Energy investments have been running on empty this year. "Among the stock market categories we follow, equity energy funds are last in 2010," says Rob Wherry, a mutual fund analyst at Morningstar. "In late October, the category was up only 1%. Real estate funds, by comparison, were up 25%." The average domestic equity fund was up about 5% for the year.

Does energy offer buy-low opportunities now? "Investors must realize that energy investments can be volatile," Wherry says. "They swing between down periods and stellar years. Investors need patience, but if they have a long time horizon, energy can deliver good results."

As Wherry points out, many clients already have substantial exposure to energy investments through holdings such as large-cap index funds. For those who would like to put a few extra dollars into an area that has lagged recently, opportunities abound. "There are more ways than ever to access the energy sector," and all may offer a potential payoff, says Sanjay Yodh, managing director of alternative investments at Rydex SGI in Rockville, Md.

Traditional energy investments-such as oil field service companies and oil and gas producer stocks or funds holding such stocks-might rebound if a worldwide economic recovery boosts oil prices. Alternative energy-basically every type of power source beyond fossil fuels-enjoys widespread political support that may hasten the day when it can compete on price. Other alternatives such as long-short funds and high-yielding energy master limited partnerships might appeal to investors seeking risk management or high-powered income.



For all of these energy investments, higher oil prices could be the rising tide that lifts them from current levels. Of course, that tide ebbs and flows, as is evident from the past few years. In late 2004, oil prices were around $40 a barrel. By mid-2008 prices peaked at over $140 a barrel. The financial crisis and worldwide recession of late 2008 and 2009 dampened demand for energy, sending prices back down below $40.

Since then, oil prices have rebounded, but they've generally ranged between $70 and $85 a barrel in 2010. Flat oil prices have led to flat investment performance in the sector this year; just like U.S. stocks, oil prices are midway between the highs and lows of the latest cycle.

Morningstar's category of equity energy funds, which hold stocks in the energy sector, show a similar pattern. These funds suffered in the last economic slowdown, posting double-digit losses, on average, in 2001 and 2002. During the global expansion of 2003-2007, which sent oil prices higher, equity energy funds enjoyed five consecutive years of double-digit growth, including four years with average returns ranging from 32% to 46%.

The 2008-2009 crash was especially severe for energy stocks; as mentioned, the subsequent recovery has lagged. Through the third quarter of 2010, the category was showing a loss of around 7% a year for the trailing three years, bouncing around the bottom of the Morningstar list.

On the other hand, good performance isn't hard to find, at least over longer time frames. Thanks to the mid-decade bull run, the equity energy category was among the leaders for the past 10 years, returning nearly 5.3% annually through the third quarter of 2010, while diversified domestic stock funds returned well under 1% annually.

Will we see another surge in energy stocks? Maybe, but a repeat of 2003-2007 returns-32%, 33%, 46%, 12% and 42%-is unlikely. "That period was over the top," Wherry recalls. However, just as a global recession suppresses the appetite for energy, lowering oil prices and stock values in that sector, so is a subsequent worldwide expansion likely to bring more demand, pricier oil and significant returns for energy investors.



Besides a trading range for oil prices, other factors contributed to a weak year for energy investments. The huge oil spill in the Gulf of Mexico, for example, increased costs and incited deepwater drilling restrictions. According to Wherry, a lot of managers were holding BP, Transocean and Anadarko. "Those are the companies likely to be at the center of the legal dispute and the ones that might have the most cleanup costs."

Losses in those key stocks drove down the results of many energy funds. For instance, Transocean, the world's largest offshore drilling company, saw its share price drop from $92 in April 2010 to $42 in June, followed by a partial recovery to about $65 in late October. According to Wherry, investors are still somewhat leery of these and other companies, opting to wait to see how large the ultimate bill will be and who will have to pay it.

China plays a role, also, Wherry adds. "Chinese stocks have had modest returns in 2010, compared to leading the market in previous years. When investors expect a great deal of growth in China and other emerging markets, they anticipate more demand for energy, which helps energy investments."

The bottom line, says Wherry, is that investors need to look at global and domestic economies. When they show signs of turning around, oil prices and energy investments probably will move up as well. "Traditional energy companies, especially oil exploration companies, will be tied to the underlying commodity price in the near term," says Chip Brian, CEO of, in New York, which offers a trend-following trading system. "These companies have been aided by the weaker U.S. dollar, which has lifted the underlying commodity prices."



One believer in traditional energy investing for 2011 is Ed Maran, co-manager at the Thornburg Value Fund. His fund has a weighting in energy stocks 60% higher than the market weight-the fund's highest energy weighting in three years.

"Valuations are attractive in the energy sector," Maran says. "Some major oil companies, for example, sell for under 10 times earnings. What's more, earnings are cyclically depressed now relative to the category average." If earnings pick up and price-to-earnings ratios also climb, energy investments can generate substantial gains.

Maran notes that major oil companies cut back on capital expenditures in the financial crisis of 2008-2009. "The impact of those cutbacks will be felt starting in 2011 and 2012," he says. That means less oil will be brought to market: Projections generally call for low output growth, if any growth at all, outside of OPEC. That's a favorable environment for oil price increases.

