Rising prices, an unstable world—what every investor needs to know about...OIL
By Nick Pachetti

(MONEY Magazine) – Quick—what's the going rate for a barrel of crude oil? Chances are, you got the answer within a couple of bucks. After all, the price of oil, as high as $56 a barrel in late October, is the lead story on the financial news most days. And the pain that number causes isn't limited to the pump. Oil anxiety has helped keep the stock market flat all year. To put things in perspective: In early 2003, MONEY said that a recent spike in oil prices was the new "X factor" threatening the economy and the markets. Crude was then at $33 a barrel.

So what's next? Based on conversations with a dozen leading economists, oil experts and energy investors, here are the answers to frequently asked questions about the future of oil, the markets and your investments.

Are we headed for $70 or $30? Let's start by looking at how oil got above $50 in the first place. Iraq and terrorism are just part of the picture. Oil prices have risen on good news too. The global economy is recovering, which increases the thirst for oil. Although the rebound in the U.S. has been muted, the booming Chinese economy accounts for about half of the recent 3% increase in worldwide oil demand. The oil industry didn't see this coming and now has to run at virtually full capacity. With so little slack, any threat to supply—see Iraq and terrorism above—has the potential to send prices soaring. Few experts are willing to rule out $70 or even $80 a barrel in the short term, especially if a headline shock comes during an unusually cold winter in the U.S. And for the long term, there's a small but growing chorus of economists and geologists who subscribe to the "peak oil" theory, which says that the age of inexpensive oil is over simply because we've run out of easily accessible reserves.

But more mainstream oil experts suggest that prices are likely to moderate over the next one to two years. Tapping unused wells and new fields can increase production by about 2% by the end of 2005, according to Rick Mueller, senior oil analyst at consultant Energy Security Analysis. That's a lot—production typically increases by 1% a year. And the Chinese economy's frenetic growth rate appears to be slowing.

Certainly energy investors aren't seeing the kind of crisis that the alarmist headlines seem to portend. Long-term futures contracts indicate that oil traders expect a price in the $40s next year. And oil company stocks, while they've had a good run this year, still aren't especially expensive. Current prices—ExxonMobil (XOM) trades at 15 times expected 2004 earnings, ChevronTexaco (CVX) at 11—suggest a Wall Street consensus that oil is headed down to the mid-$30s, according to David Nelson, manager of the Legg Mason American Leading Companies fund. Nelson is bullish on oil stocks because he thinks the per-barrel price will settle closer to $45, but that's still down nearly 20% from October highs.

What does high-priced oil mean for the economy and the markets? There's no question that expensive oil hurts the U.S. and world economies. Higher energy prices cut into consumers' budgets for other goods and services, and that hurts economic growth and corporate profits. In October, Federal Reserve chairman Alan Greenspan said that high oil prices had already shaved about three-quarters of a percentage point off of U.S. economic growth this year. Morgan Stanley's bearish chief economist Stephen Roach frets that oil could even spark a recession in 2005. But he still puts the odds of escaping that fate at better than even, and he's only reduced his forecast for world growth next year to 3.6%—not a boom, but not a bust either. And remember, Roach is a serious bear. Mark Zandi, chief economist at Economy.com, says that the U.S. and world economies are healthier than they were in early 2003 and can better absorb higher oil prices.

As for the stock market, it's likely that much of the impact of expensive oil is already factored into share prices. MONEY's Michael Sivy pointed out in October's "High Anxiety" (available to subscribers at money.com) that at this point in the economic cycle, stock prices normally would be 20% higher than they are now. So it wouldn't take a big drop to spark a stock rally. "If the price of oil drops below $45, you'll definitely get a boost," predicts Zandi.

What do I do as an investor? Probably not much. A properly balanced portfolio would have a 5% to 10% allocation in commodity-based stocks, including energy producers. Review your portfolio as part of a year-end checkup. (Own an S&P 500 fund, by the way, and you already have about 8% of that money in energy.) If you're in balance, you can stay put. Here's why.

The price of oil is probably going to bounce around, even if the trend is toward moderation. Trying to adjust and readjust in anticipation will tie you up in knots. So don't try. If the price of oil declines over the next year, you'll benefit from a rally. If the price spikes, the rise in share prices among your energy stocks will help cushion any blows you take elsewhere. And remember, most experts don't expect any spike to last.

If, on the other hand, your asset allocation is seriously out of whack—perhaps you've owned lots of big technology and drug stocks and ignored energy—it makes sense to add a big, diversified oil company like ExxonMobil to your portfolio. That's a sound strategy whether oil is in the $50s or the $30s. Oil giants benefit from higher oil prices, but the breadth of their businesses gives you some protection should prices fall. If you're a fund investor, consider the T. Rowe Price New Era specialty fund (800-638-5660). The fund's top holdings include big oil stocks, but manager Charles Ober holds a variety of natural resource stocks. The fund's expense ratio is 0.72%.

I don't buy the moderation argument. How can I benefit from rising prices? If you think the Peak Oilers are onto something, you can bet aggressively in hopes of a big long-run payoff. David Goodstein, a professor of physics at Caltech and author of Out of Gas: The End of the Age of Oil, says that he and his wife have loaded up on oil stocks "because oil will be a scarce commodity." Among the stocks most directly affected by oil prices are those of drillers like Transocean (RIG) and oil services companies such as Schlumberger (SLB). But those stocks have already run up 46% and 15%, respectively, this year, and they're quite volatile: The shares often rise faster than oil prices and fall harder too. So you're running a big risk if oil prices drop sharply. But then at least filling up the gas tank will cost you less.