How To Play The Oil Price Recovery

Older investors have to stay healthy long enough to enjoy the benefit of an oil price recovery, unless they are simply hoping to enrich their heirs.

A friend who still owns shares in energy companies asked me if I thought the price of oil will ever recover. I quoted the late great New York Yankees catcher Yogi Berra:

“Predictions are difficult, especially about the future.”

Precognition is not taught at any institution, yet investors continue to put their faith in economists and other experts whose predictions are no more accurate than anyone else’s. These same experts will privately admit that any apparent foresight on their part is purely coincidental, but the companies they work for want the publicity generated by bold statements. In publishing, while readers will forgive a columnist for being wrong (“early” or “late” is the weasel word preferred by pundits) subscribers won’t pay for vague opinions, or worse, no opinion.

The only real skill is in identifying investments with the best prospects and eliminating those with the worst.

Market timing aside, logic says the longer you can wait for an oil price recovery, the more likely you are to encounter one. You must, however, be prepared to wait as running out of patience can be expensive. Most investors are more risk-averse than they initially believe, but even steel-nerved investors may have little choice but to sell if they need cash to fund their retirement.

It’s a basic investment principle that young people can afford to take on more risk than old folks, since they have more earning years ahead of them and have more time for a depressed stock or sector to recover. Older investors are advised to keep more of their money in government bonds and GICs, since if their holdings go into a tailspin, there may not be time to wait for a rebound.

Along with financial health, physical health is also a factor in deciding whether to bet on a rebound. An energy sector recovery could take five years, for example, which means older investors have to stay healthy long enough to enjoy the benefit of an oil price recovery, unless they are simply hoping to enrich their heirs.

It’s clear that oil is in a glut situation, as members of the Organization of the Petroleum Exporting Countries (OPEC) have been unable to agree on production cuts and have even abandoned their traditional output ceiling. As well, once lifted, sanctions against Iran that had curtailed its oil exports will add this country’s considerable production to the oversupply problem.

Shares of energy companies and units of exchange-traded funds (ETFs) that focus on energy are trading at the lowest prices in years, and even relatively large producers have seen their market capitalizations shrink dramatically. Everything looks like a bargain, but some are bigger bargains than others.

For those who do have a high tolerance for risk and a thorough knowledge of crude oil pricing patterns (perhaps thanks to a long career in the energy industry) trading energy futures ought to bring huge rewards. For everyone else, however, energy futures are too risky.

For more conservative Canadian investors, the iShares S&P/TSX Capped Energy Index ETF (XEG/TSX) is an excellent way to position yourself for an energy sector recovery, since it is heavily weighted toward the largest and best capitalized companies, and its unit price has fallen.

The fund, launched in 2001, carries a management expense ratio of 0.61% and pays a varying quarterly dividend of about 2.5% to 3%. XEG holds stakes in 50 energy companies, with the top 10 accounting for about 75% of its assets. A full 26% of the fund is in Suncor Energy Inc. (SU/TSX), so its fortunes have a big influence on XEG’s returns. At the other end of the spectrum, tiny stakes in 40 different companies add up to just 25% of the fund.

Suncor’s shares, which traditionally fluctuate in the $35 to $40 range, have weathered the oil price slump nicely, falling just 2% in 2015. Another major holding in the fund, Imperial Oil Ltd. (IMO/TSX) has generated excellent total returns (dividends plus capital gains) over the long term, although its shares are less resistant to oil’s slump, having fallen more than 20% in the past year.

When their dividends are factored in, both Suncor and Imperial Oil are excellent choices for conservative investors prepared to hold for many years. The site www.longrundata.com, which factors in a company’s dividends and price fluctuations to come up with an annualized return, shows Suncor generating an annual total return of 3.9% over the past five years, while Imperial Oil did even better, at 4.2%. The returns improve over longer periods. Since January, 1996 (the earliest date available) www.longrundata.com shows Suncor shareholders have enjoyed an annualized return of 16.34%, turning a $1,000 investment made 20 years ago into $23,675. Imperial Oil shareholders earned 12.16% over the same period; a $1,000 investment in IMO in 1995 would be worth about $11,000 today.

