio. But this isn't a good time to make an entry into the sector. All the energy stocks have had strong runs and are starting to look rather expensive. Wait for a correction that brings the oil price back to about $54 a barrel (WTI crude), and natural gas back to $6.75 a unit (Henry Hub). Then go out and considering buying.

If you're already holding energy stocks, I wouldn't take profits unless you're a speculator. This is a powerful bull market that could run up much further before suffering a major correction.

By Martin Spring in On Target, a private newsletter on global strategy