Oil and other energy costs are one of the few economic elements that affect nearly every person, let alone every investor. With worldwide debate surrounding supplies and production, how concerned should investors be?

With oil prices hitting 20-year highs, some investors have begun to focus on new energy sources. Surprisingly perhaps, this hasn’t proved very fruitful yet. Despite high oil prices, there is not a significant amount of investment going into exploration. Many of the world’s major fields have already been found and it is unlikely we will soon be hearing about new sources of supply. That’s why the major oil producers and oil exploration companies were among the market’s best performers in the second quarter, earning windfall profits.

With opportunities to benefit from the current high oil prices relatively limited, investors seem to be sitting on their hands. For the most part, institutional managers of global equities are slightly underweight the major oil stocks. Value-focused managers, attracted by the cash flow characteristics of the sector, are on the more optimistic end of the spectrum. The dilemma facing this group of investors is that while the oil price is much higher than is reflected in the share prices of oil companies, they have doubts about the sustainability of current spot prices and the underlying earnings they are generating for these companies.

One reason is that despite the numerous threats to oil supplies, be they strikes in Venezuela or bombings in Iraq or Saudi Arabia , the political tensions within the Middle East are likely to eventually recede, restoring oil supplies. A second reason for optimism in the current situation is the belief that today’s oil prices are due less to supply concerns than they are to increased demand. Growth in China and other developing areas, along with the upswing in the United States economy, has created demand that is running ahead of inventory levels. This influence is so strong that, according to a recent article in the Financial Times, some observers feel there is a $10 to $12 premium on spot oil prices due to hedge fund activity. The potential danger to investors is that if you factor out this premium, the earnings projections some lesser-known oil producers are making may suddenly become quite suspect. One of the risks of any extended market bubble is that investors who come in late and go for the lower-quality names generally end up regretting it.

It is clear that as long as oil prices remain at relatively high levels, markets will struggle to make much progress. Perhaps the strongest catalyst for reduced oil prices will be renewed market optimism. We are in a temporary phase where the markets are adjusting to higher interest rates. However, the improving prospects of many companies are being discounted. As investors begin to focus on underlying strengths, there may be a return to decent economic growth and a settling down of current energy price jitters

<B>Nitish BENIMADHU

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