XEG’s large holding in Suncor has done little to stem the effect of the oil price on the fund, and XEG’s unit price has fallen into bargain territory. At prices below $11, the XEG fund’s units would be near what legendary value investor John Templeton would call “maximum pessimism.”

(Templeton, you may recall, started his career in 1939 by buying $100 worth of all stocks trading for less than $1. He quadrupled his money in four years.)

Two other Canadian ETFs are tied to the energy sector. The tiny $35-million BMO Junior Oil ETF (ZJO/TSX) and the $25-million BMO Junior Gas ETF (ZJN/TSX), both launched in May, 2010, are each thinly traded, hold companies you’ve never heard of, and pay relatively small dividends just once a year, making them unsuitable for conservative investors.

In the United States, there are more than a dozen large exchange-traded funds that focus on energy. Some of these hold only the largest integrated producers, while others invest only in juniors, pipelines, or oil and gas services.

The largest energy ETF, the US$12-billion Energy Select Sector SPDR Fund (XLE/NYSE), launched in 1998, holds big stakes in several energy sector giants. The fund’s top 10 holdings, in descending order: Exxon Mobil Corp. (XOM/NYSE), Chevron Corp. (CVX/NYSE), Schlumberger NV (SLB/NYSE), EOG Resources Inc. (EOG/NYSE), Occidental Petroleum Corp. (OXY/NYSE), Kinder Morgan Inc.l (KMI/NYSE), ConocoPhillips (COP/NYSE), Pioneer Natural Resources Co. (PXD/NYSE), Valero Energy Corp. (VLO/NYSE) and Phillips 66 (PSX/NYSE). Together, these 10 stocks account for 64% of the fund’s assets.

Any U.S. investment exposes Canadians to currency risk. If you buy a U.S. ETF or stock and sell it at a time when the Canadian dollar is stronger than when you made your initial investment, either your gains will be eroded or your losses magnified. Since an oil price recovery would lift the loonie, buying what looks like a bargain-priced U.S. energy stock or ETF now means your U.S. energy holding may be worth less if and when oil recovers.

Two Texas-based energy-sector companies, however, have weathered the oil price slump: Pioneer Natural Resources and Valero Energy, which each account for about 3.5% of the Energy Select SPDR Fund.

Based in Irving, Texas, Pioneer produces oil and natural gas in Texas and Colorado, and has interests in six gas processing plants and eight treating facilities. Although its dividend is practically nonexistent, www. longrundata.com indicates Pioneer’s shareholders have enjoyed a 9.6% annualized return over the past five years, turning an initial US$1,000 investment into US$1,570 since early 2011, despite the falling oil price. A long-term chart of Pioneer indicates the shares represent good value at prices below the US$120 mark.

Valero Energy, based in San Antonio, Texas, is a US$34-billion oil refiner that makes and sells gasoline, diesel fuel, jet fuel, asphalt and ethanol. Over the past five years Valero’s shares have climbed steadily to about US$70, yet it still trades at a relatively modest 7.4 times earnings of US$9.51 per share. Valero’s dividend yields 2.8% and its total debt to equity is just 30%.

Figures from www.longrundata.com show Valero shareholders have reaped huge gains: annualized returns, including dividends over the past five years, have been 32.2%, which means an investment of US$1,000 made five years ago would now be worth more than US$4,000 today.

In summary, a conservative Canadian investor should decide how much to wager on an oil price recovery, then divide the total in three. Put one third in XEG, another third in Suncor and the last third in Valero Energy. Nobody knows when oil will recover, but XEG’s bargain price, Suncor’s long history of rewarding shareholders and Valero’s resistance to oil price fluctuations should position you reasonably well, even if it takes several years for the oil price to bounce back.

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