If the stock market teaches a lesson worth learning, it is to have energy represented in your portfolio all the time.

The payoff comes, of course, at times like these, when oil the commodity reigns. When plentiful, a commodity generally trades close to the cost of production. When it becomes scarce, the price reaches for the sky — there is no upper limit.

When disaster disrupts tight supply, as hurricane Katrina has done, price pressure intensifies. The result is fury at the gasoline pumps and local gasoline shortages.

Tight supply also is why we have had US$70 per barrel prices in the crude oil futures market, compared with US$20 four years ago, and why some analysts expect to see the crude price at US$100.

But another factor is at work, as well. During inflationary times, such as we have experienced for a century, energy prices lead the charge.

There are two main types of oil stocks, with different patterns of behaviour. In Canada, we have mainly the wildcat variety — the boom-and-bust exploration and production
(E&P) companies.

The dominant U.S. oil stocks are huge integrated oil and gas companies; they have provided stable investment returns through the decades despite the volatility of oil prices.

Canadian stocks produce big profits in short bursts and drop more heavily, so their risks are higher.

U.S. integrated oil companies have provided the most consistent profits for investors.
From the Second World War stock market low, U.S. oil stocks have risen steadily with few notable interruptions, few of those lasting more than a year.

From the secular low in 1942, U.S. oil stocks have risen by a multiple of 300 (the comparison is approximate because of changes in stock indexes). Measurement is approximate in Canadian terms, too, because of similar changes. But the comparable gain by E&P stocks is about 34 times.

In terms of relative strength, investing in oil and gas reveals another aspect. There have been long periods when oil and gas stocks underperformed the market — that is, you would have made better profits in other industries.

Despite this, oil stocks have produced real gains through long periods of relative underperformance.

The amazing example of dropping relative strength but overall gains by U.S. oils is the 20 years from 1980 to 2000. Their relative strength dropped, yet oil stock prices gained almost sixfold.

In that period, Canada’s volatile oil explorers had six big swings, as much as 53% down and 108% up, but overall produced only a 10% rise.

Wall Street oils outperformed the market from 1940 to 1980 — that is, relative strength increased. During those 40 years, there were eight downturns in price by the oils. Most were only a year long, with single-digit percentage drops.

The pattern of relative strength differs in Canada: it dropped from 1940 to 1960 and gained from then up to 1980.

The Canadian stocks also had eight price drops from 1940 to 1980, but the drops typically lasted two years and were larger. The largest drops were 51%, 42%, 41% and 38%; only one was a single-digit percentage drop.

The 1940-80 period included the end of a frustrating era for oil exploration in the West, when the promise of early petroleum discoveries went unfulfilled. The Leduc discovery in 1947 changed that.

Within these secular trends, swings by the dominant E&P stocks in Canada tend to be shorter than major swings by U.S. stocks. A typical oil bull move in Canada lasts six to eight years. Major swings on Wall Street have endured for as long as 15 years.

The current bull move in Canada is in its seventh year, with the E&P stock index up about 480% since 1998. Oils on Wall Street dipped in 2002-03, and have gained 73% since then.

So a pattern emerges: big integrated oil stocks are long-term buy-and-hold propositions, but it is worth waiting for a downturn to buy them. Exploration and production stocks are shorter-term buys and much more vulnerable to big price drops, so timing becomes a significant issue.

Between 1918 (when U.S. oil stock price indices begin) and the 1940s, the market for oil stocks was less reliable. Price swings were more frequent and more violent. But that may reflect the particular conditions of the bull market of the 1920s and the Depression of the 1930s.

@page_break@The larger question now is the status of the secular price trend since 1942. That hinges on the secular trend of crude oil prices. Crude oil from the Persian Gulf cost less than $2 a barrel in the 1940s. The Arab oil embargo of the 1970s lifted the price of crude oil from the $3 range to the mid-$30s in 1981. Oil prices dropped to a low of less than US$13 in 1998.

The rise since then seems inexorable, but supply and demand respond to price changes, and high prices eventually subside. For oil, the questions are: subside to where; and when will it happen?

All that is sure is a price drop will occur, notwithstanding warnings the world is running out of oil.

The only obstacle to continuation of the secular price rise for oil is genuine deflation, ending the century-long inflation wave. That, too, is inevitable.

The one indication to suggest the end of the inflation era and the end of the secular oil rise might be near is the current price frenzy. Historian David Hackett Fischer, who has studied inflation and deflation through the centuries, has found that inflation waves end with “sharp surges in the cost of energy.”

Katrina has done her best to help. IE