From the December 2006 issue of Wealth Manager Web • Subscribe!

Hit the Gas

The oil and gas sector has become so popular over the last three years that the number of commodities-oriented hedge funds alone has more than doubled, and demand for investment opportunities in the sector often outweighs supply. In fact, investor interest has been so strong--pardon the pun--that it has often fueled the price of oil and gas stocks more than any other factor in the market. And industry observers expect the sector's popularity to remain strong for the foreseeable future. Nonetheless, fund managers and financial advisors warn that investments in this sector should be made cautiously and that investors need to be careful when it comes to the investment vehicles they choose.

"People have been chasing returns in the last few years, and that's why there's so much money flowing into the asset class and why there's so many hedge funds investing. They've seen the returns, which have been good," says Jon Yankee, CFO of Fox, Joss & Yankee LLC, a Reston, Va.-based financial planning firm with just over $200 million in assets under management. "But they haven't looked at the returns in 1986, when oil and gas was down. People have been chasing returns without remembering that it's a very volatile asset class." Yankee believes exposure to oil and gas is important for his clients' portfolios, and allocates an average of roughly 5 percent to the sector. Still, he remains cautious about how he accesses the sector, viewing investments in pure oil and gas companies or partnerships as far too risky. Favoring more diversification, his investment vehicle of choice for exposure to gas and oil is commodities mutual funds, which usually include other natural resources as well.

Dennis Barba, a managing partner with The Oxford Group of Raymond James & Associates in Cleveland, Ohio, also favors diversification when investing in oil and gas. In the past, Barba has traditionally relied on commodities and oil and gas ETFs to give his clients exposure to the sector. Recently, however, he believes that has become too volatile. So, at the end of the summer he completely removed oil and gas from his investors' portfolios. "Right now we don't have any exposure to this sector, because if you look at the technical aspects of it, it looks like these stocks are getting top heavy," says Barba, whose firm has roughly $200 AUM. "Supply began to control the prices of those ETFs, so we elected not to invest there anymore."

Like Yankee, Barba believes some investors in oil and gas have become too shortsighted, and that they are overlooking the sector's cyclicality. He, too, points to the mid 1980s and the fallout that occurred when oil prices tanked--in 1986 the price of oil fell to just under $9 per barrel, after a seven-year run of more than $20 per barrel.

There are those who believe that the good times have lasted far too long, and that the sector is due for a cyclical downturn. "It was January of 1999 that energy started to outperform the S&P. It's had a seven-year run, and that's a pretty good cycle," says Tim Hartzell, a senior vice president and chief investment officer of Houston- based Kanaly Trust Co., which has $2 billion under management and whose average client has a net worth between $2 and $5 million. Hartzell is among a growing number of advisors who believe the sector is poised for a near-term decline. "We've all learned from the tech sector how things that go up go down," he says.

Fears of d?j? vu in the sector have prompted some advisors to pull back their exposure, but others view its volatility as an investment opportunity. "We have begun to underweight energy, with respect to other sectors held in our portfolios, due to overall market uncertainty," says Lacey Buteyn, a financial advisor with Merrill Lynch's private client group in Dallas. Nonetheless, she thinks growing pessimism about the sector could provide opportunities for long-term investors.

Long-term is exactly how J. Michael Martin, a financial advisor and chief investment officer of Columbia, Md.-based Financial Advantage Inc., believes the sector should be approached. "We actually think [volatility] gives us a portfolio management opportunity. If we have conviction about the long-term attractiveness of our energy-related investments, we can make volatility our friend by rebalancing to our intended allocation whenever there is a significant drop in market prices," he says. And he is not alone in his thinking.

Don Martin, president of Los Angeles-based financial advisory firm Mayflower Capital, says he favors direct investments in blue chip oil companies over natural resource mutual funds that tend to carry high fees. "My gut feeling is that oil stocks are priced on the cynical assumption that oil will sell for $40 a barrel, so it is safer to buy and hold quality oil stocks--like the majors--instead of oil futures.

