Many market mavens on Wall Street are predicting $50 to $60 prices for crude oil for the near term-one energy seer actually sees an oil-price spike to $105. Yet a more sober consensus is that prices will likely dip to near $40, with natural gas prices retreating in tandem to the high-$4 to low-$5 range. What this means to energy-sector investors is the real possibility of a significant correction in oil and gas stocks. In recent years, smart high-net-worth individuals-those with net assets in excess of $5 million-and institutional investors-those with net assets of at least $25 million-have sought to cushion themselves against such corrections, while at the same time achieving above-average market returns, by participating in hedge funds. Unlike mutual funds or long-only equity portfolios, hedge funds have the ability to short securities. Through such transactions, hedge funds sell borrowed securities, betting those securities will decline in value; later, the funds buy back those securities at a targeted lower price, profiting from the spread. Also, unlike mutual funds, hedge funds have the ability to use leverage to own a dollar amount of securities greater than the net equity in their portfolios. Typically, under Regulation T guidelines set forth by the SEC, long-plus-short equity positions in a limited-partnership hedge fund cannot be greater than two times, or 200%, of a limited partnership's capital. In the past, hedge-fund leverage has typically ranged from 50% to 100%. Yet another distinction: hedge funds have greater flexibility than mutual funds, in terms of being able to buy and sell stock options or commodities futures, with the aim of profiting from the spread between the price at which the options or futures contracts are bought and the price at which they're sold. In addition, unlike mutual funds, hedge funds have no restriction as to the amount of cash they can hold, or the amount of money they can invest in any one industry. There are, in fact, hedge funds today that are dedicated solely to energy-equity investments. The upshot of all this investment flexibility? Using leverage, shorts, options and commodities trading, a hedge fund has the ability to manage market risk and volatility in a variety of ways and potentially achieve better-than-average annual rates of return over time, not correlated with the general market. Indeed, during the past 10 years, many hedge funds have been able to achieve annual returns ranging from 40% to better than 100%; the average target return for most, however, has been more in the 20% to 25% range. For such returns, hedge funds typically charge a 1% management fee and receive a 20% incentive fee, taken out of an investor's capital gains. With such performance, these funds have become extremely popular with the deep-pocket set. That explains why their number has mushroomed from 880 in 1992, with assets under management of $55 billion, to 8,050 in January 2005 and $934 billion. Along with this growth, however, has come severe criticism of the hedge-fund industry; some of it warranted, some not. One of the more pervasive complaints is that these funds are such big players that they have the ability to significantly move the equity and commodities markets, creating huge levels of volatility and run-ups in equities and futures pricing. This, according to some, is a misperception. Issues answered On the margin, hedge funds can make a difference in market movement, with or without leverage, says Charles Gradante, managing principal and chief investment officer for the Hennessee Group LLC. "But with hedge funds approaching $1 trillion in invested assets and mutual-fund investments nearing $8 trillion, it is mutual-fund inflows and outflows that should be regularly highlighted as moving the broad markets, as they did in our last bear market when they experienced heavy redemptions," he adds. The New York-based firm is an SEC-registered investment advisor that consults investors in hedge funds on asset allocation and hedge-fund manager selection. The group also monitors hedge-fund managers and publishes the Hennessee Hedge Fund Indices, which monthly benchmarks the performance of hedge-fund managers. Gradante's contention is supported by a March report issued by Nymex. The report, covering specified periods during 2004, notes that hedge-fund trading activity comprised only a modest share of trading volume and open interest in both the crude oil and natural gas futures markets. The report adds that hedge funds tend to hold positions significantly longer than the rest of the market, "which supports the conclusion that hedge funds are a nondisruptive source of liquidity to the market." Furthermore, the report emphasizes that, with respect to the price volatility in natural gas futures, "when hedge-fund activity alone is evaluated, the data strongly indicate that changes in hedge-fund participation result in decreases in price volatility." On the issue of the SEC wanting more regulatory authority over hedge funds, Gradante believes such sentiment is not without basis and that regulation could have a positive effect on the fund industry. "It will force hedge-fund managers to become more institutional, in terms of how they run their business," he says. "They'll need to have in place tangible policies and procedures and abide by generally accepted investment-management rules. Most of them already do, but now they'll have to document those rules and show an ability to enforce them." The Hennessee Group principal notes that by February 2006, all hedge funds with $30 million or more of assets under management will have to be SEC registered. His take on the energy sector? Gradante, whose firm has $1.4 billion of assets under advisory with 120 hedge-fund portfolio managers, says that for the past two years the Hennessee Group has been emphasizing energy, broadly speaking, to both investors and in its hedge-fund-manager selection. "We've been emphasizing emerging markets, and energy has been an emerging-markets play," he explains. "However, we now believe that strategic supplies of oil are at or near all-times highs and that crude prices will drop to around $40 in the near term and stay there for awhile. "The firm is recommending an asset reallocation away from the crude-oil price game to the refining sector. As we see it, the world's strategic capacity to produce gasoline is insufficient to meet demand and refining stocks are the place to be through the middle of 2006." Long on energy An SEC-registered hedge fund with nearly $500 million of assets under management, Palo Alto Investors in Palo Alto, California, has a somewhat different take on the sector. "We're in a very long-term trend of high commodity prices-our base case is $40 oil and $6 gas-and we believe