STREET WISE by Sam Jaffe

OIL PRICES ARE DOWN, BUT THIS ENERGY FUND ISN'T

Just a year after Michael Hoover started following the oil industry in 1989 as an analyst for U.S. Trust, he watched in horror as oil prices nearly doubled following Saddam Hussein's August invasion of Kuwait. A year later, he watched prices collapse after the American victory in Desert Storm.

But the dramatic 30% drop in oil prices over the last six months -- including a decade-long low of $12 a barrel on St. Patrick's Day -- was even more painful to Hoover. Why? Because now he manages the Excelsior Energy & Natural Resources fund (UMESX), a no-load fund that he took over in 1995. But unlike most other portfolio managers who have been burned by the big bets they made on oil stocks, Hoover came away from the latest price trough relatively unscathed. His fund actually returned 2.4% from the beginning of the year through the end of May. While about 10 percentage points below the S&P 500's first-half return, Excelsior Energy remained in the top quartile of all energy-sector funds. It also has the best three- and five-year records of any energy fund, according to Morningstar, a Chicago mutual-fund research firm.

How has Hoover done it? When prices were higher at the end of last year, he stocked up on the oil giants, especially Exxon (X), Royal Dutch (RD), and Mobil (MOB). By the end of the year, those three stocks accounted for almost a third of the fund's assets. Traditionally, big oil companies have been held hostage to oil prices: When prices rise, their stocks do well, and when prices drop, they fall. But Hoover stocked up on these oil majors while oil prices were higher because he believes a sea change has occurred in the oil multinationals. Thanks to aggressive cost-cutting and managements' commitment to increasing dividends, these stocks are no longer as linked to oil prices as they formerly were. "In the past 10 years, these stocks have outperformed the market on a total-return basis," says Hoover, noting that the past decade has also been a time of historically low prices.

The current phenomenon of ridiculously cheap oil won't last very long, though, says Hoover. He cites three reasons why prices have gone so low. First of all, new technology has made the discovery and extraction of oil much cheaper. He figures that production costs per barrel have dropped one-sixth, to $5 a barrel, in the last five years alone. The Asian crisis has also put tremendous pressure on demand, as the Tiger economies of the East shut down factories and slacken production. Finally, he points to the gradual readmittance to the world market of Iraq's oil, which is already near full production, as another stimulus to low prices. All of those factors have already been priced into the market, Hoover says, and he expects oil to return to its traditional trading range by the end of this year. "Historically, oil has traded in a range between $15 to $20 per barrel [in current-dollar terms]," says Hoover, "and when it leaves that range, it tends not to stay out of it for more than six months."

That's why he's now starting to buy stocks that are linked more to the price of oil, namely, oil explorers and service companies. These stocks are more volatile, he admits, but they should give an extra kick to his returns if oil prices rise.

On the exploration front, Hoover's favorite stock is Ocean Energy (OEI), which is developing several fields in the Gulf of Mexico and off the coast of West Africa. The stock closed at $19.75 on June 30th, near its low for the year, even though analysts expect its earnings to grow by 67% in 1999, to $0.78 per share. Hoover estimates that the company's unit volume is increasing by 25% a year, which will lead directly to revenue growth. In addition, it has the technology to discover and exploit new fields. "Just a few years ago, you couldn't pull up oil from 5,000 feet under water," says Hoover. "We knew there were deposits, but we didn't know how to map them or drill for them. Now it's being done."

Hoover's favorite oil-services play is R&B Falcon (FLC), which builds deep-sea oil rigs. It also is involved in the new fields off the coasts of Mexico and Africa, and it currently has four major contracts to place rigs in deep water. "They have a number of jobs that are guaranteed for the next 24 months," he says. "These are contracts with major producers that are likely to be honored even if prices stay low." R&B Falcon is currently trading at a price-earnings ratio of 11.6 and is expected by analysts to make $3.08 in profits per share in 1999. If oil prices head north, its profits will too. And that will help keep Hoover at the top of the energy fund heap.

Sam Jaffe writes about the markets for Business Week Online