NEW YORK (CNN/Money) -
With all the turmoil in the Middle East, it's hardly surprising that the cost of crude is soaring and prices at the gas pump are setting highs.
As a result, at a time when most stocks are down for the year, two energy subsectors of the S&P 500 are among the top performers, up around 14 percent. (See which other sectors are leading the way this year.)
Nonetheless, it's a mistake to chase energy stocks and buy them after they've run up substantially. There is a compelling long-term case for some energy issues, but it's based on scooping up undervalued oil and gas reserves.
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In the midst of a minor oil panic like the current one, it's worth reviewing the effects of soaring oil prices on the economy and the stock market.
A sudden rise in energy prices raises manufacturing and transportation costs, which can slow the economy and also squeeze companies' profit margins, unless they are able to pass the costs through to consumers. If they succeed in passing on the costs, rising consumer prices will encourage inflation.
The fear of stagflation (slower growth and faster inflation) tends to depress price/earnings ratios for most stocks. But a few groups are hurt disproportionately -- and a few actually benefit.
Those that can be especially hurt include energy-dependent companies, such as utilities that burn fossil fuels and airlines, because of their consumption of jet fuel. In addition, some chemical companies that use oil as a feedstock and some plastics companies, such as Newell Rubbermaid, may suffer.
Among the beneficiaries are energy companies, particularly those that focus on actual oil exploration and production (as opposed to refining and marketing).
If rising energy prices appear to be encouraging general inflation, a runup in oil shares may be echoed by other inflation hedges, such as a North American gold-mining index fund.
Nothing lasts forever
There's just one catch in all these general principles. Extremes in oil prices are self-correcting. Prices above $35 a barrel encourage stepped-up exploration and production. They also make consumers more conscious of energy efficiency. By contrast, cheap oil below $15 a barrel encourages demand.
It may take a couple of years for oil prices to self-correct. But because the stock market anticipates the near future, you run the risk of buying energy stocks near the end of their runups if you chase them during oil panics.
The smarter approach is to buy oil and gas stocks when their reserves look undervalued, without paying too much attention to short-term blips. Here's a look at how four energy stocks on the Sivy 70 list measure up.
Schlumberger (SLB: Research, Estimates), an oil-service company, tends to be highly volatile. Since its fortunes are tied to oil-drilling, changes in the current oil price signal potentially enormous changes in business demand for such companies. Up 86 percent over the past 19 months and now trading at more than 30 times estimated earnings for 2004, Schlumberger is the type of energy stock that's most risky at times like these.
ConocoPhillips (COP: Research, Estimates) and Exxon Mobil (XOM: Research, Estimates) are integrated oil companies that offer only moderate growth but provide worthwhile diversification for a portfolio heavily weighted toward growth. They would both likely benefit from a long period of steadily rising oil prices. But so far, both stocks are up a lot less than Schlumberger. Exxon trades at a 16 P/E, while slower growing Conoco looks cheap at only 11 times earnings.
Anadarko Petroleum (APC: Research, Estimates) continues to be my long-term pick in the energy sector. The stock doesn't elicit a lot of support from analysts, because it hasn't moved a lot in the recent runup. The stock is up only 42 percent from its lows and still looks cheap at less than 13 times earnings.
The stock's big plus is that it has more than three-quarters of its reserves in North America, attractive if investors become concerned about the security of oil supplies. And its reserves are so cheap that Anadarko can now get a better earnings bump by using cash flow to buy back stock instead of investing in new drilling. That's true for potential acquirers as well, so Anadarko is widely regarded as a possible takeover target.
In any event, oil and gas in the ground in North America is only likely to get more valuable -- whatever price is on the gas pump this week.
Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Tuesday and Thursday of Sivy on Stocks.
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