The price of oil - recently bouncing between $36 US and $41 US a barrel - is too far above the OPEC target range of $22 US to $28 US a barrel, according to Roger Mortimer, senior portfolio manager of AIM Canadian First Class. "Generally we feel good about energy, but there is the possibility that in the short term the commodity price comes off," he says. As the world economy picks up, he expects the cartel will move to manage the price by boosting supply.

The current high price in U.S. dollars also reflects recent weakness in the greenback. Mortimer says as the dollar strengthens against the euro, the commodity price should ease back into OPEC's target range.

"If oil were to correct back to the $25 US or $26 US a barrel range, investors would actually be bullish, because the downside of the market would have been demonstrated to be at a level that is high enough that the oil companies are still very profitable," says Mortimer.

Still, Mortimer feels this correction will likely be temporary, with the price moving higher over the next two years, as world demand increases. Even if prices do rise in the long term, just buying the energy sector is risky.

Diversification matters

"People should invest in the [oil] sector, but they should be diversified within it," says Robert Farquharson, chief investment officer at AGF and manager of AGF Canadian Resources Fund. He agrees with Mortimer's assessment of the industry as a long-term winner, but thinks his correction range may be a little too low.

Investors seem to be valuing companies based on prices much lower than where they currently are. Farquharson says oil is not overpriced and that $30 US oil is not unreasonable in the current environment.

"As long as we have reasonable worldwide economic growth, we're going to see prices solidly in the $30 [US range], maybe in the high thirties in the next two or three years," says Farquharson.

Robert Lyon, portfolio manager of the CI Global Energy Sector Fund, thinks that the market is trading oil stocks at a discount.

"We think the outlook is still quite favourable, frankly," says Lyon. "If you look at oil prices, we see them staying higher than what is currently priced into the stocks."

Investors seem to be counting on a drop in oil to between $28 US and $30 US a barrel, but Lyon expects crude to remain higher, perhaps around $32 US or $33 US. The same can be said for natural gas, as investors are reluctant to accept the higher priced environment.

"Even if you take $5 off the oil price, oil stocks are still, in our minds, inexpensive," says Lyon.

"I think part of the reason we're seeing higher prices today is the political risk in oil-producing regions - particularly Iraq - and investors having some uncertainty as to how the situation over there is going to play out," adds Lyon.

The Asian card

On top of that, there is swelling global demand from restarting economies, particularly emerging ones.

"You've got huge and healthy demand out of the U.S. as its economy recovers, you've got both China and India with good demand," says Glenn MacNeill, manager of Sentry Select's Canadian Energy Growth Fund. "But you have very little excess supply capacity out there. I think we're in a supply-demand squeeze here and I don't think we're going to see low oil prices for some time."

He points out that oil tends to trade in peaks and valleys, and thinks the current upward spike will be followed by a drop of about $5 US to $7 US.

"I like a price in the $30 US to $32 US range," adds MacNeill. "That provides good cash for the companies and the income trusts I invest in and it doesn't hurt the economy too much. I think the economy is very vulnerable to price spikes in oil."

Price and production

While higher oil prices have attracted the headline attention, they are not necessary to fuel the energy sector's ascent. Stickier prices, however, would allow producers to boost capacity with a greater degree of confidence.

"The amount of oil is not the limiting factor there - the limiting factor is how quickly you can build new plants and infrastructure," says Lyon. "Once investors and companies believe $30 US oil is here to stay, there's a lot of oil out there to go get, such as the oil sands in Canada. They are a huge resource that could support significantly more production than what they produce today."

The elevated commodity price is not the only factor making the oil sands commercially viable. Mortimer says the apparent lack of risk makes it likely that the major American oil companies will add oil sands operations to their production portfolio in the longer term.

"The oil sands companies are extremely attractive to American investors, because they are seen to have no political risk and no exploration risk. The 'no political risk' is something that can't be underestimated," adds Mortimer "And there's no exploration risk - it's not like drilling a hole in the ocean and wondering if you're going to find something. You simply go up there with a big bulldozer and shovel it into a truck."

The vast quantities of oil held in the oil sands make it one of the few areas in the resource royalty trust market to be consistently recommended. While other trusts are cursed with the need to replace their depleting resource base, firms in the oil sands see virtually no end in sight.

