Diversified energy opportunity

As Members will know we have long had a bullish view on the oil price. We regard the correction that has unfolded since August as a temporary pullback within a long-term bull market. In fact we believed that recent price action would open up selective buying opportunities. To this end, we have identified Petroleum & Resources Corporation (NYSE: PEO) as an ideal way for Members to gain diversified energy exposure.

PEO is a US-listed investment trust that specialises in the international and domestic natural resource sector. The investment trust is one of America's oldest, having traded on the New York Stock Exchange since January 1929. The closed-end fund has assets under management in excess of US$800 million. The Fund's investment objectives are fairly simplistic - preservation of capital, attainment of reasonable income, and an opportunity for capital appreciation.

The investment strategy of the research team is a "bottom up" approach, with the goal being to identify energy and natural resources stocks which offer long-term earnings growth at a reasonable price. As value investors ourselves we believe this style of active management holds much merit. In addition to the Fund's investment style we are also encouraged by the longevity and continuity of management. The current team of portfolio managers have been running the fund together for over 17 years.

The recent performance of the Fund has been robust. Over the 12 months to September 30, the adjusted return on net asset value was 42.9 percent compared to the benchmark Dow Jones Oil & Gas Index, and the S&P500 of 48.2 and 12.3 percent respectively. Not surprisingly the Fund has significantly out-performed the broader equity indices following this year's rally in the energy sector. The Fund's relative underperformance versus the index in our opinion reflects the weighting of the portfolio towards larger capped stocks. The gap would likely narrow on a risk-adjusted basis.

The Fund's returns have been achieved through exposure to large cap majors as well as junior producers and oil services companies. As at 30 September the top ten holdings were:-

PEO is heavily weighted towards the energy sector with an 85.8 percent holding, of which around a quarter is invested in integrated oil majors (including Royal Dutch Shell and Total not listed above). The trust also has around 12 percent in US based companies such as Connoco Philips and Amerada Hess. Mid-sized producers such as Devon, EOG Resources, and Noble Energy account for 20 percent and distributors a further 13 percent.

Of the remaining energy exposure we are also encouraged that PEO has a significant 17 percent weighting in oil services companies. These include global oilfield services provider Schlumberger, and BJ Services, a leading supplier of pressure pumps. Noble Corp meanwhile, is one of the world's largest offshore drilling contractors. With the majority of oil producers around the globe operating at full capacity, the demand for the expertise of oil services companies is set to remain robust. We therefore expect further strength in the margins and earnings of these companies.

During the latest financial year, many of the world's largest oil companies have produced stellar results. Exxon Mobil, BP, Chevron, ConocoPhilips for instance have all reported record earnings and cash flows as well as increasing dividends and buying back shares. In our opinion, results look equally promising over the next 12 months.

We believe that the current valuations for many of the larger oil companies are still too low, and that analysts are being too conservative in their forecasts. Since the start of the oil bull market forecast prices and earnings have constantly been subjected to upward revision which has favourably impacted company share prices.

Consistent with the valuations of the broader energy sector, many of the companies in the PEO portfolio are currently trading on low price earnings multiples. We believe current multiples for energy stocks reflect the notion that the bull run witnessed over the past year is not sustainable and that oil and gas price levels are due to correct sharply lower over the medium to longer term. We beg to differ.

The case for a high oil price environment grows ever more compelling in our opinion. A primary driver has of course been the demand/supply equation. At this stage neither side shows any signs of faltering.

The outlook for global demand remains robust. The International Energy Agency (IEA) puts worldwide demand in 2006 at 85 million barrels a day. By 2030, the Agency predicts that global oil demand, driven by growth in China and India, will more than double.

Meanwhile supply continues to be stretched. Global oil production is currently around 84 million barrels a day and it will be difficult to increase this in our opinion. Given a lack of investment in production and refining capacity over the past few decades it seems the industry's hands are tied.

From a market psychology perspective we believe that the correction that has unfolded in the last quarter of the year is symptomatic of the behaviour which occurs in a primary bull market. During such times the bulk of participants, previously conditioned by a bear market, generally consider a period of advancing prices to be unsustainable.

In our opinion many long positions have been flushed out of the market by the correction which has unfolded since August. Prices have retreated by 15 percent to current levels of around US$60 per barrel. We believe that this price action has been positive in that the foundations are being set for the next advance.

In addition to significant leverage to the bull market in energy, the fund also comes with an attractive yield, and has a consistent history of dividend and capital gain payouts. Distributions last year totalled 1.78 cents which equate to a yield of more than 5 percent. (Members are asked to ignore the stated dividend yield in this week's email alert which was listed incorrectly) PEO still however possesses compelling income characteristics - over the last 5 years the stock has yielded an average of 5.8 percent.

We are also impressed by the low cost nature of the fund. PEO's expense ratio last year was 0.35 percent, compared to 1.42 percent for the average US diversified mutual fund.

PEO currently trades around US$33, a 7 percent discount to underlying net tangible asset backing of almost US$36. In our opinion this gap will potentially close over the next 12 months as the oil bull market reasserts itself.

In September PEO traded at an all-time high of US$35.74. We believe that the stock is in a long term bull market and that the recent correction has provided an opportunity to establish a position. In the event of further consolidation, the shares should be well supported between US$30.50 and US$29.50.

PEO represents a relatively low risk, diversified, exposure to energy market. While the possibility of a near-term correction cannot be ruled out, we remain fervently bullish about the direction of the oil price over the longer term. Given the current discount to NTA and our robust outlook we believe PEO presents an attractive buying opportunity. Accordingly, further to this week's email alert we re-iterate our buy recommendation on PEO around US$32.90.