Although energy fund managers see continued volatility and occasional short-term weakness in oil prices, they remain bullish on the sector for the long term. Despite a pullback to about US$41 a barrel this past fall, the price of a barrel of crude has been hovering in the US$55 range.

“The oil price will continue to be fairly volatile, but will also stay north of US$40 a barrel,” says Glenn MacNeill, manager of Sentry Select Canadian Energy Growth Fund and vice president of investments at Toronto-based Sentry Select Capital Corp.
“There is little capacity in the system and demand continues to be strong. Certainly, US$50 oil is not high enough to suppress demand.” He notes that excess production capacity globally has dropped from four million barrels a day to about one million barrels, which contributes to volatility.

“The supply isn’t there as it used to be,” he says. “We are pushing the upper limits of the system, so we will hit points above US$50 and points below. The market will exaggerate its movements either side.”

At present levels, energy prices do not pose a threat to the North American economy, he says; the cost of energy is significantly lower as a proportion of household income than 20 years ago. Moreover, high prices are being driven by the rapid growth of the Chinese economy. MacNeill cites a Merrill Lynch & Co. Inc. study that forecasts China’s energy consumption will grow to 11 million barrels of oil a day in 2010 from six million barrels recently. “The fundamentals continue to be strong,” he says.

But the short-term picture from the investment standpoint is less rosy. “It is time to get into a defensive mode,” says MacNeill, citing concerns about valuations. “But I still believe the long-term trend is very positive.
Energy stocks are a good place to be.”

MacNeill has raised cash to about 11%. He is also “high-grading” the portfolio, which has about 38 names. “I’m keeping the best possible companies I can find,” he says. On an asset-allocation basis, there is 13% in integrated companies, 18% in energy trusts, 18.5% in senior producers, 8% in mid-caps and 31% in juniors. “We have had the best capital returns in the mid- and junior caps.
It’s a lot easier to grow a company to 1,000 a barrels a day from 500 than for a big company to achieve a comparable increase.
But this is the area of some targeted selling.”

Still, he likes junior Galleon Energy Inc., a gas producer in Western Canada that is looking at boosting daily production to about 7,000 barrels of oil equivalent in 2006 from 4,000 barrels. Purchased in August 2002 at about $8 a share, it is now trading around $11.85. At 7.8 times cash flow, he admits, the stock is not cheap. “But the company has the assets and ability to grow its production significantly. It earned a premium multiple,” says MacNeill, who has a 12-month target of $15 a share.

He also likes senior producer Talisman Energy Inc., which has been in the fund since 1997. Bought at about $15 a share, it is trading at $39. He has a 12-month target of $45. “We like it because it is large, and part of the high-grading process. It is growing, but we don’t expect it to have the same growth rate as the juniors,” he says.
The firm produces about 450,000 BOEs a day in Indonesia and Mexico.

Equally bullish is Bill Bonner, manager of Dominion Equity Resource Fund and president of Calgary-based Network Portfolio Management Inc. His optimism is based largely on movements in the underlying commodity. “Skeptics say oil has gone too far, too fast. I’d say, ‘The price is at which it should have been awhile ago.’ We are playing catch-up,” he says. “I am having a hard time seeing oil drop back down to US$30-US$35, which is what it would take to derail this market.”

Echoing MacNeill, he does anticipate price volatility, however. “There will be blips here and there as we move from the heating season to the driving season. But the pricing risk remains on the upside,” he says. He expects oil prices to settle in the US$40-US$50 a barrel range. “The market is not discounting US$55 oil forever; it is discounting a much lower number. But even at US$45, the industry is very profitable.”