Investors looking to tap into the red-hot energy market have a number of questions to consider before making the leap. To start, record oil prices have many wondering if US$60 a barrel will hold steady and, if so, for how long. There is also concern that depleting oil supply will drive energy prices to astronomical levels, making the sector too expensive.

The viability of alternative energy only complicates matters. Rising fuel costs and aging power grids that are struggling to keep up with demand mean other energy sources such as solar, biomass, wind, hydrogen and natural gas are poised to hit their stride. But which one will take off first, and when?

Energy experts don’t agree on how to play the sector. Some say the market is bound to implode, much like the dot-com bubble did in 2000, while others are confident current trends will continue.

Dan McClure takes a more moderate view. Co-manager of Investors Summa Fund and director, research, for Investors Group Inc. in Toronto, sees opportunities in both traditional oil and gas companies and in alternative energy providers. He says investors would be remiss to ignore one for the other.

“Given demand for energy consumption and growing demand in developing nations, we’ll need to rely on all sources of energy in the foreseeable future,” he says.

He holds traditional oil and gas stocks in the Summa fund — SunCor Energy Inc., EnCana Corp. and Husky Energy Inc., to name a few — yet, he says, a number of obscure names will benefit from a move to alternative energy sources.

One such firm is MEMC Electronic Materials Inc., a Montana-based polysilicon producer that provides material for electronics and computer manufacturers. In the past two years, 25%-40% of the company’s production has been used by the solar-power industry.

McClure also likes ATS Automation Tooling Systems Inc., a Cambridge, Ont.-based company that makes automated manufacturing systems. ATS is poised to spin off its solar-power business in an initial public offering in the coming year, which could give its stock a lift.

Those looking to play the alternative energy market would be wise to invest in companies that supply materials and technology to the more risky project developers, says MacMurray Whale, an alternative energy analyst at Sprott Securities Inc. in Toronto. He says B.C.-based fuel-cell pioneer Ballard Power Systems Inc., for instance, is a risky play because its commercialization is so far away and its technology is in its infancy.

“Service companies are a good way of playing the alternative energy sector because they’re usually lower-risk and they’re already operating companies,” says Whale.

He likes Xantrex Technology Inc., a B.C. company that manufactures inverters for solar panels and wind turbines. The firm has a stable business in making inverters for consumer electronics, but the real growth opportunity is in the alternative energy space, Whale says. Xantrex has already introduced products in Europe and California, where wind- and solar-powered energy are more advanced.

VRB Power Systems Inc. is another strong contender in the alternative energy space. The Vancouver-based firm manufactures energy-storage devices to sell to wind-power companies, and operates a business that builds backup systems for the telecom industry.

Both McClure and Whale are equally enthusiastic about Calgary-based renewable-energy producer Canadian Hydro Developers Inc., which uses natural resources to produce clean power through several hydroelectric plants, three wind plants and one biomass plant. The firm has more than 1,000 megawatts in the pipeline, and capacity is ramping up since it won power-purchase agreements from the government. “Over the next five years, you could see an eight- or ninefold increase in the amount of capacity it has for generating power from wind and biomass,” Whale says.

Not everyone is convinced alternative energy is the way to play the energy market. Bruce Jackson, co-manager of GGOF Resource Fund and managing director of Barrantagh Investment Management Inc. in Toronto, says oil prices may fluctuate modestly but won’t drop much lower than current prices, barring a global recession. He’s sticking to traditional oil and gas firms that have demonstrated significant free cash flow, such as Calgary-based Rider Resources Ltd.

In the meantime, he’s looking to the service arena. “There [has] been a huge transfer in power from oil and gas producers to companies that service them,” he says, counting Calfrac Well Services Ltd. and Western Lakota Energy Services Inc. among his biggest holdings.

@page_break@He explains their appeal: “Look at the gross dollar amount that comes out of a pool of oil and gas. A higher proportion of that is going to service companies every year because it is getting more difficult to get oil out,” he says. “The service companies have that manpower and experience, so they have a strong bargaining chip. They’re becoming more powerful, which means higher margin and a more sustainable business model.”

Bruce Carscallen, portfolio manager with Saxon Mutual Funds Ltd. in Toronto, agrees. “Everybody is paying attention to the ones out in the oilfields grabbing the stuff out of the ground,” says Carscallen, who manages Saxon Small-Cap Fund. “But cheaper names that represent good value are being overlooked.”

Despite being bullish on energy over the long term, he is hesitant to pour money into the sector now, citing a lack of “compelling valuation opportunities” in the small-cap arena. Saxon Small-Cap Fund has about $260 million in assets, with a small energy weighting (11%).

The problem, he says, is several of his energy plays converted into income trusts, which he does not hold in the fund. In many cases, a management team that spins off into an income trust will start up a brand new oil and gas exploration firm that typically trades at four to five times net asset value because investors are enthusiastic about management’s previous success.

“These little firms start up with zero production, a pile of land and a pile of expectations that they’re going to get oil out of the ground, but they have no material nor cash flow,” Carscallen says.

He holds stock in Calgary-based Dynetek Industries Ltd., which manufactures storage facilities for compressed natural gas. But, in general, he thinks the alternative energy space has a long way to go before investors will buy into it. IE