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High oil prices create difficult choices, greater risks for equity investors

by Wayne Cheveldayoff, 2005-08-18

High oil prices are creating difficult choices for investors as they have raised the risks of holding energy stocks and index funds linked to the S&P/TSX Composite, of which 25% is energy stocks.

A soaring energy sector is the main reason the S&P/TSX Composite Index was up 15.7 per cent from January 1 to August 11 of this year, compared with little change for the low-energy-weighted U.S. indexes (S&P500 +2.1 per cent, Dow Jones –0.9 per cent and NASDAQ no change). The TSX energy index was up 55 per cent during this period.

A disbelief that oil prices can stay at $50 or $60 U.S. a barrel has promoted some forecasters, such as Clement Gignac, chief economist and strategist at National Bank Financial, to predict a 10-per-cent decline in the S&P/TSX Composite Index over the next 12 months (based on a drop below $50 a barrel for oil).

The escalating oil sector probably is also the main reason why Standard and Poor’s found that the S&P/TSX Composite Index outperformed 80 per cent of actively managed Canadian equity funds in the second quarter of 2005. Many active managers likely didn’t believe oil could get so high and had a much lower weighting for energy stocks than the index.

The situation raises many questions. While it was more advantageous to be in energy stocks and index funds than in actively managed funds so far this year, what does the future hold?

Should those holding energy stocks sell? Should those holding index funds now switch to actively managed funds to escape the predicted slide in the S&P/TSX Composite Index as oil prices come down?

One cannot escape making an oil-price forecast. The demand-supply factors are still strong for oil and natural gas markets, leading some analysts to predict continued high or even higher prices over the next several years – quite the opposite of what Mr. Gignac thinks will happen.

With economists disagreeing and investment advisors no better at forecasting than anyone else, it is really up to investors to choose their own path.

A complicating factor is the loose linkage between oil and gas stocks and commodity prices. Even if oil prices slip from the $60-a-barrel range into the $50-a-barrel range, it may be that oil and gas stocks would still be higher a year from now – especially if enough market participants believe the oil price will stay high for some time.

A recent commentary by Greg Pardy, an oil and gas analyst at Scotia Capital, noted that the stock prices for large oil and gas integrated and exploration companies in Scotia’s coverage universe were discounting only $45 oil. That means the market was not assigning any value to the share prices for the rise in the oil price above that level.

When the commentary was written on August 10, PetroCanada shares, for example, were near record highs at $96.17, Canadian Natural $58.16, Talisman $57.21 and Suncor $70.08.

Mr. Pardy said that if the market began to discount an oil price at $50 a barrel, the group’s stock valuations would have upside of 13.6 per cent. If the market discounts $55 a barrel, the upside is 27.2 per cent.

So, it is not simply a question of whether or not oil prices will fall, but also how far they will fall and, further, what market participants collectively think they will be at in a year or two.

And it is important to remember that even at $45 a barrel, oil and gas producers would still be very profitable.

One way investors could stay invested in the sector and attempt to reduce risk is by shifting from the large energy companies to junior oil and gas exploration companies that are growing their production at much faster rates. The expected good-sized gains in production levels at junior explorers should offset some or all of any commodity price decline that may occur.

Also, by allocating some money to oil and gas tax shelters, where the investment can be fully written off against employment or other income, the resulting break on income taxes would provide a cushion to offset any share-price declines that could come if oil prices nose-dive. A new batch of oil and gas tax shelters should be available this fall through investment dealers.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2005 Wayne Cheveldayoff