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Domestic Equity—Growth | August 2013

Rising U.S. energy production appears sustainable and should create subtle opportunities for discerning investors

By Thomas Pence, CFA; Michael Smith, CFA; and Chris Warner, CFA—Portfolio Managers, Wells Fargo Advantage Discovery Fund

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We believe rising U.S. energy production, easing domestic energy consumption, and falling energy imports in the U.S., are sustainable trends over the next few years. These trends are likely to have positive effects on the strength and sustainability of U.S. economic growth. We also believe discerning investors may find attractive investment opportunities in companies outside the energy sector that should benefit if U.S. energy production increases further.

Technological innovations have facilitated a healthy rise in U.S. energy production over the past five years, after a 10-year period of slight production decline (see Chart 1). We have seen newer drilling techniques, particularly hydraulic fracturing, significantly improve the amount of recoverable resources in various shale locations across the country. Also, increasing U.S. energy production has combined with easing domestic consumption patterns to reduce the country’s dependency on energy imports. We believe these supply-and- demand forces are sustainable, secular trends that will have transformational effects on the U.S. economy.

America’s energy resources can transform dynamics for employment, consumer spending, and housing

Based on access to abundant and cheap resources (oil and natural gas), manufacturers are likely to consider expansion in the U.S. going forward. Affordable land, skilled workers, and stable wages should provide these manufacturers additional incentives to expand in the U.S. This potential North American manufacturing renaissance should drive the unemployment rate lower in the U.S., which we expect to provide a lift to domestic consumer spending and to support a long-term recovery in U.S. home values. As a result, we believe some investors may be underappreciating the prospects for resilient U.S. economic growth.

Annual U.S. energy consumption, production, and imports (1997–2012)
Past performance is no guarantee of future results.
Source: U.S. Energy Information Administration

Attractive return potential exists in companies that should benefit from higher energy production rather than higher energy prices

Some investors may be inclined to emphasize companies in the energy sector in order to benefit from the growth prospects of rising U.S. energy production. However, we believe it is important to understand the impact that commodity prices often have on many energy companies. While we do not focus our research efforts on forecasting oil and natural gas prices, we do believe that more fuel-efficient vehicles and lower-cost energy production could limit the upside in oil and natural gas prices over the next few years. Therefore, we believe investors may find more attractive investment opportunities in companies outside the energy sector that can benefit primarily from the production volume increases rather than focusing exclusively on energy companies with a greater reliance on commodity price increases.

Select industrials companies that meet the needs of energy customers have strong growth potential

Through all-cap research we have identified opportunities in the industrials sector that we believe should benefit from rising U.S. energy production while limiting investment exposure to the changes in oil and natural gas prices. For example, some exploration-and-production companies with acreage in prolific shale locations lack sufficient pipeline capacity to transport their higher production levels. Railroad companies in the industrials sector have increasingly met these transportation needs. In addition, we believe increasing energy production will require additional pipeline infrastructure. Construction and engineering companies in the industrials sector with track records of successful pipeline build-outs could capitalize on these needs.

Concluding observations

We believe rising U.S. energy production is likely to have transformational effects on the U.S. economy that may provide equity investors with attractive opportunities to benefit from secular growth trends. While some investors may be inclined simply to focus on the broad energy sector to benefit from increasing energy production, we also encourage them to consider companies outside the energy sector that are uniquely positioned to benefit from sustainable improvement in energy production and its transformational potential on the overall economy.

Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Smaller-company stocks tend to be more volatile and less liquid than those of larger companies. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund’s prospectus for additional information on these and other risks.

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