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Market Update

Should You Dip a Toe Into Oil?

There may be some investment opportunity in oil's slide, writes contributor John Waggoner.

Every so often, you notice that something's really different. Hey, you might think, no one's worrying about the Ukraine these days. Or gosh, you might say, I haven't heard anyone say what a great guy Jeff Bezos is lately.

You probably haven't heard anyone gripe about gas prices recently, either: As of this writing, prices have fallen 31% the past 12 months, to an average of $2.32 a gallon for regular unleaded, according to AAA. The one exception is if you work in the energy industry--or if you've invested in it. Morningstar's recently revised long-term price outlook for oil is in the $64 to $70 range, and that makes energy stocks an interesting proposition for long-term investors.

West Texas intermediate crude--the light, sweet crude oil that the U.S. produces--peaked in 2008 at $145.38 a barrel. From there it slid, relatively gently, to $105.34 in July last year. But from there, it was a greased sled ride downhill, finishing the year at $53.35. Prices have remained in the mid-$40 range as of this writing.

The carnage in energy stocks hasn't been quite as bad, but it has been bad enough: The average equity energy fund has taken a 19.7% pounding this year. And some unfortunates, such as the snake-bit Chesapeake Energy , are down more than 50%.

The fact that oil has fallen a long way doesn't necessarily mean that prices will soar anytime soon. Oil spent most of the 1990s hovering around $20; in November 1998, oil sold for $11.37 a barrel, or less than your average case of beer. "When we first hit $40 oil in October 1990, we didn't see $40 oil again for 164 months," says Tom Kloza, global head of energy analysis for the Oil Price Information Service.

Much of the blame for lower oil prices has been levied at Saudi Arabia, the largest oil exporter with the lowest cost of production. "They're the only ones with any additional crude in their pockets," Kloza says. Why the Saudis are pumping so much oil is unclear. It could be to hurt their two main enemies, Russia and Iran, both of which need higher oil prices to support their economies.

The Saudis may also be flexing their muscles against U.S. oil producers, whose fracking techniques have turned the U.S. into the largest non-OPEC oil producer. But many U.S. producers have found ways to reduce their costs and maintain production.

The explanation may be as simple as this: Saudi Arabia was often the one member of the Organization of Petroleum Exporting Countries that pulled back on production when OPEC decided prices were too low. "Whenever it was time to balance supply and demand, it was the Saudis who had to take one for the team," Kloza says. "Maybe they were tired of that."

New oil from Iran may come online later this year if Iran and six other countries, including the U.S., sign an agreement limiting Iran's nuclear weapons program. The U.S. Energy Information Administration doesn't expect the Saudis or the rest of OPEC to cut production if new oil from Iran comes online.

Demand slowdowns in Europe and China aren't helping oil prices, either. China's consumption is expected to grow by 0.3 million barrels a day in 2015 and 2016, versus 0.4 million barrels a day in 2014, says the EIA. And current world crude inventory should rise to 3.08 billion barrels at the end of 2016, versus 2.99 billion barrels at the end of this year.

The blowout in oil prices has left some bargains, according to Morningstar energy sector strategist Mark Hanson. His two favorites:

Devon Energy (DVN) has a solid balance sheet, which means it can weather a downturn more easily than most energy exploration and production companies. And it has a good mix of oil and natural gas production, Hanson says. He estimates the company's intrinsic value at $51 a share, well above its current price of $38.79.

Cabot Oil & Gas (COG) owns 200,000 acres in Susquehanna County, Pennsylvania, the heart of the Marcellus Shale formation. It's one of the lowest-cost producers of natural gas in the U.S., Hanson says. And it's on the short list of takeover candidates in the energy sector. Its intrinsic value is $41 per share, versus a current price of $22.45.

Low oil prices aren't bad for everyone. For refiners, low oil prices can be a good thing, since the price of refined products, like gasoline, tend to fall more slowly than the prices of crude. Marathon Petroleum (MPC) and Tesoro  currently earn 4-star ratings from Morningstar.

If you're tempted to wade into energy stocks, bear in mind that you may already have plenty. The S&P 500 has 6.8% of its assets in energy, and a few large funds have supersized that. DFA US Large Cap Value (DFLVX), for example, has 16.9% of its portfolio in energy. American Century Equity Income (TWEAX) has 12.7% in energy. (For energy haters, Fidelity Capital Appreciation (FDCAX), Janus Twenty and Jensen Quality Growth (JENIX) have no energy at all).

Investors who prefer to buy the sector, rather than single stocks, should consider a low-cost exchange-traded fund. "For broad exposure to the sector, Energy Select Sector SPDR ETF (XLE) does the trick," says Morningstar analyst John Gabriel.

The EIA notes that there's an unusual amount of uncertainty in the forecast for world oil, and if your main reason for buying energy stocks is a feeling that oil is cheap, you should be aware that predicting commodity prices isn't easy. A better bet is to look for companies with strong intrinsic value whose prices have been unfairly beaten up in the market's recent turmoil.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

John Waggoner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.