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Oil investing: 2007 a tough act to follow

It was a banner year for energy - the sector was up 30% and crude jumped 60%. But don't count on a repeat performance in '08.

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By Steve Hargreaves, CNNMoney.com staff writer

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Crude prices and oil company stocks surged in 2007. Can they keep the momentum going next year?

NEW YORK (CNNMoney.com) -- It's been a phenomenal time to invest in oil, but analysts say the huge gains of the last year are most likely a thing of the past.

2007 was truly a banner year for the industry. The big integrated oil companies - ones that produce and refine crude - saw stock gains in the 30 percent range. Crude itself rose nearly 60 percent. The biggest winners were the oil production companies, some of which saw their stock prices double. Overall, the AMEX oil and gas index rose about 30 percent in '07, trouncing the near-stagnant S&P 500.

But most analysts say 2008 is unlikely to mimic the staggering returns of the last year. And on the heels of such a runup, some say the sector is simply overvalued.

Oil company stocks tend to rise and fall with the price of crude, so any prediction on stock prices needs to start with a look at the underlying commodity.

Although U.S. crude is trading near $100 a barrel, 2007 was a very volatile year. Prices began the year by dipping below $50 in January, spiking above $75 in July, then pulling back to the high $60s by the end of August before embarking on its recent record run. For the year, the average price for crude was around $72.

Most analysts have bumped up their estimate for 2008 to around $80 to $85 a barrel from the low $70s, reflecting a view that oil prices will rise but not by another 60 percent, like they did in 2007.

"I don't think too many people are talking about $150 oil, unless they're also stocking up on canned goods and ammunition," said Jeff Tjornehoj, a research analyst at the data and research firm Lipper.

John Kilduff, an energy analyst at MF Global in New York, said he expects crude prices to top $100 a barrel in the first quarter - perhaps peaking around $110 - then pull back to maybe $70 as the economy slows and speculative money retreats.

Still, he says investors are still pricing oil company stock as if oil costs $50 a barrel and sees room for those stocks to go up.

Companies that produce oil - as opposed to refining it - have been the stars of the sector in 2007. Frontier (FTO, Fortune 500) stock is up 45 percent, Occidental (OXY, Fortune 500) is up 60 percent, and Hess (HES, Fortune 500) has surged a staggering 105 percent.

But the stock of those companies is most directly tied to the price of crude, and with crude unlikely to post another 60 percent runup, its doubtful those stocks will see similar gains.

For the integrated companies - those that produce and refine oil - earnings growth for 2008 may be stronger than in 2007.

In the third quarter companies like Exxon Mobil (XOM, Fortune 500), BP (BP) and Chevron (CVX, Fortune 500) saw profits slip as oil prices rose much faster than gasoline prices and eroded the profit margin for refining.

When these companies report their 2007 earnings in January they will struggle to beat their 2006 results. As a result, stocks for the integrated companies lagged the producers, although they still posted healthy - 30 percent - growth for the year.

But gasoline prices have rebounded, and Reuters estimates predict a 9 percent growth in energy company earnings in 2008. That's lower than the 15.7 percent growth that it predicts for the S&P 500, but still a solid performance.

"It's still a good place for investors to hide out an make money in 2008," said Kilduff.

But others think the sector is played out.

"Fundamentally, it's expensive," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "A lot of investors are eager to get into energy, and it's pushed the values to unattractive levels."

Ablin said stocks of energy companies are expensive by a number of metrics. Their price-to-book value - the value of all their outstanding stock compared to book value of their underlying assets - is about 5 percent higher than the S&P average. Normally, energy companies have a price-to-book value about 15 percent lower, said Ablin.

He said he sees a similar pattern with other measures like price to cash flow and price to sales.

"For people holding [energy stocks], we recommend they continue holding them," said Ablin. "But we'd encourage buyers to wait on the sidelines until the values come back down to earth."

Other analysts don't see the sector as expensive, and point to the long-term trend in crude prices - strong demand and limited supply - that pushes prices higher and higher.

"It's high, but it's high in anticipation of higher prices," said Hugh Johnson, chairman of asset management company Johnson Illington Advisors. "Earnings prospects in 2008 are much brighter than they are for many other sectors."

For those looking for a deal in energy, one analyst suggested natural gas.

While companies like Chesapeake (CHK, Fortune 500), EOG Resources (EOG) and XTO Energy (XTO, Fortune 500) have had an impressive year - their stocks are up between 30 percent and 40 percent for the year - natural gas prices are likely to rise faster than oil prices in 2008, said Neal Dingmann, an energy analyst with the New York-based energy investment boutique Dahlman Rose & Co.

Dingmann said oil prices are more than 13 times higher than natural gas prices. The usual ratio is about 6 times higher, he said.

"Either oil is too high or natural gas is too low, but they won't continue at that level for very long," he said.

The spread will encourage more use of natural gas, which should drive up prices and stock values.

"I don't see any way oil can go up another 60 percent," said Dingmann. "But could natural gas go up [from about $7 per 1,000 cubic feet] to $9 or $10, absolutely. That's where I think the play is."  To top of page

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