After an uncertain first half of the year, oil stocks were one of the only investments to gush higher this year, and they still look to be the most profitable for the remainder of the year.

“I still think it’s the place to be in the back half of the year,” Jason Votruba, vice president and co-portfolio manager of the UMB Scout Small Cap Fund (UMBHX), told SmallCapInvestor.com. “I’m still very bullish on it.”

The fund manager dismissed the recent pullback in oil, calling it temporary. “If you use technical analysis you can look at the trend channel: we touched the top of the trend and now we’ve pulled back to that of 21-day moving average. I think we could go back to $120 perhaps, if that low, but I think we’re going see higher prices for a while.”

Votruba said that a major factor behind high oil prices for the foreseeable future is scaled-back oil production and burgeoning global demand for tightened supply. Mexico’s production, for example, has slipped 9.1% in the first four months of the year.

“You’ve got a lot of countries that nationalized their oil production; that leads to decreased production and now we’re paying the price,” Votruba said.

In addition to Mexico, Russia and Saudi Arabia have cut back production. China and India are also slurping up oil, as billions of both countries industrialize and new people begin driving automobiles. Government subsidies have also come into play, as gas in the Middle East, for example, goes for a very affordable $1 per gallon.

According to Votruba, there is currently less than 700,000 barrels of spare capacity in the market.

Aside from production, extracting oil takes time. Brazil has recently discovered oil off its coasts; however, there is still realistically five years until those reserves can be tapped. The United States possesses billions in oil as well; however, Congress has banned drilling such reserves.

“There’s plenty of oil out there. That’s not the issue,” Votruba said. “It’s just being able to get to it.”

In a hearing before the Committee on Homeland Security and Governmental Affairs on May 20, Michael Masters, managing member and portfolio manager of Masters Capital Management, said that institutional investors are to blame for the surge in oil futures.

“… We are experiencing a demand shock from a new category of participant in the commodities futures markets: institutional investors. … Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant,” he said.

According to the Department of Energy, annual Chinese demand for oil has increased by 920 million barrels over the last five years to 2.8 billion barrels from 1.88 billion barrels. Over the same five-year period, Index Speculators’ demand for oil futures has increased by 848 million barrels, almost equivalent to China’s demand.

As a result of the escalating demand, Votruba said he thinks “we’re going to be in for some higher prices over the next several years unless demand gets destroyed.” 

Richard Wyman, vice president and senior oil and gas analyst at Canaccord Adams, also said oil will remain the most profitable play for the rest of the year, and sees prices only climbing higher. However, Wyman said anomalous factors could also play a role. 

“The wild card will be how various resource rich governments can attempt to extract more economic rent out of it by jacking up royalties or shifting the fiscal terms,” Wyman told SmallCapInvestor. “The last time we went through one of these oil booms in the ’70s, it tended to be the pattern: resource-rich jurisdictions grabbed more and made it more difficult to reinvest, which exacerbated the price rise.”

Higher oil and gas prices have undoubtedly translated to windfalls for oil and gas companies, and with prices only soaring, higher investors question the formation of a bubble. Votruba admitted we’re near the development of a bubble, but far from “popping.”

“I don’t think we’ve entered the bubble stage yet,” Votruba said. “I think we are just getting there.  This is like the third or fourth inning. I still see a lot of upside ahead and I don’t know if we’ll see $200 [per barrel] this year, but I’d expect it to trend higher from here. I don’t think we’ve seen highs.”

Far from the bubble bursting, Votruba says valuations look good.

“If you look at the valuation on these oil companies; they’re no way near reflecting where we’re at on oil,” Votruba said. “In some cases, I see some [valuations] with built-in oil forecasts of as low as $60 per barrel. … It’s going to take a lot for these oil companies to fully appreciate in their valuations because nobody believes oil prices can sustainably remain this high.”

Wyman, too, said small-cap energy stocks are undervalued compared with large-cap peers. “A lot of that has to do with the state of the capital markets, not necessarily the state of the commodity markets,” he said. The analyst pointed to the ability of smaller companies to tolerate escalating costs as cost structure rockets within the oil and gas business worldwide, due to a general rise in commodities and skill labor shortages. 

Wyman cautioned, though, that “if the price of crude falls to $60 a barrel then it would be difficult for [small-cap] companies to survive. They would be operating at the margin, so they are at the high-cost part of the business. In a lot of ways, they need high commodity prices to keep the lights on.”

Even if oil prices were to plummet, Votruba said many oil companies he invests in buy floors, such that they can lock in the current higher prices.  “I think they’re going to see higher profits for a long time,” he said.

Visit the Reporter’s Notebook corner of SmallCapInvestor.com Friday to read Votruba’s and Wyman’s favorite small-cap stock picks within the oil and gas sector.