As commodity prices have soared during the past few years, so have energy equities. As a result, E&Ps have experienced increased earnings capacities and net asset values have had a serious boost. But as forward-looking oil prices have moved beyond $60 per barrel, it's reasonable to wonder whether the market has set itself up for future highs or if a sudden decline in prices will pull the rug out from under E&P equity returns. "Although there is a general belief that commodity prices will likely be higher-for-longer, the market typically does not move in a straight line," Michael Bodino, E&P analyst for Sterne Agee & Leach, says in a new report, "Living with Acrophobia." "We continue to be cautiously optimistic about the ability to generate attractive rates of return for investors in the E&P sector although the 'easy and obvious' stock picks are becoming increasingly difficult to identify." During the past 10.5 years, the S&P Supercomposite Oil & Gas Index has underperformed a commodity index of 12-month strip pricing of Nymex West Texas Intermediate crude oil and Nymex Henry Hub gas prices, each weighted at 50%, according to Bodino. During this period, the compounded annual return for the E&P index was up 12% while the commodity index was up 13%. Since the beginning of 2003, the E&P Index has provided a compound annual return of 40.6% while the commodity index is up 30.2%. Bodino says, "In general, the E&P Index outperformed the commodity index in 1995-97, 2001, and since the beginning of 2003. The commodity index outperformed the E&P Index on a relative basis during 1998-99 and 2002." From this, he concludes that "the E&P Index tends to outperform the commodity index during periods of sustained increases in commodity prices and tends to underperform the commodity during periods of falling commodity prices." But there are exceptions. In 1999 and 2000, energy prices rose sharply but the E&P index was lackluster in performance; and in 2002, market conditions affected E&P equities despite a noteworthy recovery in commodity prices. "Even more impressive is that the E&P Index has outperformed the commodity index by 20% since late October 2004, when crude oil prices pierced $56 for the first time." Bodino says that while the steady climb in oil prices has been unusual, several cyclical and structural issues are pushing the oil markets into a period of even higher pricing. "These issues have taken years to emerge and it should take years of investment into this industry before many of these issues are resolved," he says. "Our models indicate that equilibrium should occur in the oil markets near mid-$30 oil prices, but as we have cynically pointed out previously, one incremental barrel of demand beyond the supply in the market will likely send prices spiraling upward and one incremental barrel of supply in the market will generally push prices precipitously downward. This makes the thought of equilibrium prices more a concept than a true price." The issues that have forced oil to $60 include limited refining, transportation and production capacity. "To fix these from a demand-side perspective would take about a month, and be the result of a worldwide economic meltdown." During 2004, oil prices leapt from $32.35 in January to $56.30 in October, and many analysts eyed the surge in Chinese demand as the leading cause. Worldwide, oil demand was 82.5 million barrels per day in 2004, up 3.4% from 2003. In 2003, demand was 79.8 million barrels per day, up 2.3% from 2002. Bodino expects 2005 oil demand to be up another 2.2% and is likely to hit 84.3 million barrels per day, with China driving the growth. "Should the volatile economies of developing nations slow, demand for oil could drop as well, which could easily take the legs out of the market." As for near-term U.S. oil and gas supply, this may depend a great deal on hurricane activity in the Gulf of Mexico through the fall. As for hedging, while popular, the market may be taking a slight turn. "Given the economic returns at $60 oil prices, there is likely less incentive to mitigate risk for suppliers. However, concerns about future supplies given the combination of limited excess productive capacity and rising demand is a strong incentive for purchasers to mitigate risk on the futures market. This has created a rather unique market situation." Now purchasers appear to have "capitulated" and the market is in full contango, as questions about future supply have sparked anxiety. In June, OPEC raised its daily production ceiling by 500,000 barrels of oil equivalent to total 28 million, and Bodino anticipates that an additional 500,000 will be added to the market if prices either stabilize or creep yet higher. He adds that the market's major push to get increased supplies is not about meeting today's demand, but rather the much higher fourth-quarter demand, which is forecasted to exceed supplies. "We are using our forecasted commodity prices through 2006 and then long-term prices of $36 oil and $6 gas, which we believe is consistent with value for assets in the private market. However, given the contango commodity market and relatively low costs of capital compared to the economic returns of drilling many projects, there could be further valuation increase within the group." In reviewing the combination of year-to-date 2005 returns and high commodity prices, Bodino says a daunting situation is brewing, given the historical correlations between stock-price and commodity-price performance. "For this reason, we are urging a higher level of caution and selectivity when investing in the E&P group. We are not saying that commodity prices are going to collapse from these levels, although significant price volatility should continue, but there should also be increases in stock-price volatility given current valuations."