Oil producers vrs oil service.

Someone asked the following question a little while ago:

What is your opinion about investing to oil companies vs. oil service companies? During 70's oil service companies were better bet than big oil companies, but do you think history will repeat itself during next decade?

I learned the same thing reading Stephen Leeb's book, The Oil Factor, but unfortunately, he didn't provide much detail behind the statistics. The numbers, according to his book, for 1970's real returns (after inflation) per year:

Big oil cos= 6.8%
Oil service= 23.6%
Independent oil producers= 11.8%

That is some significant outperformance. I have some guesses as to why it happened:

1.) The picks and the shovels argument from the gold rush, i.e. the real winners are the folks selling to the prospectors (oil producers), some of whom end up spending money and find little or nothing, and earning little or no return.

2.) I suspect there are probably fewer oil service companies and they are probably smaller cap than the oil producing companies they service. With fewer stocks and smaller caps, you get a more concentrated, volatile portfolio, and thus probably more 'juice' in a long term upcycle.

3.) I also believe that service is even more boom and bust (i.e. risky) than the rest of the industry. When times get bad for oil producers, they can still sell oil and gas (perhaps very cheaply, but at least money is coming in), but when things dry up for the service co's, they have some very expensive equipment that lies around producing no revenue. So the bad period kills off competition, and when the good times arrive, it takes time for the competition to form, as they both need to buy expensive equipment and hire employees that will demand premium pay. Since stock returns are correlated with risk, the higher risk of oil service can result in higher returns.

In terms of whether I think history will repeat, I don't have a strong opinion. There is an argument that says that since drilling opportunities are now (apparently) depleting, that in total, less oil service will be needed. On the other side of that is the idea that although oil companies are not welcome to participate in all opportunities around the globe as countries retain more ownership, oil service companies, at least for now, are still participating. Additionally, because new technologies tend to be expensive, oil service may benefit as smaller companies lease/rent it rather than buy it to keep capital costs down.

So while I have no strong opinion, my sense is that yes, history could well repeat. But do I feel strong enough about that to own only (or even mostly) oil service? No.

One further point: I was looking at the Vanguard Energy Fund's (which I think is a reasonable proxy for energy mutual funds) semi-annual report the other day. The record for the recent past is:

2004 +36.5
2005 +38.9
2006 +28.7 (this is actually 2005 through July 31)

Those are very big numbers over a 3 year period. We probably need a pause. It could last a while. If you think that's likely, you may just want to set up your dollar cost averaging with a 2-3 year time horizon and take advantage of the pause.