Investing July 12, 2009, 9:49PM EST

Energy Stocks: Gusher or Dry Hole?

The demand picture for oil and gas remains cloudy as experts debate the speed of economic recovery. Still, pros see some attractive names for the months ahead

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Investors who are still convinced oil prices are headed higher even if the economic recovery turns out to be much slower than initially expected must have been taken by surprise last week, as oil prices fell 10%, dragging energy stock prices down with them.

Energy investors got another kick in the pants on July 9, when Chevron (CVX) announced that its second-quarter earnings would be hurt by lower U.S. refining margins and currency effects. The week was capped by yet another setback for the energy crowd: On July 10, Nymex crude oil for August delivery finished 55¢ lower, at $59.86 a barrel, 18% lower than its recent peak above $73 a barrel on June 30.

Much of last week's pessimism about energy stemmed from the announcement that the Commodity Futures Trading Commission plans to push for regulations that would sharply limit the extent to which hedge funds and other financial market speculators can invest in oil futures. But appreciation in the value of the U.S. dollar against key foreign currencies like the euro also curbed appetite for commodities, whose popularity has largely been based on the protection they offer from inflation.

Speculators in the Mix

There's still a lot of disagreement among analysts and fund managers as to what level oil prices should be at, based on current and projected future supply-and-demand fundamentals. Fadel Gheit, an analyst at Oppenheimer & Co. (OPY), thinks oil prices should be between $45 and $55, with $55 being "the speed limit" if demand rebounds when the global economy recovers, given how much excess supply there is around the world. He sees the clear hand of speculators in the price of oil jumping 120% between December and the end of June even as demand forecasts were declining.

On the opposite side, Andrew Lees, lead manager of the AIM Energy Fund (IENAX), believes prices need to be significantly higher to give producers incentive to start new projects when they don't know how high the future carbon capture costs that may result from pending legislation will be. "If climate legislation truly demands we start sequestering all CO2 [emissions], there's no technology to do that right now," he says. "So what price do you have to put on crude oil to justify future investment when you have no idea what the cost of future carbon capture is going to be?"

As long as that cost is unknown, it's impossible for producers to project what the marginal cost of production will be in the future, and therefore how high an oil price is needed to guarantee a certain rate of return, adds Lees. He believes that's been one factor contributing to the rapid runup in oil prices in recent weeks.

Surge Seen as Premature

Daniel Rice, portfolio manager of the BlackRock Global Resources Fund (SSGRX), more than 64% of whose allocation is in energy stocks, says the surge in oil prices above $70 was premature given the amount of excess inventory worldwide. He thinks the runup was more of a trade by investors seeking to hedge against a weakening dollar than something based on supply-and-demand factors. But that doesn't mean he's not optimistic about the longer-term prospects for oil prices based on the magnitude of the growth he expects in global gross domestic product a year from now.

The stocks of integrated oil producers and exploration and production companies are now discounting a global oil price between $50 and $55 a barrel, but that's justified only if you believe global gross domestic product will contract by 2% a year on a sustained basis, he says. Even zero growth in the global economy warrants an oil price closer to $70 a barrel, he says.

"[Oil stocks are] saying we're in a longer term -2% GDP world. If you think differently, you'll have a lot of value [in oil stocks]," he says. He thinks oil-stock prices are attractive because investors are underestimating the potential for a quicker recovery. "I think the world will be at +2% GDP growth by the middle of 2010, powered by China," whose economy he expects to grow at 9% a year over the long term.

Hess a Favorite

Since 2% global economic growth should justify oil prices between $80 and $90, oil stocks have potential to double or triple over the next 12 months or so, he says. Every $5-per-barrel gain in the perceived price of oil translates to a 20% rise in stock prices, he adds.

Lees of the AIM Fund thinks it may take until 2011 until the global economy is able to return to 3% growth, but he says a "bigger concern is we don't have the crude oil to produce more than 90 million barrels a day" to support that level of growth.

Hess Corp. (HES) is a more aggressive way to play the major oil producers if you're confident about higher oil prices over the long term, according to a July 8 research note from Raymond James & Co. (RJ). Hess is one of just five U.S. majors that Raymond James covers that has met both production and reserve growth forecasts in each of the last three years, the note said.