that within the microcap and small-cap end of the market, both in the E&P and oilfield-service sectors, there's opportunity for significant share-price growth," says David Anderson, portfolio manager and energy analyst for Palo Alto Investors. In its equity holdings, the hedge fund is approaching a 40% weighting to energy. Within that weighting, it has a 60% bias to upstream stocks and a 30% exposure to oil-service equities. Since 2001, the firm's energy-equity holdings have achieved average annual returns in excess of 35%; from 1989 forward, the firm's overall annual returns have averaged 23%. "We're long-term investors focused on fundamental research," says Anderson. "As such, we don't do a lot of shorting and rarely use leverage-although we can and do use tools like these to take advantage of commodity- and stock-price volatility to achieve returns not correlated with the general market. "That said, our primary goal is to seek out companies that can deliver long-term growth at a reasonable price." A former Chevron finance expert and investment banker who started Palo Alto's energy practice in 2001, Anderson likes the tight supply/demand dynamic at work in the North American natural gas arena. "The cost to find new reserves and bring on production is getting higher and the targets are getting smaller, all of which suggests strong commodity pricing for a number of years." In such an environment, the bottom-up investor is targeting E&P companies with low finding and development (F&D) and operating costs. "Operators with aggregate F&D and operating costs of $2 in a $6 gas market are going to be able to grow production, cash flows and returns faster than producers whose like costs are $3," he says. "Also, they're the ones that could still be profitable in a world of $4 gas." Among the better low-cost producers, the buysider points to Ultra Petroleum, Quicksilver Resources and Southwestern Energy. However, Anderson doesn't overlook producers that may operate in high-cost regions like the Gulf of Mexico but nonetheless have sound cost structures relative to their strong cash flows and earnings. In this context, he cites E&P companies such as Energy Partners Ltd., Callon Petroleum and PetroQuest Energy. Among oilier players, the portfolio manager favors operators like Denbury Resources, Plains Exploration & Production and Encore Acquisition-all of which have niches that give them a cost advantage over time. Denbury, for instance, owns a huge CO2 field in Mississippi and uses that CO2 to produce oil that would otherwise go untapped, he points out. "In the case of Plains, one of their strategic prospects offshore California, Trancheon Ridge, could, once onstream, double the company's proved oil reserves, to 400 million barrels." In addition, Plains is now in the process of trading out of a former $25 oil-hedge position and putting in place a $45 oil-price floor for its production. "That will have a huge impact on cash flow and become very visible to the market a year from now." Anderson is no less a fan of Maple Leaf operators engaged in the oil-sands plays around the Fort McMurray area in Alberta. "Unlike typical oil projects, these plays aren't depletion-driven; they're essentially mining operations that will produce at stable rates for 30 to 40 years." While Shell Canada and Canadian Natural Resources are among the more visible oil-sands names, one that isn't on many radar screens is UTS Energy, a small Calgary-based C$600-million-market-cap producer. This March, UTS announced a partnership with Petro-Canada in an oil-sands project. The result: the junior oil's stock doubled, to C$2 per share, says the buysider. But that's not the reason Palo Alto owns the stock. The company, run by Will Roach, who helped Husky Energy bring on the White Rose project offshore eastern Canada, has a 46,000-acre project near Fort McMurray which sits on known in-ground resources of several billion barrels of oil. "True, a lot of capital will have to be deployed before first production comes online three to four years from now, but once that starts, the company has tremendous cash flow for the next 40 years." Says Anderson, "UTS is a good example of our energy-investment strategy: buying small-cap stocks with plenty of growth potential at a reasonable price." Short-term softness Also very bullish long-term about oil and gas stocks and the commodities that underpin them is G. Bryan Dutt, president of Ironman Energy Capital LP-an SEC-registered, Houston-based hedge fund with $70 million of assets under management. However, in the short term, high inventory levels will push crude prices below $50 and natural gas into the high-$4 to low-$5 range, he says. "Currently, we have quite a bit of cash on hand, and as oil and gas stocks weaken, we expect to use that as an opportunity to build back some of our positions," he says. "Service stocks may get hit hard, but fundamentally we believe that $55 or $40 oil isn't going to have a tremendous impact on the growing demand for oilfield services." Among service companies, Dutt favors land drillers and pressure-pumping companies, the latter due to the high demand for fracing unconventional gas plays. Within the former group, he favors Pioneer Drilling, with 52 land rigs operating in south Texas, the Barnett Shale and the Rockies; and Precision Drilling, the largest land driller in Canada. Within the pressure-pumping arena, the analyst sees market leader BJ Services as the best play, followed by two smaller Canadian competitors, Trican Energy Services and Calfrac Well Services. As for E&P stocks, Dutt concedes that an oil-price decline from $50 to $40 would hurt those issues the most within the energy sector. However, he's quick to point out that most upstream stocks have been reflecting high-$30 to low-$40 oil in their market valuations-not $50 oil-so any fall from market grace would also present a buying opportunity. Upstream stocks that may get hit the worst in a commodity-price slide, he says, are the smaller-cap, more speculative names like ATP Oil & Gas, involved in the North Sea and Gulf of Mexico; Vaalco Energy, focused offshore Gabon; and Carrizo Oil & Gas, an onshore U.S. player. "Should these stocks head down, we'll be buyers," says the analyst. In an E&P share-price decline, Dutt would also target larger-cap names like Penn Virginia and Range Resources, which are growing through a balanced exposure to Appalachian and Midcontinent drilling opportunities, plus exposure to coal in the case of Penn Virginia. In the current environment, Dutt doesn't use leverage in his hedge fund. "We only do that when commodity prices and stock valuations are low, which would present much more of an opportunity to invest very strongly."

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