Hold On To Energy Stocks

After a precipitous decline in crude oil prices in the last half of 2008, investors scrambled to get out of energy stocks. From peak to trough, the price of a barrel of crude oil dropped by more than 75 percent. As the worldwide recession deepened, natural gas prices crashed too, to $3.25 per thousand cubic feet, a 74 percent decline from a peak above $13. In many cases, the common stocks of energy companies dropped about as much as energy prices.

At the time, we advised investors to hold most energy positions—and we still believe that to be a good course of action.

Historically, the energy market has been self-correcting as a result of its supply and demand characteristics. Energy companies can respond to large price movements relatively quickly—but not instantaneously—by either increasing or decreasing drilling activity, which directly affects future supply. The past 14 months exemplify this. As the price of crude oil and natural gas skyrocketed last summer, drilling increased rapidly in an effort to keep up with demand. However, production from new drilling projects doesn’t show up in supply for about six months. Since the supply response lagged, prices kept climbing in July 2008.

The economic slowdown that began in the fall of last year triggered a sharp drop in energy demand just as supply was peaking. As a result, energy prices and energy stocks collapsed.

In an effort to correct for the low prices and high inventories of gas and oil, energy companies cut back on drilling: Existing and new projects were reduced, delayed, or in many cases, cancelled altogether. Now, the number of rigs drilling for natural gas, for example, is down about 60 percent since peak levels last September. The Organization for Petroleum Exporting Countries, whose member countries produce one-third of the world’s crude oil, cut production. It simply isn’t profitable for companies to drill for oil or natural gas at depressed prices.

But such supply and demand adjustments don’t coincide exactly with reality. So just when oil and natural gas producers have cut back on production, it’s not inconceivable that we could be nearing the end of the recession and the start of a resultant increase in industrial demand for energy. Falling supply and rising demand may lead to a very swift increase in prices next winter.

What does this mean for energy stocks? It means they are going up. Last spring, when energy prices hit bottom, energy stocks started to recover in anticipation of renewed economic growth later in 2009. But more energy stock appreciation is coming. Commodities are often an investment choice to guard against inflation. The falling dollar, which is an early signal of coming inflation, could supercharge the anticipated rise in energy prices.