Energy Strategies

The price of oil is down and energy companies are cutting production, postponing capital projects, idling drilling rigs and laying off staff. Shares of oil companies are trading at multi-year lows, and some investors may wonder if it’s time to start buying. Taking a chance on an oil price recovery is not for everyone, however.

Passive investors content to simply match the market’s returns by owning index funds should not be trying to find undervalued stocks, while retirees who must use their investments for income should focus on safety, not capital gains. These latter two groups should simply be content with the money they’re saving at the gas pump.

For other investors, exchange traded funds and notes that track the oil price look like a wonderful bargain and a great way to play an oil price recovery. There are several to choose from, including United States Oil Fund (USO/ NYSE), ProShares Ultra Bloomberg Crude Oil (UCO/ NYSE), iPath S&P GSCI Crude Oil Total Return (OIL/ NYSE), PowerShares DB Oil Fund (DBO/NYSE), as well as funds that allow investors to short-sell oil, or bet on its downturn. The funds have appeal since investors can simply play oil and needn’t worry about companyspecific risks such as geese and ducks falling into a tailings pond, protesters blocking access roads, rogue traders, wars and so on.

Unfortunately, they all trade in US dollars, which makes them less of a bargain for Canadians who have to pay with US80-cent loonies. If the price of oil recovers, the Canadian dollar will too, eroding U.S.-dollar denominated gains, especially when you add in your broker’s currencyexchange commissions. Speculating on U.S. oil ETFs will only work if you can keep your gains in a U.S. dollar account for many years, allowing the oil prices to rebound, then waiting until something else sinks the Canadian dollar before repatriating them—a tall order.

Focus On Quality First

Instead, Canadian investors should confine their focus to Canadian companies with the strongest balance sheets that are still profitable, even if their cash flow is not as healthy as it was a year ago. These same companies must be large and established enough to pay a dividend, and that dividend needs to be easily covered by cash flow, however reduced it may now be. You might call shares in these companies “recovery plays” that can wait out a prolonged oil price slump, as opposed to “turnaround plays” -- the money losers, and those whose cash flow is a fraction of their dividend payouts. Speculators gambling on turnaround plays will be left holding the barrel if the oil price stays low for several years.

In Canada, the three safest ways to play an oil-price recovery come in the form of the two largest integrated producers, Suncor Energy Inc. (SU/TSX) and Imperial Oil Ltd. (IMO/TSX), together with the iShares Capped Energy Sector Index ETF (XEG/TSX), whose basket of holdings provides diversification. Everything else involves too much risk.

Shareholders of some companies were suffering even before the oil price plunge. The following large-cap Canadian energy producers are down more than 25% over the past five years: Penn West Petroleum (PWT/TSX), Pacific Rubiales Energy (PRE/TSX), Bonavista Energy (BNP/TSX), Pengrowth Energy (PGF/TSX), Canadian Oil Sands (COS/TSX), Talisman Energy (TLM/TSX), EnCana (ECA/TSX), Enerplus (ERF/TSX) and Baytex Energy (BTE/TSX).

If the price of oil does not recover, a takeover bid for these laggards is really shareholders’ only hope. (A recent spike in the shares of Canadian Oil Sands, for example, reflects such speculation, and keep in mind Talisman recently received a takeover bid.)

Other companies have managed to sustain their dividends but their payouts now exceed their cash flow. Companies such as Crescent Point, Enerplus, Bonavista, Whitecap Resources, EnCana and Baytex are all paying out much more than what they earn. If the price of oil does not recover, these companies may have little choice but to reduce their dividends, like Canadian Oil Sands, Encana and Baytex have already done, or even eliminate them altogether.

This is where Suncor Energy Inc.(SU/TSX) and Imperial Oil Ltd. (IMO/TSX) have an edge, as both are giant, conservatively managed and consistently profitable. Their dividend payout ratios—28% for Suncor and 15% for Imperial Oil--show a downturn would have to last years before dividends would be threatened. Suncor is the largest energy company in Canada, but its main advantage for investors comes from the variety of markets in which it operates. Suncor has assets in the oil sands, together with interests in oil and gas exploration and production in Canada and abroad, oil refining and gasoline retail sales (Petro-Canada), and crude oil and natural gas marketing operations.

The company also produces ethanol, sulfur and petroleum coke, and generates 255 megawatts of electricity from six wind farms.

Suncor’s fourth-quarter 2014 earnings and cash flow were crushed by the low oil prices. Fourth-quarter operating earnings fell to just $386-million or 27c a share from $973-million (66c), and net earnings for the quarter tumbled to a paltry $84-million (6c) from $443-million (30c). Cash flow fell to $1.49-billion ($1.03) from $2.35-billion ($1.58).

Despite the dismal news, the shares actually gained about 2% the following day, a sign institutional investors such as pension and mutual fund managers (who own about 73% of Suncor’s shares) had expected even worse figures.

Suncor remains a solid choice for investors. While everyone has been talking doom and gloom, Suncor shareholders enjoyed a total return (dividends plus capital gains) of 13.9% over the past year, according to the website longrundata.com. The site’s data on Suncor, which goes back to Jan. 12, 1995, shows that a $1,000 investment in Suncor made on that date would be worth $25,191.08 today, for an average annual total return of 17.44%. (These figures are exceptionally high, however.

Total annual returns for Suncor are most likely to range between 6% and 10%.)

Outside of some brief plunges below $36 in mid-October and below $32 in mid-December, Suncor shares have generally stayed above $40 over the past year, so a dip below that represents value. Imperial Oil’s fourth-quarter net income fell to $671-million (79c a share) down 36% from the $1.06-billion ($1.24) reported for the same quarter a year ago. Cash generated from operating activities fell to $1.09-billion, down $568-million from the fourth quarter of 2013. Like Suncor, Imperial Oil’s shares climbed after the results were released.

Imperial Oil shareholders have had a 10.2% total return over the past year, longrundata.com says. When total return is measured back to Jan. 12, 1995 (the earliest date available) longrundata finds a $1,000 investment in Imperial Oil made then is now worth $12,872.73, for an average total return of 13.6%.

These two conservative blue chips are able to withstand oil price fluctuations, but the iShares Capped Energy Sector Index ETF (XEG/TSX) has not fared so well. The fund, launched in March 2001, has stakes in 58 large Canadian energy companies, including Suncor, Canadian Natural, Encana, Imperial Oil, Crescent Point, ARC, Husky Energy, Canadian Oil Sands and Tourmaline Oil.

The ETF’s dividend payout varies, rising in good times and falling in bad. Some of the major holdings in the XEG fund have not done so well over the past five years. An industry ETF that tracks an index based on market capitalization does not look beyond size to determine which companies are on it -- a form of random diversification that tosses in overpriced stocks with undervalued ones. Nevertheless, the fund is acceptable for those content to simply track an index.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca