By Cynthia Harrington

Skyrocketing gas prices are on consumers’ minds these days, and that interest has shown up in the markets.

According to figures from Lipper Inc., flows into natural resource sector funds are healthy. From a bouncing monthly path of positive to negative flows through July of 2003, the influx hit $165 million in August last year and never looked back.

The funds attracted $500 million each in March and April of this year. But the flood of new money may not be coming from the advice of professionals. If so, these funds could well be in for a fall.

“Oil prices are driven by feel-good factors,” said Carl Kunhardt, certified financial planner and director of investor management and research at Quest Capital Management, in Dallas. “Looking back at the first Gulf War, prices skyrocketed when we went in, but were back to the starting price just a few weeks later.”

The short-term volatility of the price of oil and oil company stocks keeps Kunhardt from using this sector, despite his use of others like real estate and financial services. “With other sectors, one can attribute the movements more to the conditions of the markets or economy,” he said.

One of the reasons for the flood of new investor monies is the performance. “Natural resource funds show very strong performance year to date,” said Jeff Tjornehoj, a research analyst at Denver-based Lipper Inc. “A look at some funds in the sector reveals 50 percent-and-above returns for the year.”

The U.S. Global Resource Fund, for instance, sports a 64 percent increase for the year. A closer look at the top holdings of this fund reveals few household names, however. The fund holds primarily refiners and oil and gas exploration companies. “This shows the tale of two markets that has gone on so far this year,” explains Tjornehoj. “The real action has been lower down in the food chain, as investors have focused more on companies they expect to directly benefit from the price per barrel of oil.”

This left the large integrated oils with lesser performance. In general, the big companies like ExxonMobil, ChevronTexaco and BPAmoco are up 6 percent to 10 percent.

More diversified funds, like the Vanguard Energy Fund, clock in at half that of the narrowly focused U.S. Global Resources. “I could imagine only the very wealthy individuals who pick up slices of the market would be focused on the energy sector,” said Tjornehoj. “If so, from the advisors’ point of view, the familiar names of the big companies may seem less risky to clients.”

In fact, the biggest and the best are all that appear in clients’ portfolios at Chas Smith & Associates. The firm does both comprehensive financial planning as well as asset management for investors. Oils comprise 2 percent to 3 percent of every client’s portfolio. “For the most part, these companies grow earnings and dividends regularly,” said James M. Luffman, CPA/PFS, of the Lakeland, Fla.-based firm. “The change in the tax law makes the 2-to-3 percent yields even more attractive.”

Advisors that are buying oils for clients seem to follow this fundamental analysis, versus a trading or tactical strategy. “The big six companies are now the big three, and that should increase profits as they take advantage of economies of scale,” said Luffman.

Advisors stuck with the big oils despite the shakeup in the first quarter of 2004 by the accounting adjustments at Royal Dutch Shell. The chief executive was summarily fired in response to the movement of a full 20 percent of reserves from proven to unproven status. Investors held their breath until management at other companies provided assurances that they were not going to need to announce similar moves.

For some advisors, the presence of oil stocks in a portfolio serves broader planning goals. “As gas prices go up, oils help clients hedge that expense,” said Luffman. “The increasing value of the assets of the oils also helps as an inflation hedge to other assets in the portfolio.”

An oil sector fund might also manage the risk of concentrated positions of companies that are uniquely hurt by rising oil prices. A client with a concentrated position in an airline or delivery company such as UPS would be exposed to risk of loss in the event of significantly higher oil prices.

“We’re really committed to a diversified portfolio, and follow modern portfolio theory,” said Glenn Frank, CPA, PFS, CFP, of Tanager Financial Services, in Waltham, Mass. “We might use the oil sector as a risk management technique, but we’d never look to buy in for additional return or to try to time the market.”

An international bet
Bulls on the oil sector point to the high degree of uncertainty in the major oil producing regions in the Middle East. In the event of big disruptions there, domestic producers might have much to gain. Additionally, some mutual funds have already begun branching out from oils with big exposure to the Middle East conflict. “Russia is the world’s second largest producer now,” said Tjornehoj. “Also, there’s lots of talk not only about China’s refiners and exploration companies but about the growing domestic demand in that country.”

Despite the fact that usage in the U.S. has not dropped with higher prices, Tjornehoj thinks the market looks overbought. “Americans are notoriously big oil consumers, and we haven’t given up our SUVs despite the rising prices,” he said. “But I think a lot of that is built into these prices, so I personally don’t see it going up much more.”

There is some evidence that traders may be looking at oils in the rearview mirror. The open-end mutual fund company that caters to traders, ProFunds, offers a sector fund. Like other offerings, the fund has no redemption or exchange charges. Like the other ProFunds’ sector funds, the Energy UltraSector Fund offers the leverage component of 150 percent of the underlying index. Assets stood at $4.5 million in April 2003 and climbed to $7.9 million by October. This year, the size peaked at $52.5 million in March and now stands near $20 million.

Traders may be telegraphing the end of the good feelings.

“I read that though the headlines report that the Saudis have agreed to increase production, all they’ve really done is go back up to their previous quota,” Kunhardt said. “Besides, if oil is now at all-time highs, where is it going to go? Certainly we aren’t going to see it at $100 per barrel.”

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