No Oil Crisis--yet Many investors fear a return to 1970s-style stagflation. Here's how to prepare your portfolio--and even profit
(MONEY Magazine) – The economy is growing fast enough to spark new hiring, and recent data show an uptick in inflation. Investors have started to worry that interest rates will rise and make the stock market stall. Many of them also have a deeper fear--that oil prices are headed higher and could cause a return to stagflation. In the 1970s that poisonous mix of inflation and sluggish growth knocked down the price/earnings ratio of the average blue chip to less than 15. Given today's much higher P/Es, any move toward stagflation could end the bull market and possibly even trigger another major slump.
There are always factors that might deal the stock market a short-term setback. So it's possible that strife in the Middle East could disrupt oil supplies, causing a price spike that would depress the market temporarily. But barring such a shock, the economy should adjust to higher energy prices. Moreover, there are ways you can protect your portfolio and even profit from more expensive oil.
In fact, the economy is doing fairly well at the moment. Mild inflation isn't necessarily a bad thing this early in a recovery--it simply shows that the economy is gaining steam. Nonetheless, the Federal Reserve may soon start pushing up short-term interest rates. One plausible forecast has the Fed nudging up rates by a quarter of a percentage point sometime this summer and another quarter point after the elections, with at least one more increase likely in 2005.
Those rate hikes would be bad news for bond prices. But they wouldn't necessarily hurt stocks. Over the past 50 years, there have been 11 periods in which short-term interest rates have risen and stocks have gone up as well, according to the Leuthold Group, an institutional investment advisory firm in Minneapolis. During those periods--some of which lasted three years--interest rates typically rose more than two percentage points, while the S&P 500 gained 37% on average and as much as 60% in one case.
The crucial question for long-term investors is whether oil prices are likely to shift higher on a permanent basis. The answer is yes, for the simple reason that the world is running out of cheap oil. As far out as anyone can project, there will be plenty of fossil fuels--and even adequate supplies of petroleum. But the price needed to make new sources of oil available will be significantly higher than those that have prevailed for most of the past 20 years.
The end of cheap oil
The cost of finding and lifting oil varies enormously from place to place. Many of the cheapest oil fields were developed first--both in the U.S. and in the Middle East. After 40 or 50 years, oilfields can decline rapidly--and there's no simple fix. Advanced technology can postpone the problem. But while horizontal drilling and water injection help prolong the life of a field, these techniques don't create more oil--they just recover more of what's already there.
It's evident that irreversible decline has begun in many Middle Eastern fields. Some wells in Oman, for instance, are yielding 85% water and only 15% oil. Shell, which has substantial production capacity in that country, recently had to write down its proven reserves. And you can expect that the Securities and Exchange Commission will prod all the oil companies to raise their standards for figuring reserves.
Cheap oil can be replaced--but only with more expensive oil. Exploring in less obvious places, drilling offshore, tapping heavy oil and tar sands, synthesizing fuel and adding ethanol to gasoline can all stretch dwindling supplies from older wells. And in some uses oil can be replaced by natural gas, which is still abundant. But over time, the average price of oil will trend higher.
How much higher? Although the price of oil has been close to record levels lately in nominal-dollar terms, it looks quite different after adjusting for inflation (see the chart on the preceding page). Today's $33 oil is less than half the peak 1981 price in 2004 dollars. From here, the oil price is likely to fluctuate in a wide band, but future peaks could easily reach the $40-to-$45 range.
Smart moves to make now
There are three ways to benefit from an uptrend in oil prices. The most defensive is to invest in large integrated oils, such as ConocoPhillips and ExxonMobil, to diversify your portfolio.
The more direct approach is to focus on independent exploration and production (E&P) companies because their share prices largely reflect the value of their extensive oil reserves. Anadarko Petroleum has equal reserves of oil and gas, 80% of which are in North America. Earnings are projected to grow at a compound annual rate of 9% over the next five years, and the yield is 1%. At $54 a share, the stock trades at 11.2 times earnings. Apache has a similar reserve profile, largely in North America, Canada, Australia and the North Sea. Earnings could grow at a 9% rate over the next five years, and the yield is 0.5%. At $44, the stock trades at a 12.1 P/E.
Oil service companies are the most aggressive play. They benefit from increased drilling activity, especially if sophisticated technology is needed. The leader in the field is Schlumberger, but its stock, recently $62 a share, is expensive at a 31 P/E. Schlumberger's total-return potential is impressive, however. In addition to its 1.1% yield, earnings are projected to grow at a 15% compound annual rate over the next five years. My preference is for E&P companies with valuable reserves. But Schlumberger has great potential upside when the era of expensive oil finally arrives.
Michael Sivy can be reached at firstname.lastname@example.org.