But it is not the blue chips that have been the big draw in oil and gas as of late; it has been private companies and partnerships. "There's a difference between the current boom in oil and gas and the last boom in the 80s," says Steven King, president of PetroInvest LLC, an investment banking firm that caters to small oil and gas companies in need of financing along with financial advisory services. "The last time around was basically a public company boom, whereas this time it's a private company boom," he says, adding that 60 percent of wells in the U.S. are currently being drilled by private companies.

One advisor who has been active in energy's private partnership arena is Richard Sanford, owner of Houston-based Sanford Capital Management. A major proponent of the sector, Sanford believes that "oil and gas is the single best asset category that people can be putting money into long-term." And he is quick to note that the amount of natural gas used annually has not been replaced since 1964. "All we're doing is using our reserves, and they're shrinking... every year we're using 2 percent to 3 percent more natural gas than the year before," says Sanford.

In particular, Sanford is a fan of drilling partnerships, which provide significant tax incentives for investors who buy into them--up to 35 percent depending on the state they operate in. In fact, tax benefits for oil partnerships can be so attractive that advisors have been able to use them to help clients eliminate hefty tax bills. Because of government incentives to address the shortage of natural resources, general partnerships in working interest drilling programs can write off all their intangible drilling costs upfront--a benefit that allows investors to write off their own tax debts.

For example, in California, where the highest tax bracket is 40 percent, an individual subject to that rate cashing in on $100,000 of stock options would owe the government $40,000 in taxes. But if the $100,000 in proceeds were re-invested into a general drilling partnership, the ability to take the tax benefits of that partnership upfront would allow that individual to write off the entire $100,000--effectively reducing their investment risk to $60,000 because of the $40,000 tax savings.

Gregory Banner, a financial advisor with San Diego-based Asset Preservation Strategies Inc., with about $70 million AUM, has done just that for clients whose net worth averages $2 million. "We use these quite a bit with executives who have stock options coming due or people who have spikes in their income," says Banner. When a client in the 40 percent tax bracket was recently forced to unwind a sizeable position in Exxon Mobil Corp. stock, Banner helped him eliminate his tax debt by investing the proceeds in a working interest general oil partnership. Nonetheless, Banner is quick to note that these partnerships are not without their risks, and advisors must understand the intricacies of both the tax laws and liabilities of partnerships before placing clients in them. This is particularly true for general partnerships where an investor's liability is unlimited, he adds. Should something go wrong, they could find themselves on the hook for more than they invested.

Tax incentives are available for a wide range of oil and gas partnerships and trusts, for everything from exploration to shares in existing wells. Each vehicle's benefits and terms can also vary substantially. Limited partnerships limit an investor's liability to the amount they have invested, while general partnerships tend to be riskier. There are also general partnerships where an investor's liability status converts to limited after a certain period of time. Though most partnerships require that investors be accredited--a status usually applied to an individual whose net worth exceeds $1 million--a growing number of partnerships such as Bridgeport, W. Va.-based Petroleum Development Corp., have begun lowering the suitability standards to participate in their ventures and allow non-accredited investors. Before investing in any partnership, Banner says it is important for an advisor to know the extent of his client's liability given a worst-case scenario.

Despite the risks, the potential benefits of such vehicles have made them extremely popular over the last few years. Gone, says Banner, are the days of just a few years ago when advisors could almost always find spots for their clients as late as December 31. In the current environment, however, Atlas Energy Resources LLC recently sold out a $100 million program in only four hours.

"What scares me is that now everyone's on the bandwagon, and there's a lot of people out there who don't understand these and there are a lot of brokers who don't understand how all the taxes work," says Banner. Even though he has been investing clients, along with himself, in oil partnerships for several years, he remains cautious about them--avoiding individual wells, favoring smaller companies, which have traditionally yielded higher returns, and seeking out programs where the companies put their own money into their ventures alongside investors.'

