The Sector Strategist: Using New Asset Allocation Techniques to Reduce Risk and Improve Investment Returns

CHAPTER 4

The Energy Sector

Drill for oil? You mean drill into the ground to try and find oil? You're crazy!

Anonymous to Edwin Drake, 1859

The energy sector is composed of five major industry groups: integrated oil and gas, oil and gas equipment and service, oil and gas drilling, oil and gas exploration and production, and refining and marketing firms. Oil and natural gas are considered to be “commodities.” That is, they are basic materials that are available from a wide variety of suppliers and whose prices are intensely subject to the laws of supply and demand. The prices of virtually all commodities, from copper to pork bellies, had been very low throughout the late 1990s and early 2000s. This has dramatically changed over the past decade as the price of oil has increased above $100 a barrel.

In general, the energy sector today is one of (1) heightened competition, (2) increased capacity and higher operating costs, both driven by dramatic leaps forward in technology, and therefore (3) heightened demand from emerging nations such as China, Brazil, and India. The result is restricted supply, typically leading to higher prices. Energy stocks represent a 13.2% weighting of the benchmark S&P 500 Index. The sector has delivered exceptional investment returns over the 24-year period ending December 31, 2010. As demonstrated in Chapter 2, this category's return, as measured by my data, was a 10.5% annual return. Future performance of the energy sector will be determined by global ...