Higher oil prices may boost all types of energy investments, some more than others. "We especially like the oil field service sector," says Maran, who names Transocean and Baker Hughes among his favorites. "Baker Hughes has had some problems with the federal government, but those issues may be resolved soon. There's a high barrier to entry in oil field services, so the market leaders are likely to do well when production picks up."

Beyond oil service companies, Maran is upbeat on other players in energy. "Major oil companies can find and develop oil for $20 a barrel and produce it for another $10," he says. "With oil at $80, they have excellent returns on equity." Some oil companies have dividends over 3% and payout ratios around 40%, Maran adds, boosting their attractiveness in today's low-yield environment.



Maran's overweight position in energy does not include any alternative energy companies. "They're not economic yet," he contends.

Brian of agrees that the traditional energy space offers greater value and stability than the alternative side. "The valuation of many alternative energy companies is hard to justify, as it implies a significant ramp-up in growth," he says. "That may never materialize if the technology does not take off." That said, a small allocation into alternative energy may be useful, if for nothing else than as a hedge against traditional energy positions.

Uncertainty notwithstanding, alternative energy investments have been attracting investors and enthusiasts. "Global economies are too reliant on one energy source, supplied mainly from politically unstable countries," says Jens Peers, lead portfolio manager of Calvert Global Alternative Energy Fund. "We need a broad mix of energy sources." Those sources should include renewable energy, which is starting to enjoy a great deal of political support, he adds.

Peers contends that the costs of alternative energy are coming down, thanks to technological advances, and more investment choices are appearing. "Just as is the case with traditional energy, investors are not limited to the producers of wind or solar power," he says. "There is a whole chain of companies behind them, supplying equipment and services." If financial planners are working with clients who have long time horizons-five years or longer-they should have some exposure to alternative energy. Over time, the technology will improve and prices to consumers will fall.

For now, though, alternative energy is not cost competitive with traditional energy, according to Stephen Simko, an analyst who covers alternative energy stocks for Morningstar. "There are other issues, too, such as intermittency for wind and solar power," he says. In places where sunshine and strong breezes are in short supply, these sources might not produce adequate power.

With cost and operating drawbacks, what is fueling demand for alternative energy? The industry is based on subsidized technology and incentives to promote use, Simko explains. "Those subsidies and incentives are politically popular in many countries. The numbers involved are not huge, on government budgets." Therefore, there is no groundswell for cutting back on these subsidies and incentives, which may even increase in the future.

Simko adds that if planners or clients want to invest in alternative energy, they should understand the risks. There are many small companies in this industry, and they tend to be volatile. For example, one of the most widely followed companies, First Solar, traded at nearly $200 a share in the spring of 2009 and just over $100 a year later.

"If you buy these companies, you should monitor them carefully," he says. "Technology changes rapidly, and that can affect an individual company. You can't just put these stocks away and forget about them."

Historically, alternative energy investments have moved up or down with traditional energy investments, following the price of oil. Just as higher oil prices can mean higher profits on the traditional side, pricey oil has been perceived as making renewable alternatives more competitive.

This correlation might not be as strong today, however. "When oil was rising from $100 to $150 a barrel, there was a great deal of interest in alternative energy," Simko says. "With oil around $80 a barrel now, I don't think that a move down to $60 or up to $90 would make a big difference."

Wherry concurs that investors' enthusiasm for alternative energy is lower now than it was when oil prices were gushing skyward. "A lot of the financing fell through in the financial crisis, and it may take a while to get alternative energy projects back on the drawing board," he says.

Brian concludes that alternative energy companies, for the most part, remain in the speculative area of client portfolios, mostly because there is no clear winner in terms of which technology will achieve mass adoption. Planners interested in alternative energy but not inclined to predict winners can find several mutual funds and exchange-traded funds specializing in this industry. They've posted losses in recent years, just as traditional energy funds have, so the time might be right for tiptoeing in.



If investing in traditional energy is volatile, alternative energy can be even more volatile. Besides various business risks, geopolitical events are a growing concern, Rydex's Yodh says. Planners who want to participate in energy at a lower risk level may want to explore some relatively new investment choices.

"You can hedge somewhat by using leveraged and inverse exchange-traded funds (ETFs)," Yodh says. Some of these ETFs are pegged to oil prices, energy stock indexes or indexes of energy futures contracts. It is possible, for example, to buy an ETF that will rise as oil prices sink, thus offsetting weakness in energy stocks, or an ETF that will rise twice as much as oil prices fall.

Long-short strategies also are available, Yodh says. "With some funds, managers go long on one component of the energy sector, such as crude oil, heating oil, gasoline or natural gas, and short on another component." Such tactical approaches are not guaranteed to work, but the long-short structure may prevent severe losses when prices tumble.

Yet another way to reduce risk is to focus on energy investments with high yields. Energy master limited partnerships (MLPs), which have a high income component, are growing in popularity, Yodh explains. "They can be helpful as long as you know how they work."

Many MLPs invest in energy infrastructure such as pipelines; they may pay 5% to 7% returns to investors, with distributions that include untaxed returns of capital. Typically, these MLPs earn fees based on the volume of products they carry, rather than oil or gas prices, so they tend to be stable businesses with the potential to grow in an expanding economy.

Many energy investments offer similar benefits: necessary products and services, connection to economic growth and even high cash flow. After some dry years, planners might feel like drilling a bit deeper for profits that are likely to come, sooner or later.

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