The best play in the energy sector

It's been a mediocre week for investors in the UK's big oil companies. BP and Shell both posted disappointing results, with neither company quite meeting analysts' expectations.

Despite that, overall, the oil sector has been on a tear, particularly in the last six months. And little wonder, with oil prices (at least as measured by Brent crude) now above $100 a barrel.

But how long can this last without hurting the global economy? And is there a better way to play the energy sector?

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For how long can oil prices stay so high?

Royal Dutch Shell saw its share price slide yesterday as investors were disappointed in its fourth-quarter earnings, which missed City expectations, mainly due to weak refining margins. Meanwhile, on the exploration side, Shell was also impacted by the knock-on effects of BP's Gulf of Mexico disaster. It had to put its own plans for drilling in Alaska on hold.

However, the company is hardly in the poorhouse. Quarterly profits rose from $2.8bn a year ago, to $4.1bn. Annual profits were up 90% to $18.6bn. And with oil above $100 a barrel, it's hard to see how oil companies can fail to prosper. The trouble is, how long can this continue?

As a sector, S&P 500 energy stocks have outperformed the market sharply since August, reports the FT, as the price of crude has shot up. But as Jack Ablin of Harris Private Bank tells the Financial Times, "the big worry is that energy stocks can become victims of their own success. If the price of oil goes too high, too fast, it can hurt the economy."

This might seem overly gloomy. Ten years ago, if anyone had suggested the oil price would hit $100 a barrel, most of us would have envisioned a Mad Max-style world of petrol queues and fuel riots. Yet now, most mainstream pundits argue that the world economy has been surprisingly resilient to high oil prices in recent years. The FT's Lex column notes that "record highs barely earned a cameo as a villain in the recent recession, while they played a starring role in 1973-74, 1980-81 and 1990-91".

Meanwhile, Jim Paulsen of Wells Capital Management points out that oil is in fact cheap relative to other commodities. If the price of oil had kept up with its peers this year, it would be at $120 a barrel.

No one can accurately predict where the oil price is going

But it's all very well saying where the price of oil 'should' be. The fact is that it's currently a lot higher than anyone had expected. We had a Roundtable on the future of energy around about the middle of last year. At that point, everyone around the table all of them smart people, heavily involved in the energy sector thought oil would trade in a range of around $60 to $85 a barrel or so for the year ahead. No one was punting on $100 (or $40 for that matter).

That's not a criticism. The point as our experts also made is that no one can hope to accurately predict where the price of oil is going to go, certainly not in the short run. And despite the global economy's apparent acceptance of $100 oil, as Jeremy Warner in The Telegraph notes, "in the US, all post-war recessions have been preceded by an oil price spike." And it's a mistake to dismiss its role in the 2008 crash too hastily. "Record prices at the pumps had put [US] consumer confidence and spending into a tailspin several months before [Lehman Brothers collapsed] Americans took one look at the price of filling up, and decided to stop spending."

The best play in the energy sector now

We may not be quite at that level yet. And the long-term outlook for oil remains bullish. After all, it isn't getting any easier to find. But if you're looking to get into the energy sector right now, we'd be more interested in ways to play an energy source that looks cheap and at the moment, that's not oil. It's natural gas.

As Marc Faber points out in the latest issue of US magazine Barron's, "the cheapest energy is natural gas. It is volatile and depressed." However, he adds, "that is precisely when you buy commodities." Of course, lots of big oil stocks have interests in natural gas. But if you're looking for a purer play, then Faber likes Chesapeake Energy, which coincidentally enough, my colleague David Stevenson tipped in our November cover story on natural gas.

Chesapeake's share price is up almost 40% since then. "So further progress will probably be slower," David tells me. But prospects for the stock still look bright. It has just done a deal with China's CNOOC, "which looks a solid endorsement. And less than a third of analysts are bullish on the stock, which is always a good sign." On top of that, if natural gas prices rise, the company is sure to benefit.

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