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The energy sector should be a key component of any savvy investor's portfolio. 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 3) heightened demand from emerging nations like China, Brazil, and India - and thus restricted supply, typically leading to higher prices. Energy stocks currently represent a 11.3 percent weighting of the benchmark S&P 500 Index. The sector has delivered exceptional investment returns over the 24-year period ending December 31, 2010. According to data from Lipper/S&P and published in The Sector Strategist by Wiley Publishing, the energy sector has returned 10.54% on an annualized basis over this period. This is the third highest of any of the nine major sectors.

Additionally, the sector provides excellent diversification through low cross correlations. For example, in the past decade, the energy sector maintained a correlation below 0.5 with healthcare (0.38), consumer staples (0.40), technology (0.42), financials (0.42), and consumer discretionary (0.48).

S&P

CD

CS

E

F

H

I

M

T

S&P 500

Consumer Disc.

0.88

Consumer Staples

0.56

0.69

Energy

0.55

0.48

0.40

Financials

0.82

0.75

0.68

0.42

Healthcare

0.59

0.47

0.66

0.38

0.55

Industrials

0.90

0.85

0.58

0.61

0.80

0.58

Materials

0.72

0.75

0.61

0.68

0.68

0.49

0.83

Technology

0.82

0.76

0.31

0.42

0.48

0.40

0.70

0.55

Utilities

0.41

0.47

0.47

0.61

0.47

0.51

0.52

0.47

0.58

Source: Morningstar Sectors, based upon monthly correlations,1/2000 to 1/2010

I believe there are four main characteristics that favor owning energy firms in a diversified portfolio:

1) Global demand for energy services will continue to accelerate.

2) Future supplies of oil will be harder to find and more costly to extract.

3) The strong financial characteristics of energy firms, including rising dividends.

4) A strong inflation hedge in a diversified portfolio.

The combination of these factors should enable these stocks to continue to generate the returns necessary to make this sector very attractive for long-term investors.

Global Demand

World oil consumption has been increasing at a rate of 2.2 percent per year since 2000, and reached 87.6 million barrels per day in 2011. Demand is projected to increase to 89.4 million barrels per day in 2012, and 90.9 million barrels per day in 2013 (Source: U.S. Energy Information Administration, Short-Term Energy Outlook, January 10, 2012). Although the U.S. currently accounts for one-quarter of world consumption, growth in oil use has been lower in the U.S. than in the rest of the world for the last 40 years.

The Energy Information Administration (EIA) projects that world oil demand will grow 2.7 percent per year through 2020. Oil consumption in Asian countries will be equal to that in the U.S. by 2020. China, India, and South Korea will more than double their oil consumption over this period. Similarly, demand in Central and South America is expected to double.

Oil demand and price are set to grow strongly over the next 25 years despite environmental policies, essentially dooming climate-change goals, according to the International Energy Agency (IEA). Slightly more than a third of the new demand would come from China's appetite for energy. The IEA forecasts the price of crude oil to increase 88 percent by 2035 to 113 dollars a barrel in inflation-adjusted dollars. Under the calculations, which take into account climate change pledges made under the Copenhagen Accord in 2010, fossil fuels will still accounting for more than half the increase in total energy demand, with oil to remain the dominant fuel. The IEA forecasts demand for oil to rise by 18 percent between 2009 and 2035, driven by developing countries, with nearly half the increase accounted for by China alone. Global demand for oil would total 99.0 million barrels per day in 2035 - or 15.0 million barrels per day more than in 2009 - and all of the increase would come from outside the OECD area of advanced economies

Future Supplies

The future of energy is of enormous importance. Oil (and all fossil fuels) occurs in finite amounts on planet Earth. Therefore, assuming demand continues to expand rather than diminish, some point in time will occur when the rate at which they can be extracted will peak and thereafter, can only decline. That is the point to which "Peak Oil" refers. In contrast, "renewable energy" refers to solar, wind, hydro, and geothermal sources for generating electricity, all of which are dependent on the recurring energy we get from the sun or from heat stored underground. The supply of renewables, in theory, is virtually infinite, and their production can be expanded almost indefinitely, so long as the planet remains roughly as it is today climatically. In addition, there are "hybrid renewables," which refer to products like ethanol and hydrogen. These depend in some ways on a renewable input such as corn or cellulose, but also require a substantial input of processing that, at least at present, consumes a good deal of fossil fuels.

While Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and the other major oil firms are undeniably huge enterprises, the vast majority of oil is still owned by various national governments through their state-owned oil companies. In fact, the governments of such major producers as Mexico, Venezuela, and Saudi Arabia control about 90 percent of the reserves and 69 percent of the production of the world's oil and gas. Consequently, political considerations will continue to be of intense influence on the energy business.

Providing the kind of massive surges in the demand for oil projected requires massive investments to build new infrastructure and finance new technologies. The IEA projects that with world oil demand rising by 60 percent by 2030, the world energy market would need $16 trillion of cumulative investment between 2010 and 2030, or $580 billion a year. Even this estimate is based on unrealistically low estimates of investment cost and outdated assumptions about the sophisticated exploration, development, and production technology and equipment needed in modern oil fields. Yet it still requires vast transfers of capital. This capital should flow to the major oil and service firms like Schlumberger (NYSE:SLB) over the next decade.

Strong Financial Characteristics And High Dividends

A strong financial position is always important to an energy firm, as the capital requirements for exploration and development are very high. Strong balance sheets with low debt levels, high return on equity and significant free cash flow generation are key drivers to success in the energy sector. The generation of positive cash flow is particularly important in the current market environment, as funding for more technological challenging oil projects will become more critical. Energy firms now maintain strong balance sheets and diversified business mixes that involve energy production, refining and chemicals. For example, Exxon Mobil has $30 billion in net cash (cash less debt), while Chevron maintains a cash balance over $20 billion. The major energy firms not only are strong financially, but the shares trade at low valuations on a price/earnings basis (6-12) with above average dividend yields (2.5-5%). Exxon Mobil recently boosted its dividend by 21%, while Chevron has increased its dividend twice in the past 12 months. Foreign-based oil companies such as Royal Dutch Shell (NYSE:RDS.A) and Total SA (NYSE:TOT) maintain dividends at the levels of many large telecoms such as AT&T (NYSE:T), with yields around 5 percent.

Strong Inflation Hedge

Part of the case for a separate allocation to energy stocks is the fact that the sector will outperform and provide an investor diversification during periods of inflationary times. Peng Chen and Joseph Pinsky found in their report, Invest in Direct Energy, that during a period from 1970-1981, energy stocks dramatically outperformed broad-market stocks. The energy sector also excelled in this period of booming commodity prices and rising inflation. According to data from S&P Comstock, energy stocks were up 68% in 1979. The sector also excelled in 1980, rising an additional 83%. Evidence from the 1970s supports the contention that energy stocks provide an excellent performance hedge during periods of rising inflation and oil prices.

I recommend a consistent above-average portfolio weight in the energy sector. The sector is greatly valued due to its excellent long-term performance results, along with inflation protection. The sector also maintains a low correlation with many of the other major sectors that account for a large weight in the index. Energy stocks can also reduce the volatility of your overall stock portfolio, not only due to the low cross correlations, but also the low betas of many of the major oil and gas integrated firms. I further suggest that any investor also maintain exposure to those firms that are at the forefront of exploration, and that maintain a high correlation to the price of oil (oil equipment and service companies and drillers). Next, I will focus a series of articles on my favored energy firms, including Exxon Mobil, Royal Dutch Shell, Schlumberger, and Apache (NYSE:APA).

Disclosure: I am long XOM, SLB, APA, RDS.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Energy: A Compelling Sector To Own