But the need to replace depleted resources provides an opportunity to some of the smallest players in the oilpatch. Some small exploration firms are built on the premise that once they develop a new well they become attractive for trusts seeking to replace their reserves. Smaller exploration companies can offer some exciting growth opportunities, since they do not need to make massive discoveries to have an impact on their bottom line. Modest oil fields that may not be worth exploring by the larger players can become a boon to the smaller firms.

"The elements of the market we find most attractive currently is that smallest element, which, in addition to having positive leverage to the commodity price, is in a position where they are growing organically," says Mortimer. "You're getting volume growth as well as price growth."

MacNeill says he may be more heavily weighted toward the junior oil stocks, rather than the large caps, but that he has favourites within each sector of the market.

"We've had a bull run here for some time, so I think you have to be very selective in your approach," says MacNeill. "You have to be very careful how you pick them. You have to pick both on the basis of value and future potential."

Post-consolidation bump

In the 1990s, the oil sector was swept by consolidation, with major oil companies being swallowed by the "super majors." In the wake of the acquisitions, the oil giants have been focused on integrating their prizes, rationalizing operations and realizing savings.

"We haven't had the big spending increases yet from the big [exploration and production] companies that you would have expected," says Lyon. "Relative to what we've historically seen in a high commodity price environment, they've been pretty muted in increasing exploration expenditures."

But with the integration processes now complete, the giant firms are set to join the small prospectors and start exploring again.

"Up until recently we've had insufficient investment in terms of looking for oil and gas," says Farquharson. "The odds are we're on a long-term decline in terms of supply, particularly with oil.

"We really like some of the 'big guys' like Shell, Imperial, PetroCan and Suncor," he says. "The critical area for enhancing value is in having good quality reserves in the ground. You want to make sure your investments have terrific resources to pull on and sell to consumers."

While U.S. consumers continue to curse OPEC for the high price of gasoline, many experts, including Saudi Arabia's ambassador to the U.S. Prince Bandar bin Sultan, point to problems in refining capacity. This explains the volatile price of gasoline north of the border, where locally denominated crude prices have remained stable.

"There are a number of refining bottlenecks and capacity constraints in North America that are causing retail prices to be particularly high, and I think those are likely to persist," says Mortimer. "So the downstream side of the business looks quite good - integrated companies look quite good in that market."

MacNeill says a big part of the refining bottleneck comes from tougher regulations, requiring higher octane at the same time as lower volatility to reduce evaporation.

The banning in the U.S. of fuel additive MTBE has left gasoline producers with little choice but to devote more refinery capacity to producing cleaner gas, restricting overall output.

Power capacity

Mortimer also says it's virtually impossible to build a new refinery today, since they are about as popular as nuclear power plants for would-be neighbours.

In fact, nuclear plants could soon become more welcome neighbours than refineries.

In terms of electricity, people have been rejecting investment in generation and infrastructure for years. Proposed closings of coal-fired plants in Ontario - Canada's largest energy market - are now forcing the public to reconsider opposition to nuclear plants.

"In the late 1990s and early part of this decade, we didn't invest very much in energy. The result is that we're probably going to have a longer, stronger energy cycle than usual," says Farquharson. "We just have a huge challenge to make up for lost ground in investment. You see it in the transmission lines, you see it in the price of the commodities, you see it in the growth of demand in China and India. It's a pretty interesting sector."

Farquharson says that in the longer term, uranium miners should be good investments, since feasible options to nuclear power are few. The problem is the scarcity of companies in this field, with Cameco the dominant player and just a few small miners operating on the edges of the market.

"There are few public ways to participate in the electrical market as it stands," says Farquharson. "The major companies are publicly owned and not available to us. We think something has to change in that area."

"In Ontario, we need more generation," adds Lyon. "What we're hearing is that the government will be incentivizing new electrical generation construction, by back-stopping long-term fixed-price agreements, which are going to be high enough for generators to make some money."

Lyon says that will benefit companies like those that own the Bruce nuclear power plant, including Cameco and TransCanada Power.

"We're going to be living with the existing sources of power for a long, long time," says Lyon. "That doesn't mean we won't have new sources, but they're starting from such an incredibly low base."

Lyon points to wind-power generation, which is growing at an incredible pace, but is still miniscule compared with traditional energy sources.

"Clean power would be wonderful for everyone in the world, and I believe we're going to get there," says Lyon. "I just believe the time horizon is a lot further out than the optimistic scenario would suggest, simply because they're not cost competitive yet."

Steven Lamb