Watch out for the oil trap

Energy stocks are great long-term investments, but you should buy them very carefully.

Seems like only a couple of weeks ago, everyone was worried that oil was on its way to $100 a barrel. Since then, the oil price has fallen 15 percent to below $66.
It's fairly clear that the cost of energy will rise over the next couple of decades. And top-quality oil & gas stocks figure to be excellent long-term investments. But you have to be careful about when you buy them. Even if the value of oil reserves rises considerably in the years to come, oil prices - and energy stocks - could still go a lot lower in the short run. The greatest success will go to investors who buy slowly and shrewdly.

There are a variety of forces driving oil prices.

The oil market has been tight over the past year or so. Demand has been strong. And there hasn't been a lot of unused capacity that could be tapped. And the problem hasn't been only at the level of crude production. The U.S. doesn't have spare refining capacity. So shortages can occur in refined products even when there's crude oil available. This climate has led to buying by traders and speculators that has bid up the price higher than pure economics would require.
In addition, fears of escalating conflict in the Middle East has added a risk premium - more than $10 a barrel by some counts - to the price of oil. Estimates of the fair price of oil in the absence of all speculative and risk premiums range anywhere from $45 to $65 a barrel.
An outbreak of war or terrorism in the Middle East could send the price right back toward $100 a barrel. On the other hand, a period of stability could allow oil to drift down further from today's level.

Watch the overshoot

It may seem like a no-brainer that if the oil price drops to $55 a barrel, say, you should move all you spare cash into energy stocks. Either those shares will soar during the next crisis or you'll have a great buy price for long-term investment. There's a catch, however. Historically, once a price spike has ended, oil has overshot on the downside.
It's very instructive to look back at the 1970s and 1980s using inflation-adjusted prices.
In 1970, oil was trading at less than $18 a barrel (in today's dollars). In 1980, the price peaked above $89. By 1985, the price had fallen to around $50 a barrel. But that wasn't the end of the decline. Between 1986 and 1999, oil traded for less than $30 a barrel in 12 of those 14 years. And as recently as 1998 and 1999, the price of oil was below $20 a barrel.
I'm not saying that the Middle East will stabilize and the price of oil will plummet to $20. But the range of possible prices is far greater than one might expect. And while the long-term prospects for reserve-rich oil producers is very positive, you could load up on those stocks and watch them lag the market for a year or longer. So accumulate your holdings slowly. As the 1980s show, it can take five to 10 years for a price trend to run its course.
Recent expensive oil has called forth a lot of exploration and we could see a mini-glut of oil production at some point in the next few years. That excess will be absorbed by an oil-thirsty world, but it may take a couple of years beyond that. I'm in favor of having a sizable chunk of money - possibly more than 25 percent - in inflation-hedge investments.

Above all, be prepared to be surprised if the oil price goes down much further than seems possible. If there's a global recession that chokes off energy demand and the oil price drops well below $50 a barrel, you could become a more aggressive buyer.

But until such a recession hits, the slower you buy, the better.