The Wall Street Journal: Can Energy Help Investors Running on Empty?: Monday 3 October 2005

Portfolios lacking energy have been sluggish performers this year. The third quarter has come to a close and the major indexes still don't have much to show for themselves.

The technology-laden Nasdaq Composite Index is down 1.1% this year and the Dow Jones Industrial Average is down nearly 2%. But the Standard & Poor's 500-stock index -- a broader benchmark against which many professional investors judge their performance -- has risen 1.4%.

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The reason the S&P 500 has performed better: It has a higher energy weighting than do those other indexes, and energy stocks have been on a tear. The sector represents 10.26% of the index's total market capitalization (that is up from 7.16% at the beginning of the year). Just one of the 30 Dow industrial component companies -- Exxon Mobil Corp. -- comes from the energy sector. What energy stocks there are that trade on the Nasdaq Stock Market have mostly small market capitalizations.

Thanks to the big move in crude oil, which has risen to $66.24 a barrel on the New York Mercantile Exchange from $42.45 at the year's start, energy shares in the S&P 500 have risen nearly 40%. Of the index's remaining nine sectors, only two others -- utilities and health care -- are in positive territory. Without energy, the S&P 500 would be down 2%, on par with the DJIA.

It is a long way of saying that investors who avoided energy stocks have been having a lousy year. To catch up, they are facing the hard decision of whether to embrace the energy bull or hope for a bounce someplace else.

James Paulsen, chief investment strategist at Wells Capital Management, feels those investors' pain. He was bullish on energy until last year, but then switched teams and recommended that his company's portfolio managers carry lighter-than-usual weightings in the sector.

He admits that has been a bad bet, but he worries that investors have gotten so carried away by the sector that it is too late to switch gears. The sector has been trading in lockstep with crude-oil prices, he says, making it vulnerable to any pullback in energy prices.

"Investors who are overweight energy -- I don't think they should delude themselves into thinking they own a good value," Mr. Paulsen says. "They own a commodity: Crude oil."

Mr. Paulsen is the minority. A Merrill Lynch survey last month showed that 3% of U.S. fund managers were underweight energy stocks in their portfolios, while 60% of fund managers were bullish. Surveys from New York research company International Strategy & Investment show that hedge-fund managers are similarly bullish.

That bullishness is part of the problem, says Doug Kass, head of the hedge fund Seabreeze Partners, who has begun to bet against energy. "This is a terribly over-owned sector," he says.

Mr. Kass thinks energy prices have run high enough to prompt energy companies to step up exploration and production while at the same time pushing consumers toward conservation. The falling demand and rising supply that results will end up forcing energy prices lower, he says.

Energy companies, which suffered in the late 1990s when energy prices cratered, have been hesitant to commit to conservation. On his Web log, Jeff Matthews, head of the hedge fund Ram Partners, related attending an investor conference at which BP PLC said it would spend $9.5 billion to $10 billion on exploration and production this year while spending $17 billion on dividends and share repurchases.

He suggested that the United Kingdom company, commonly known as British Petroleum, change its name to British Dividends & Share Repurchases.

Meantime, among geologists there is a raging controversy over whether world oil production is near peak levels and is set to decline. Wall Street is full of enthusiastic supporters for and detractors from this "Hubbert's Peak" hypothesis -- never mind that few of them would know shale from schist. (M. King Hubbert was a geologist at the old Shell Oil who in 1956 accurately forecast the 1970s peak in continental U.S. oil production.)

The more telling indicator may be that if you mouth the words "Hubbert's Peak" on Wall Street, a lot of people will profess to know what you are talking about.

The increasing ranks of such energy experts have spooked some fund managers who have been positive on the sector. Brett Gallagher, head of U.S. equities at Julius Baer, worries that the sector has become crowded and that some highflying names are far ahead of themselves.

He has been selling the standout stocks in his portfolio -- price gainers such as ConocoPhillips, Williams Cos. and Grant Prideco Inc. -- and buying Exxon Mobil shares. He reckons that Exxon, which hasn't risen as fast as most energy stocks, represents a better value. By holding onto it instead of the highfliers, he aims to maintain exposure to the sector while avoiding a big hit if it turns south.

William Sterling, chief investment officer of New York investment company Trilogy Advisors, says that he has been carrying a heavier load of energy stocks this year. He says with hurricanes Katrina and Rita behind us, investors may become less rapturous about the sector. Like Mr. Gallagher, he is reluctant to cut his energy holdings to an underweight position and risk seeing the stocks race forward without him.

"A true frenzy can go a lot further than we imagine," he says.

Fund managers who have shied away from the energy sector, and whose returns are lagging behind those of their peers as a result, are in more of a pickle. If they start putting money into the stocks now, and the stocks go down, they won't only lose even more money, they will look really dumb (perhaps with good cause).

A typical fourth-quarter ploy that many underperforming managers have adopted in recent years -- loading up on volatile technology and retailing stocks in hopes that they will get bailed out by a year-end rally -- may not work this year.

Thanks to high energy prices, many companies are seeing steeper production, raw-material and transportation costs -- leaving them less cash to spend on technology equipment. Consumers are getting pinched, too, and it looks like an expensive home-heating season is on the way.

Still, Morgan Stanley strategist Byron Wien thinks the best thing for investors whose disdain for energy stocks has cut into their returns is to bite the bullet and buy. With the economies of China and India expanding at a breakneck pace (and assuming there is no global economic downturn), he said, demand for oil is going to keep getting stronger.

"If you don't own energy, you better start buying it now," he says.

Write to Justin Lahart at justin.lahart@wsj.com