Advisors who are leery of partnerships point out that for every one that produces strong returns, there is almost always another where investors lose out. James DiGeorgia, publisher and editor of the Gold & Energy Advisor, is one such naysayer. He notes that oil and gas partnerships have been around for years and that when similar enthusiasm spurred investors to rush into them in the 1970s, many lost money.

DiGeorgia is in the camp that believes a long-term investment approach is the safest and most logical way to gain exposure to oil and gas, and that investors not only need to avoid overexposure to the sector, but should be prepared to remain devoted to their investments despite the myriad factors that can so dramatically affect the sector. "So much in the press is geared only toward the negative, short-term aberrations that appear, and it paints oil as a disaster commodity," says DiGeorgia. "But when you look at consumption, investing in oil is really a function of optimism...the supplies of oil we've found to replenish what we've taken out will all be gone in a few decades."

Recent fluctuations in the sector notwithstanding, Ben Halliburton, chief investment officer of Summit, N.J.-based Traditional Capital Management, believes the energy business has been experiencing a secular bull market since 2002, and that this year will be a correction year for energy stocks. But Halliburton believes the long-term supply and demand imbalance is so attractive that he recently upped his average portfolio allocation to energy to 17 percent. "Crude production is having a difficult time keeping pace with demand, and we've experienced a tripling of crude prices over the past few years," says Halliburton, whose firm has roughly $445 million under management. "Still, demand continues to grow in the face of higher prices, which indicates that we've not yet reached the breaking point on the pricing side," he continues, noting that in the wake of higher prices, gasoline demand in 2006 is actually about 1 percent higher than it was in 2005.

Like the technology sector, the energy/oil and gas sector has a number of subsets through which prospective investors can gain exposure--everything from drilling, exploration and refining companies, to service providers such as Schlumberger Ltd. and Halliburton Co. Less traditional alternative energy plays like Toyota Motor Corp--with the strong initial success of its hybrids--and the Ethanol companies that have begun springing up across the country to produce an alcohol-based fuel alternative distilled from fermented corn, wheat and barley, are also starting to attract more interest.

"You want to have diversification among different aspects of this sector, because they will behave differently," says Michael Cuggino, president and a portfolio manager for the Permanent Portfolio Funds, a San Francisco-based fund family with a collective $760 million under management. But when it comes to the world of alternative energy, Cuggino is still waiting it out on the sidelines and believes the infancy of alternative fuels and related products makes it too difficult to determine which are most likely to gain mass adoption. Instead, he recently enhanced his portfolio's energy exposure (roughly 5 percent) to the energy service companies--an area where he believes there is still substantial room for growth.

Bill Gerlach, a senior portfolio manager for Gartmore Global Investments, is also staying close to the sidelines regarding alternative energy investments. "There are no earnings there yet," says Gerlach, who manages natural resources, small cap and mid-cap funds for Gartmore, which has a combined $20 billion under management.. "You could have spent the last 10 years investing in fuel cells and have never made a dime," he says, adding that alternative energy stocks are unlikely to take off until there is a strong political push within the U.S. for greener energy sources. Until then, he believes the best alternative fuel play is likely to be nuclear energy."

On the flip side, Matthew Paz, an analyst who selects the commodities funds at Chatham, N.J.-based financial advisory firm RegentAtlantic Capital, believes alternative energy solutions should not be overlooked. "With the state of energy consumption in our society and surging demand for energy products, we have taken a serious look at alternative energy solutions as the wave of the future for energy," says Paz.

No matter what method investors choose to gain access to oil and gas, one thing most financial advisors and fund managers seem to agree on is that demand is not going anywhere, and investors should have at least some exposure to the sector. As Mayflower Advisory's Martin says: "The big picture is that people need oil, are addicted to it, and oil stocks have some of the best PE ratios."

Britt Erica Tunick, a writer who specializes in financial topics, wrote about market neutral investing in October.

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