Oil's Fledgling Recovery: Should Investors Jump In?

The rally in oil prices has many pros closing out bearish positions and moving to neutral ones. But will the trend continue upward?

By David Bogoslaw

Amid growing confidence about an economic recovery by the end of the year, the energy sector seems to be off to the races again. One nagging question persists: Will it last?

The May oil contract on the New York Mercantile Exchange settled at $54.34 on Mar. 26, up 13% since Mar. 16. The Amex Oil Index, which contains 12 oil-oriented stocks, closed at 910.68 on Mar. 26, up nearly 9% from 836.60 on Mar. 16, the day before the price of oil settled above $50 for the first time since Jan. 26. The index is still well below its closing price of 1,019.80 on Jan. 2.

Much of the rally in oil prices and energy stocks over the past week or two may simply reflect a more positive tone in the broader market as investors become more confident that the Obama Administration is getting a handle on how to resolve the toxic assets issue.

Weaker U.S. Dollar a Factor

Given how bearish market sentiment in the energy sector has been over the past six months, many fund managers and other investment pros have decided that the risk of a rapid run-up has increased, and it's time to at least exit their short positions and return to a neutral energy weighting, according to Clay Hoes, who is a sub-adviser for the $50 million AmEx Global Equities Energy Fund.

While fund managers and analysts recognize that a weaker U.S. dollar and resurgent fears about inflation due to ballooning government debt have contributed to the oil rally, many believe it's based more on anticipation of economic recovery by the end of 2009. "Energy is looking for an uptick in global gross domestic product," says Hoes. That's the central aim of all the money that the U.S. and foreign governments have pumped into the system, he adds.

There's always the chance that gloom will resurface and oil prices will resume their downward spiral, but analysts say they're reassured by a high level of compliance with a recent 4.2 million barrel-a-day cut in the OPEC's production quotas. Cartel members are 80% to 90% compliant with the cuts this time, compared with 60% to 75% compliance in the past, says Tom Nelson, an analyst for the Guinness Atkinson Global Energy Fund (GAGEX), which manages $30 million in assets.

Confidence in OPEC

"That suggests to us that not only does OPEC have the firepower to support this oil price but there's enough internal agreement between OPEC members that they can actually achieve it," he says. That means the oil market may have put in a bottom and that prices will range between $50 and $70 a barrel from now on, he adds.

Another reason to believe that $45 to $50 could be a floor for oil prices is that the International Energy Agency has already abandoned any optimism it had about non-OPEC supply growth this year. The Paris agency said it now expects production from those countries to be unchanged from 2008. Nelson thinks non-OPEC production could end up lower than last year.

Still, with U.S. crude inventories at 16-year highs—they rose by 3.1 million barrels to 356.6 million barrels during the week ending Mar. 20, according to the latest data from the Energy Information Administration—it's just as easy to argue that fundamentals are not the primary impetus for the hike in oil prices. "We still haven't seen an uptick in demand. The EIA predicts oil usage will be down 4% in the second quarter of 2009 from [a year ago]," says Mike Zarembski, senior commodities analyst at OptionsXpress (OXPS) in Chicago.

Timing is Everything

Based on its optimism about market fundamentals, the managers at Guinness are looking toward stocks with greater exposure to the commodity. Nelson prefers independent exploration and production, or E&P, companies to the integrated producers whose refining and marketing businesses tend to put those companies in a more defensive position, and hamper their ability to profit from any upside in commodity prices.